| Greater Philadelphia Chapter October 12, 2024 | |
| Redefining Stock Option Compensation by Robert M. Flood, III, CLU, ChFC, MSFS Westport Worldwide Over the last few months, many companies (i.e., Coke, The Washington Post, Cendant, General Motors, Procter & Gamble and Allstate) broke with traditional ranks and decided to begin expensing their employee stock options on their income statements. Warren Buffet and his disciples were long-time proponents of companies recording their stock based compensation on their income statements as apposed to locating them deep in their financial footnotes in the companies annual reports. Today, some companies are even contemplating reducing stock option grants and opting for more traditional compensation methods to reward senior management for meeting their performance targets and goals. Despite the negative publicity and corporate malfeasances, stock options are still considered by many compensation experts a valuable tool to reward, attract and retain a companys top executive talent and motivate them to exceed their peak performance levels. A key goal of implementing stock options should be to align senior managements productivity and performance to the long-term success of the company compared to the current practice of short-term quarter-by quarter financial results. Modifying stock option vesting provisions with longer-term time horizons and higher or premium exercise prices of 40%-50% over the current market price when issued should provide more harmony between senior management, shareholders, employees and corporate boards. In order to maximize the benefits of premium options senior management needs to make profitable investment decisions and convince the financial markets its companys intrinsic value is worth more than its current value. It is important for the management of a company to be encouraged by growth. Restructuring stock options should minimize senior managements pressure to massage the short-term financial results for their own self-aggrandizing reasons. Companies that are pulling back from stock option based compensation are factoring in the short-term fluctuations of the financial markets and are looking for traditional alternatives (i.e., bonus or incentive payments). Stock options are a form of performance pay and if the companys stock performs, the executives are paid. Alternatively, a companys stock price increasing or decreasing may not be tied to the operating performance of the company but rather by overall external market conditions. Therefore, a companys stock performance may not necessarily be driven by operating performance. In todays business and economic climate, shareholders desire operating performance irrespective of short-term stock price. A compensation program based on operating performance will align shareholders and executives interests for the long-term growth of the company. Implementing an operating performance based compensation plan may be designed to include stock options, cash or bonus plans. Typically operating performance is measured by income or loss measured by the companys financials. Going forward investors, have stronger incentives to know the number of stock options issued or replaced, to whom they are issued and in what magnitudes, all contributing to more efficient equity markets. Investors should know if a companys stock options are expensed or if they will be expensed in the future. More importantly if the options are expensed what is the valuation method selected for establishing their values. Several reasonable valuation methods exist but with different effects on corporate earnings. The current state of the economy, recent corporate scandals and legislative backlash appear to be driving forces for change in business and accounting practices. The efficiency of equity markets will definitely be enhanced by rigorous enforcement of old and new regulatory legislation. Stock options no doubt will be affected by this change. It is still too early to diagnose the major fall-out from the current environment but it is fare to assume that the mega awards of stock options and special arrangements to benefit executives are gone the way of the dinosaurs. It is back to the basics to reward and incent senior management. What is wrong with that? The following is an example of the Advantages and Disadvantages of a long-term Non-Qualified Stock Option plan from both the Employee and Company Point-of-View.Employee: Pros If market price eventually rises above 'strike' price, employees options are in the money Gain at sale over market price at exercise is taxed at long-term capital gains rates Cons If market price fall below 'strike' price, employees options are 'under water' Requires cash investment in the company The difference between market price and 'strike' price at time of exercise is taxed at ordinary income tax rates Company Pros Under APB 25, there is no charge to earnings as long as options are granted at full market value Options are tied to a vesting schedule, encouraging retention When exercised, company gets a tax deduction Cons Dilution If market price falls below 'strike' price, employees options are 'under water' and lose their retention value _______________________________________________________________________________ Back to KeyFacts Main Page |
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