SINGAPORE (June 4): Last November, I wrote an article questioning whether existing stock option plans were good for shareholders. I have no doubt that the theoretical proposition is valid: that if the interests of senior management are aligned with those of shareholders through long-term incentives, they will work towards achieving a company’s strategic objectives to enhance value.

The question is whether the facts validate the proposition. And if they do not, why not?

Our quick analysis using the 30 component stocks of the Dow Jones Industrial Average failed to validate any relationship between the size of stock-based compensation and stock-price performance or the company’s profitability. Instead, it showed companies took on higher leverage or risks.

To quote from my earlier article, “If you give someone who has the authority to make investment and operational decisions an option to exercise if the stock price goes up, and there is no penalty if the company fails, would this person not take excessive risks? It is encouraging a one-way bet for executives, at shareholders’ expense. Worst still, stock options are often granted at a discount to market price.”

To avoid acrimony, I chose not to use data of Singapore and Malaysian companies, but I suspect the results would have been similar.

Why, then, does the evidence contradict a sound theoretical proposition? The answer, as always, lies in the details, the execution.

Almost all stock option plans I have reviewed have the following general features:

  • They are granted to management, at no cost to the employee;
  • The exercise period is usually within three to five years, and valid only as long as the grantee remains in the employment of the company (often as an inducement for the employee to stay in the company);
  • The exercise price for the options is agreed upon when the options are granted, and almost always at a discount to the prevailing stock market price; and
  • The size of the share option (the number of shares granted as an option to the staff) is agreed upon upfront, often based on seniority, as part of the total compensation package.
  • Given the above features, common in almost all stock option plans, it is easy to see why the outcomes are often contrary to the intent. The solution is, therefore, simple enough.

I believe you should do what you preach. Last month, shareholders of Avarga (previously UPP Holdings) approved a stock option plan that addressed some of the causes that limit the usefulness of stock option plan s. Specifically:

  • Bonuses for management are determined transparently, based on profits achieved in excess of the required rate of return on capital employed;
  • The required rate of return is, in turn, based on the risk-free rate plus risk premium. The risk-free rate reflects the overall market cost of funds. Risk premium, on the other hand, comprises a matrix of risk determinants (such as earnings sustainability, currency and country risks, operational risks), discussed and agreed upon at the beginning of each year by the risk committee and the board;
  • Further, the higher the financial leverage (of the balance sheet) of the company, the higher will be the overall required rate of return on capital employed, forcing maagement to use an optimal capital structure;
  • Once the bonus amount is determined for each staff, a percentage of this will be paid in stock options instead of cash. The more senior the person, the higher the portion that will be paid in stock options, up to a maximum of 50%;
  • The value for the options is based on the Black-Scholes options pricing model;
  • The options are valid for up to 10 years, and exercisable from Years Four to Seven, at a rate of 25% a year. It can be accumulated but can never be exercised in advance. The options remain valid until expiry, even if the employee is no longer with the company; and
  • The exercise price is fixed at market price when the options are approved.
In short, the options are not granted free to management but, in fact, paid by management from their entitled bonuses. Management, therefore, shares both the upside and downside of stock price performance.

It encourages management to focus on the longer term, succession planning and investing for sustainable earnings, and discourages overleveraging and excessive risk-taking.

It has the added advantage of reducing cash outflows, as half the bonuses will not be paid in cash and, when these options are exercised, it generates more cash for the company.

In terms of accounting entries, the value of the options will be expensed over the time of the vesting period, with the credit entry to reserves account under FRS 102.

Is the challenge really that simple to resolve? If so, surely many others would have already done so, or perhaps have applied other solutions.

It is possible that I got it wrong. Therefore, I would like to invite differing views and opposing arguments, and The Edge Singapore will make space to print any such opinions should you wish to expres them.

Tong Kooi Ong is chairman of The Edge Media Group, which owns The Edge Singapore

Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.

This article appeared in Issue 833 (June 4) of The Edge Singapore.

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