Of late, stock option plans have come under fire. If managers are granted share options which they later exercise, this increases costs and reduces profits. According to a study by Merrill Lynch, the US investment bank, in 2001 profits would have been 21% lower for the 500 largest US companies, and 39% lower for those corporations listed on the NASDAQ technology exchange had options costs been factored into the equation. Most programmes are too expensive and thus fly in the face of shareholder interests. In Germany, too, or so a study we did at Union Investment shows, only a few of the options programmes run by DAX-listed companies satisfy appropriate quality standards.
Notwithstanding the daily fluctuations, share prices are the most practicable yardstick for rating joint stock corporations. Day-in day-out, market plays scrutinise the business prospects of a company. And thus, on a daily basis, the stock exchange price seeks to identify the company’s ‘real’ value. By contrast, variables that are subject to interpretation and can be flexibly adjusted to meet the goals of top management are less suitable for measuring the quality of a company. In other words, anyone who shares the conviction that markets tend to be right, as opposed to books that have been cosmetically touched up or mere verbal promises of future prospects, will certainly recognise the advantages of taking share prices as a gauge of success.
Stock option plans (SOPs) can bring management and shareholders interests into line with each other.
Traditionally, a manager’s remuneration is based on the company’s size. Board members of a company with more than 100,000 employees would normally receive a higher salary than those of a company with only 1,000 employees. Shareholders, on the other hand, do not focus on the size of the company, but on how the value of their shares performs. A remuneration system based on share price would therefore eliminate this classic ‘principal/agent conflict’, as management (the agent) would increasingly pursue the goals of the shareholders (the principals). A few rules must be adhered to if stock option plans are to effectively synchronise the aims of managers with those of the shareholders. In particular, it is important to prevent any opportunities for abuse.
Rule 1: Set ambitious targets
If the price at which an option can be exercised is set too low, top managers receive an inappropriately high bonus in addition to their fixed salaries. This cannot be in the interests of the shareholders, and so it is important to dangle the carrot from higher up. The minimum annual return set should exceed risk-free interest plus a risk premium. Given the interest rate for Bunds (at present at approximately 5%), and a realistic 3% risk premium for shareholders, the current increase needed for stock options to be put would be at least 8% and managers would not lock into additional income until ‘their’ shares substantially clear that 8% hurdle. A quick glance at the 27 DAX members who run stock option plans reveals that only one company, namely Adidas, satisfies this 8% criterion. By contrast, a third of DAX-listed companies have settled for exercise points of a ludicrously low level of less than 3% annually.
Rule 2: Only reward above-
average success
The price of a share depends on both market trends as a whole, and the quality of management. It should therefore only be possible to exercise stock options if the share’s price outperforms competitors. To this end, suitable sector indices should preferably be consulted. This would avoid windfall profits – say from a national stock market bull or a boom in a particular sector – being considered. Better still, the company itself could define a group of important competitors and measures the performance of its own shares against these.
Rule 3: Disclose costs
The stock option plans of most companies are not adequately represented in financial statements – the reasoning is that the costs do not impact on cash and cash equivalents. But this argument does not hold water: Stock options are a salary component. Salaries are costs. And costs should be included in any income statement – as otherwise the company’s actual profitability remains concealed.
Rule 4: Long-term orientation
Shareholders are interested in a sustained increase in value of their shares. As such, incentive systems for stock option plans should be given a longer-term gearing. The options should be locked up for a period of five years. Unfortunately, those who benefited from most DAX option plans were able to exercise their options after only two years. Such short deadlines tend to support a take-the-money-and-run mentality.
Furthermore, it is important to prevent coincidences at the launch and exercising dates. Those who start out on a SOP when the share price is exceptionally low (due to a low point in an economic cycle or extensive restructuring) should not be able to use these price dips as the starting point for the calculation. Instead, longer-term average prices covering a period of several months should be taken. Average prices are also to be recommended when exercising options. This avoids there being any temptation to fake a great success shortly before exercising options. For example, a board member who is about to leave the company could drive the share price artificially high ready to exercise his options and thus maximise their value.
Rule 5: Careful use of options
Ideally, all employees help to raise the value of ‘their’ company. Nevertheless, only a handful of managers have any significant influence on the company. Stock option plans should thus be deliberately focused on the most important decision makers.
Although share-price oriented incentives make sense below top management level, traditional employee shares are a more suitable instrument and easier to handle. The US Citibank is one of the pioneers in a system of broader employee participation. Here, monitors placed in corridors show employees the actual value of ‘their’ shares. In this way the entire staff are constantly kept aware of how much their performance contributes to the success of the company.
Rule 6: No ‘help-yourself’ approach
Stock options offer their receivers a win-win scenario. The shareholder, by contrast, bears the full risk associated with the company. If the share price increases, the option owner benefits. If the share price falls, the option is worthless – but the risk remains within narrow limits. For this reason it is imperative that the option bearers also do their bit. In other words, the options should not just be granted ‘on top’. In Germany, Lufthansa, for example, has set the right example here. Lufthansa managers can buy ‘their airline’ shares at a 20% discount, in other words they have to pay 80% of the Lufthansa share price out of their own pockets. At the same time, they receive an option that results in additional remuneration only if the Lufthansa equity outperforms those of important competitors.
As long as the basic rules are obeyed, stock option plans can to a certain extent solve the conflict of interests between shareholders and staff. Nevertheless, it is necessary to prevent an abuse of plans, with managers simply ‘helping themselves’ to profits on the back of short-term cosmetic changes in earnings or long-term goals which lack ambition. One should not lose track of the overall pay such managers take home. Fixed salary levels have to be set lower with a highly variable remuneration system hinging on stock options. At the end of the day, it is preferable to not have a stock option plan than to adopt a bad one.
Rolf Drees is director of corporate communication at Union Investment in Frankfurt