Practice of stock option granting not all it’s cracked up to be.
During the tech bubble employees and founders were given options as both compensation and incentive and because it helped conserve that cash of these start-up companies. These are all very acceptable reasons for options. Today, however, the granting of options has simply got out of hand, for even though similar circumstances to those that are related below existed during the tech bubble, they were not on the grand scale they are today.
Just about every company has a vote at its annual or special meeting to consider some aspect of its stock option plan, generally increasing the number of options to be issued or ratifying the allocation of all unallocated options, and so on. The overall objective of the company is to MAXIMIZE the number of options it has available to grant TO INSIDERS, to the 10% maximum permitted under regulation. Companies have even devised “Rolling” plans, whereby the 10% maximum is constantly renewed without further shareholder proxy!
So, companies strive to ensure this maximum option-granting capability is available to them at all times, and this might not be such a bad thing if the next two negatives did not then come in to play.
One negative is the simple fact that many of these companies are compensating their senior officers with really good salaries and, in addition, they reward them with cash bonuses (although sometimes the latter are not accompanied by deserving financial or operational performance for the shareholders). Options are not a layer of reward that is vital if both of the former income factors are present.
However, one must remember that options are meant to be an upfront incentive for good future performance emanating from the senior officers’ own performance. They could, therefore, be thrown into the mix of rewards but where this falls down is related to the second negative. Let us give an example (but honestly acknowledge that not all companies do this… only the majority!)
ABC Company is a junior metals explorer. It, like the start-up tech companies, wants to conserve cash and induce and reward good performance from its senior officers. Today the shares trade at 40 cents and within a few days management will announce it has granted options to certain officers at the 40 cent price, with a mandatory four-month hold, and either vesting over a period or all at once.
On the face of it this might seem reasonable (it is certainly legal), but time so frequently proves that what the company is doing is granting a risk-free, or negligible risk, reward to its officers. Goodness, the current “regulations” also allow the company to grant options AT A DISCOUNT to the prevailing share price: This simply increases the aspect of risk-free rewards.
Granting options at less that a minimum percentage above yesterday’s price is hardly an incentive for continuous good performance in the medium term and beyond. The option has to be a real carrot on a stick: It has to be a target at least a little higher than the prevailing share price to be an inducement to good managerial performance.
Furthermore, no one can tell me that every grant of options is done without regard for insider information; information that may become public in a week or month but information that is not in the public realm today. The four-month hold is irrelevant if that news is significant to any extent, and who tracks if anyone might actually be shorting options? To verify the coincidence of option grants and ensuing “good news,” simply track a few option announcements and see for yourself.
This is not just a question of negligible risk/reward to those being granted CHEAP options but it also means less money goes into the treasury than should be the case, so the idea of a company conserving cash with the grant of options actually has a dark side for future shareholders. But hold on. Shareholders aren’t crying “foul!” And why should they when the stock price is going in the right direction! So let the insiders feather their own nests, just as long they feather mine, is the rule we wish to live by, is it?
Yes, it is, and this is exactly why this process persists, but I say, despite this cycle of economic gain, it is wrong.
For starters, the price of an option needs to reflect its intent of being both inducement to good performance and reward for same. It should, therefore, ALWAYS be priced at a premium, such as 5% more than the closing price at the date of grant or 5% over the average 60-day close, whichever is greater. There should also be an automatic escalating pricing element attached to reflect upward movement in the actual share price in the first 30 or even 60 days after grant, thus reinforcing the long-term performance required to “earn” the option. Options should have a life no more than (say) three years and the issue of options at a lower price should be barred for at least two of those years from the date of grant: If managers perform they earn the option during its term and, if not, the original option expires but they may then be given new, lower-priced options (but only after the two-year period).
Not all companies abuse options but I personally can record only one in the last year that issued options at a true premium or has an incremental price action attached. Then, of course, there were those recently uncovered examples of backdated options, clearly demonstrating insiders’ propensity to flout the system, even within large, blue-chip companies. Indeed, everything indicates that security regulations should be changed and regulator scrutiny must be enhanced because, quite simply, the current approach is dead wrong.
This author was written by a member of the Stockhouse community.
