The Real Issues Behind Stock Options

Financial News, March 30, 2003 | Go to article overview

The Real Issues Behind Stock Options


Byline: Christian Strenger

The abuse of stock option plans in management remuneration has been a significant setback for the capital markets, and not only in the US. The greed of managers combined with a lax and fashion-driven approach to grants by their boards are the origins of this development. One proposed solution to the malaise, which has been heavily lobbied, is the immediate and mandatory expensing of options through the profit and loss account.However, this rather inexact proposal of the International Accounting Standards Board (IASB) leaves companies to their own devices to calculate "fair value" and hardly provides shareholders and the market with a fully-fledged, convincing solution.

Although some option grants of the bubble years were obscene, one should not ignore the magnitude of the issue for the investment universe: recent calculations show expensing stock options would not result in dramatic changes in earnings per share (less than 10% for large US companies and only 3% to 4% for their European counterparts).

Nevertheless, more convincing ways should be found to avoid unreasonable executive compensation than the reliance on mandatory expensing of options as "ex-post" remedy. What is required are better "ex-ante" processes and methods to produce fair long-term incentives for executives.

The proposal for an immediate P&L-charge at grant date leads to a double impact on earnings per share. Apart from the immediate dilution effect generally attributed by the market to the new shares under option, the second impact is the immediate and unconditional charge on profits - although there is no sufficient likelihood of this happening in the future. Given the stock market developments of the past three years and modest expectations for a recovery, too many of the granted options expire worthless. An immediate, unconditional expense despite substantial vesting periods, other future-related conditions and share prices well below the original exercise price, would thus affect earnings without sufficient tangible reason.

In reality, the entitled executives enter into a wager with their shareholders. Once the vesting period is over and executives have fulfilled this additional piece of contractual service, they can earn additional money by acquiring the relevant amount of shares in cash at the exercise price.

This is the full price at grant date when the executives have been awarded the option rights. If this happens, the company receives the full consideration for the new shares. The company does not have a negative profit and loss-impact or a cash outflow; it rather enjoys the cash payments for the newly-issued shares. …

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