THIS is a follow-up article on the challenge of introducing share options in our presently subdued economic environment.
The Human Capital Telescope with Brett Chulu
Last week, we looked at how the absence of a fully mature Treasury Bill (TB) market makes it impossible for companies to arrive at accepted fair values of options.
This article zeroes in on the impact of low market-to-book values on share options pricing and governance.
In a share option scheme, a listed company grants a qualifying employee, normally managerial and executive, the right to buy a fixed number of shares in future at a fixed price. This fixed price is known as the exercise price.
Normally, the qualifying employee has to wait for at least three years from the date of grant before they can exercise this right.
This is called the vesting period. Let’s say the exercise price is set at US$1 per share, and if after three years the share price rises to US$2, the qualifying options grantee can elect to exercise their right to buy at US$1 and resell at US$2, making a pretax profit of US$1 per share.
From a talent management standpoint, it is hoped the lure of possible significant future financial gain will tie qualifying talented employees to commit to the organisation for at least the duration equivalent to the vesting period. Nowadays, share option schemes are designed in such a way that options are granted piecemeal, effectively luring talented employees to commit even much longer.
A majority of shares on the Zimbabwe Stock Exchange (ZSE) are trading well below their net asset book values, with some priced at close to half their net asset book values. Under normal economic conditions, listed shares should trade above their net asset book values.
Share prices tailing below net asset book values are a reflection of lack of confidence by investors in the future performance of companies due to an extremely uncertain operating environment.
If this negative outlook persists, we should expect shares to continue trading below their fundamental intrinsic values. Such a scenario poses a practical challenge on the setting of exercise prices for share options.
Accepted practice in setting exercise prices is to take the prevailing market price of shares at the time of granting share options. The argument for using prevailing market prices as exercise prices is premised on the logic that the prices of shares in the open market is based on pure economic forces and thus constitute a rationally determined price free from manipulation.
This is extremely important, from an investor’s standpoint for two reasons.
First, share options dilute existing shareholding and thus shareholders cringe at the prospect of executives being given perceived easily attainable performance targets. Second, setting an exercise price using an arbitrary method invites the perception of exercise prices set conveniently low.
Since share options are based on the idea that employees whose actions and decisions influence share price growth, profiting from a general improvement in sentiment outside the influence of senior executives and managers is deemed unfair.
Thus perceived low exercise prices tend to be viewed as making it difficult to isolate the share price movement attributable to general improvement in sentiment such as improving country risk-rating from purely managerial interventions.
It should not be very difficult to see why current share prices on the ZSE should not be used to determine exercise prices—these shares are heavily undervalued.
Exercise prices based on share prices valued below net asset book values, though based on supposedly free market forces, are not appropriate. This is because these undervalued shares are so due to factors largely outside the influence of the strategic and operational choices of a company’s senior talent. In light of this, a fundamental challenge arises.
If exercise prices for share options were to be based on undervalued market values, would improvement in share price to match net asset book value justify an executive profiting from this share-price improvement? Let’s put this into perspective.
A company listed on the ZSE chooses to grant share options based on a current share price that is 50% below its net asset book value.
Three years down the line, the share price improves to 5% below net asset book value. If under such as highly possible scenario an executive is allowed to exercise their options, what is being rewarded here? Does it make sense to reward improvement in performance that fails to improve the market value of shares beyond their intrinsic value? Even if the improvement would result in share prices matching book value, the challenge of justifying rewarding executives with share options remains.
Even if, in addition to a vesting period, individual and corporate performance preconditions were to be attached and met, the challenge of undervalued shares would still persist. You wouldn’t want to reward improved performance that does not result in share prices exceeding their net asset book value.
Share options are not the only share-based incentives available to companies listed on the ZSE. Under the current operating environment share options are not appropriate from financial, corporate governance and technical perspectives.
Listed companies can consider alternative share-based incentives.
For instance, restricted share performance schemes could be introduced. Under restricted share performance schemes, shares are granted when performance preconditions such as reaching a preset earnings per share (EPS) target within a specified performance period. Restricted share performance shares are free from the hassle of stakeholders sparring over the appropriateness of exercise prices.
It is expected that executives granted restricted performance shares will hold onto their shares for as long as possible, hoping the market will eventually value shares upwards of the current depressed values. No rational shareholder can cry foul since the executive is not going to benefit from a guaranteed exercise price.
That way restricted performance shares can, to a large extent contribute to retaining talented executives while satisfying the scrutiny of corporate governance watchdogs and inquisitive shareholders.
Reflect on it
A strong employer brand is a powerful source of attracting and retaining talent. What non-financial interventions can you apply to your organisation to attract and retain top talent?
Chulu is a strategic HR consultant who has worked with both listed and unlisted companies. — firstname.lastname@example.org.'