Friday, May 01, 2009

Long Term Incentive and the Black Box of Employee Stock options

Compensation of employees can broadly be divided into 3 buckets – Base Salary (fixed cash component of the salary including basic, HRA etc), Short term Incentive (aka Bonus, Variable pay, Performance driven pay), Long term Incentive (Restricted Stock/Restricted Stock Units, Stock Options). Total Rewards approach includes other elements like Benefits (Healthcare, Retirement etc) and Career development opportunities as a part of the total offering. Total Rewards is a big topic and merits separate discussion. In this article we shall focus more on Long Term Incentive (LTI) and specifically understand more about Employee Stock options. Long Term Incentive is more popular for compensating and rewarding Middle & Senior Management and Top Executives because their performance has a more direct impact on stockholder value creation. Infact, as a rule of thumb, more senior one grows in the organization, more will be the proportion of LTI in Total compensation package. The proportion of various elements also varies according to geography and culture besides the company philosophy towards compensation. As a general observation, for top executives of the company, LTI might be as high as 30%-40% of total compensation while for a middle manager, it might be around 12-15% of total compensation.

Stock Awards can be in the form of Restricted Stock or Restricted Stock Units depending on local regulations and company policy. There is a minor difference between Restricted Stock and Restricted Stock units. While grant of Restricted Stock means that the receiver holds actual stock of the company with a vesting period and restrictions applying for that vesting period (hence the name Restricted Stock), grant of Restricted Stock Units means a grant of promise by the company to award Stock at the end of vesting period. The receiver of units does not actually hold stock during the vesting period and hence may not receive any dividend and may not have any voting rights arising out of ownership in the company (depending upon the actual company plan). Taxation of LTI varies from country to country and is out of scope of this article.

Employee Stock Options are considered to be riskier than regular restricted stock/stock units. They give the receiver a right to buy stock of the company at a predetermined price (called grant or strike or exercise price) during a fixed time window. Employee Stock options are essentially ‘Call' options. 'Call' options have an upside potential linked to increase in stock price as against 'Put' options which have upside potential linked to fall in stock price. The aim of compensation is to incentivize managers to work in interests of stockholders hence the grant of 'Call' options. Usually Employee Stock options have a life of 10 years from the date of issue and can be exercised during this life once they are vested. Both Stock Award and Stock options can have cliff vesting (when entire grant vests after the specified vesting period) or graded vesting( when the grant vests in equal annual installments over vesting period). The Options can be tradable or non tradable. Usually the Employee Stock options are non tradable with some exceptions (Google and Novartis are 2 companies I know which grant Tradable Options). If stock price is lower than exercise price, options are said to be under water and if they are non tradable, they are worthless for the holder of options (even if vested). On the other hand Tradable options can be sold to a market maker (who perceives that share price might go up in future during lifetime of options) once they are vested. Hence tradable options might fetch some money to the holder despite being underwater. Tradable options are said to have intrinsic value ( difference between stock price and exercise price if positive, otherwise zero) as well as time value as against non tradable options which only have intrinsic value

There are various models that can be applied for valuation of options with the prominent ones being Trinomial model and Black Scholes model. There are various factors that impact the value of options. These are –
1) Grant/Strike/Exercise Price
2) Actual Stock Price
3) Option Life
4) Estimated future volatility of stock
5) Riskless Interest Rate
6) Dividend Yield Ratio

We shall not go into the mathematics of Black Scholes model but try to understand the impact of all these factors on value of Employee Stock options.
1) Grant/Strike/Exercise Price – As obvious, lower is the grant price, more will be the value of options


2) Actual Stock Price – Value of options increases with increase in exercise price. However, as mentioned earlier, in case of non tradable options, the value of options remains zero unless the stock price is more than exercise price.


3) Option Life – Option life is directly proportional to value of options. This derives from the fact that options give one flexibility to buy stock later in the lifetime of options. Holder of options can park the money in Riskless Instruments (such as Treasury bonds) during the life of options and earn interest on that. More is the life of options, more is the time available to defer buying the actual stock, greater is the opportunity to earn interest from riskless investments and hence more valuable options are.


4) Estimated future volatility of Stocks – Options of more volatile shares are more valuable. Let us try to understand this. High estimated future volatility means high probability of stock price moving up or down from current level. Higher Stock Price in future creates more value for Option holder (which is virtually unlimited as it will keep increasing with increase in share price). On the other hand, if share price falls lower (to any level below or equal to exercise price), the value of options will still be zero. Employee Stock options have unlimited upward potential but limited downside (worst case – options are not utilized so zero value). Hence more volatility makes options more valueable.


5) Riskless Interest Rates – Value of Employee Stock options increases with increase in Riskless Interest Rates. As mentioned in ‘Option Life’, higher Riskless interest rates present greater opportunity to earn by holding options instead of actual stock hence the value of options goes up with riskless interest rates.


6) Dividend Yield Ratio – It means dividend granted to Stock holders as a proportion of Stock Price. This can also be seen as ROI of Stock. The value of options goes down with higher Dividend yield ratio. Increase in dividend yield ratio over say last year can mean 2 things – either dividend (numerator) has increased or Stock price (denominator) has decreased. Stock Price decrease will anyway pull the value of options down (see point 2 above). The option holder does not receive any dividend as against a Stock holder who does receive dividend. Therefore, by holding options instead of Stock, the holder is suffering a loss of dividends. Hence more is the dividend yield ratio, lesser is the value of options.

Some companies do offer a choice to its employees between choosing options or stock or a combination of both as LTI. Though understanding the Restricted Stock grant is straightforward, generally option valuation is a Black box for employees as well as HR (left mostly to Compensation). Educating employees about high risk involved with options and how they are valued can help employees make an informed choice about their LTI composition depending on individual appetite for risk. In addition, having a better understanding of how value of options is modeled can significantly lessen employee resentment if they see the value of their options going down. If understood and deployed properly (performance based shares, performance based vesting, performance based multipliers etc), LTI can be very effective tool in achieving its purpose of resolving principal agent conflict.

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