NZSA Best Practice

Policy Guideline: Share Options for Management.

1. Preamble
Many New Zealand companies have share option programmes for management and directors, and the association from time to time may have to express a view on such option programmes, and as such it is considered appropriate to set out the associations view in general terms of such issues.

2. What is a share option?
In effect a share option is:

an entitlement granted by a company to another party, to acquire shares in the company at a price determined now with settlement some time in the future with the right exercisable at the option of the party other than the company.

3. Are options valuable?
An options value is driven by the exercise price and the time that the option has to run until the last possible date upon which it has to be exercised.

4. Do options granted have a cost?
No cost is recorded in the company's accounts. However the cost of an option to shareholders is the dilution of the ownership stake which can be valued with reference to the difference between the current market price of the company's shares, and the options strike price.

5. Why do companies grant options?
There are three primary factors that give rise to the grant of options:

Incentive programmes for management to add shareholder value by aligning management and owners interests, which are then in theory the identical objective of increasing share price, and/or

Locking in key management, as options are often designed to operate as a lock in programme, and/or

Disguised remuneration.

6. Are options universally the best means of providing management incentives?
It is widely accepted that for incentive programmes to be effective, the incentive offered should have a close correlation to the performance criteria set for the employee in question. Likewise the pre-requisites for deriving the incentive should be in the control of the manager or employee in question. While it is clear that options are appropriate for senior management, they are not universally the best means for rewarding other members of a team, as the individual efforts will not necessarily have any effect on the share price. In many instances targeted cash bonuses provide a better incentive.

7. When are options considered to be an appropriate method for rewarding management?
Set out below is a table of possibilities:

8. When options are appropriate, what principals should be applied in granting & reporting option arrangements?
(a) Where an option programme exists, the cost associated with all options on issue should be reported in the notes to the accounts, by reporting the movement in the total value of all outstanding options on issue in the relevant period, and adjusting this movement for the cost of shares issued at a discount to the then prevailing market price pursuant to such option contracts.

Let's take an example:

At the commencement of a period, a company has 1 million options on issue, with a strike price of $1.50 per share, and the market price at the commencement of the period is $1.60 per share.
During the year the company issues a further 500,000 options at a price of $1.75 and 200,000 options are exercised when the market price at the time of exercise was $2.10. A further 100,000 of the earlier options are cancelled and forfeited. The market price at the end of the year is $2.00 per share.
At the beginning of the year, the market value of all outstanding options is as follows -
1Million x ($1.60 - $1.50) = $100,000.00
At the end of the year the options outstanding and the market value of those options are as follows - 700,000 x ($2.00 - $1.50) = $350,000.00
500,000 x ($2.00 - $1.75) = $125,000.00
Total value of outstanding options at the end of period: $475,000.00
The value of options exercised during the year amounts to the following:
200,000 x $2.10 - $1.50 = $120,000.00
In this circumstance the cost to the owners of the business of option programmes during the period consists of:
$475,000 + $120,000 - $100,000 = $395,000.00

(b) Where options are granted to individuals and such options include an element of concealed salary, the options held by any such individuals should be separately disclosed with a full analysis as set out in example one above, by each such employee.

(c) Where options are issued at current market price (ie. they are not in the money), and the strike price is set with reference to the cost of equity over time, it will be presumed that there is no element of concealed salary.

(d) Setting the market price at the time of the grant, the price should be the higher of the spot price on the day the options are created, or the 90-day moving and weighted average price for the share. Markets are manic, and a fair market value will only emerge from such markets over time. It is also important not to be seen as granting options that are in the money, hence the higher of the two formulas should be applied.

(e) In setting the cost of equity, reference should be taken to the opportunity cost of equity, plus a risk premium. It is considered that the opportunity cost of equity is the prevailing 10 year bond rate at the time of issue, and that the equity risk premium is a relatively constant 7%, but this premium can be assessed by examining the market capitilisations and implicit yields of stocks listed within a particular market. On this basis, the cost of equity is, in our view, approximately 13% per annum at the time of this publication.

(f) Dividends paid during the option term should be deducted from the strike price as they have in part compensated the owners for their cost in equity. Let's take an example:

Current market price $1.00 per share
Weighted 90 day average $1.10 per share
Annual dividends 8c per share
Cost of equity 13%
Earliest exercise date 1 year
Latest exercise date 5 years.

Based on this example the strike price on these options would ratchet up as follows over the term over the option contract:
End year 1: $1.16 per share
End year 2: $1.23 per share
End year 3: $1.32 per share
End year 4: $1.41 per share
End year 5: $1.51 per share

(g) The terms of the option package should include adjustment provisions to deal with bonus issues, rights issues, returns of capital, share splits and consolidations and the objective of such provisions should be to ensure the equitable stake created as a percentage of the total shares outstanding is preserved, and that the contracted price to be paid for that stake remains constant.

(h) In recognition of the fact that options programmes generally result in management selling out the shares created under such programmes, almost immediately, the generosity of such programmes to specific individuals, should be curtailed. The objective should be that the number of shares created under such programmes doesn't distort the market upon such options being exercised. To this end, the maturity date for options should be staggered to ensure that options maturing on any given day do not exceed more that 20% of the long term average daily volume.

If options granted exceed this threshold, then there should be a requirement within the option contract to ensure that the options upon exercise result in the shares acquired being held in escrow. ie. Not transferable immediately. This restricted period should be not less that 3 months and thereafter 10% of the available total holding should be made available for sale resulting in a total freeing of the shares over a 15 month period following the options exercise date.

In all circumstances the total number of options issued, whether exercised or not, shall not exceed more than 10% of the total capital on issue, and no more than 2% per annum of the total issued capital should be made available in any 12 month period, in both cases, shareholder consents for exceptions should be required.

(i) In recognition of the fact that options are intended as incentive to existing management to drive current performance, option packages should:

(a) Be non-assignable
(b) Should require that options be exercised in full within 3 months of resignation, or dismissal for cause, and if not exercised, should be cancelled.
(c) Upon redundancy, retirement or dismissal that is determined to be improper, the board should have sufficient flexibility to negotiate a commercial settlement.

9. Conclusion

Options programmes created by companies for which such programmes are appropriate, and which include features such as those set out above, will generally be supported by the New Zealand Shareholders' Association provided that such programmes are commercial and fair to all parties involved in the business.

Where companies for which option programmes are inappropriate wish to develop incentive programme based on share price, we would suggest that it be done other than by way of a share option programme. Such companies will generally have the ability to pay cash rewards. The payment of cash rewards provides a tax deduction to the payer and neutrality to the recipient. Option programmes provide no tax deduction to the company, and accessibility to the recipient. On this basis alone, cash rewards provide better results to shareholders. Such rewards could be calculated on the basis of share price and a shadow share option programme.