Stock options as performance incentive: Good or bad? - www.stockhouse.com - Malcolm Haynes - June 20, 2008

DW - This is from a blog entry by a Stockhouse.com member.  Interesting point of view..

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.