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Share options: performance questions galore

SHAREHOLDERS of listed retail concern, OK Zimbabwe Ltd, were last Wednesday due to approve a share option scheme for 2010 comprising 49 120 000 ordinary shares.

This plan is “replacing” the one approved in September 2008 warehousing 52 230 000 ordinary shares.
The number of options being dangled at OK’s senior executives and management will rise to 101 350 000 in just under two years. 
It seems share options have become trendy of late. Concerning the appropriateness of share options as “please-stay” tools, a number of questions beg for satisfactory answers.
A share option is a forward contract giving a qualifying employee a right (not an obligation) to buy shares at a future date at a fixed price (called exercise price).
From the get-go we have to be very clear. Performance management is bi-coordinate, namely standards and commensurate reward/consequence. This brings us to our first question. Does it make business sense to grant options to senior executives at a time the stock market is heavily under-performing?
There is general optimism that Zimbabwe’s economy will rebound in the near future and thus share prices are expected to rise too. Exercise prices for share options are traditionally established at ruling market prices. In a depressed capital market like ours, granting options is tantamount to handing shares at give-away prices. With the Zimbabwe Stock Exchange having shed 23% of market capitalisation from its January max out, a gutsy and on-the-ball investor can snap “bargain” shares and use a humdrum strategy to profit: buy low, sell high. As the economy recovers, spending power increases and listed companies benefit from the umbrella recovery. As share prices glide, the value of the options (the difference between the fixed exercise price and the fair value of the share) rises in echo. Arguably, executives cannot legitimately take credit for that increase. If anything, a general improvement in economic fundamentals, outside the orbit of the executive’s influence is the honey-maker. Under such circumstances, what is the business case for giving executives share options?
Benefitting under this scenario equates rewarding presence rather than essence, loyalty ahead of performance.
These are the sort of issues shareholders should be raising before blessing share option schemes.
To minimise rewarding mediocrity, a remuneration committee (Remco) with a deep knowledge of performance management should be involved. Naturally, HR professionals who are performance experts (combining deep knowledge of standards-setting, remuneration and business) should be consulted. Sadly, at present, HR professionals with such a profile are hard to come by. Nevertheless, competent Remcos should craft performance standards that are part and parcel of vesting conditions. To avoid turning share options into free-rider schemes, a Remco should demand the fulfillment of at least three conditions.
First, a Remco may demand that the percentage share price movement over the entire vesting period be above the 75th percentile (among the top 25%) to see how executives are “keeping up with the Joneses”. Second, the Remco may demand that the return on equity for the performance period, excluding one-off revenues exceed the weighted average cost of capital to clearly demonstrate that each dollar invested by the ordinary shareholder is creating value.  Third, delivery of the non-financial agenda such as customer, employee satisfaction, reputational ranking and environmental responsibility should form part of the vesting conditions.
More important, the Remco should debate the appropriateness of share options under recessionary conditions.
In my opinion, share options are not appropriate under a depressed economic environment, but more fitting under a very competitive market regime where executives have to stretch intellectual capital to plot business survival. What informs my thinking is, should the market price at the time when the options vest fall below the exercise price, qualifying  executives are not obliged to buy the shares since the options contract gives a right and not an obligation. They will simply defer exercise until the share price climbs high enough to make a killing. If executives are genuinely optimistic about future economic conditions, buying the shares now at fair value unequivocally demonstrates that buoyancy. In the case of OK Zimbabwe Ltd, assuming the combined 101 350 000 shares are still to be exercised and have an exercise price of 7,5 cents per share, a 100% share price ascent yields net wealth touching a lip smacking US$7, 6 million. A 100% share price climb within a three-year horizon is realistic. You would not want to give away such wealth to reward just sitting behind an oak desk, gleefully waiting to piggy-back on a prophesied economic upswing.
The second principal question is how, under economic doldrums, will the executives finance their costly options upon vesting? Is it not possible that they will be “loaned” the shares and use profits from reselling at fair value to “purchase” the options? At what rate will the “loan” be repaid? What is the taxman’s take? These are the issues schemes should address beforehand.
A third fundamental question is: how are the exercise prices being determined? Share option schemes should have in-built, pre-emptive early warning mechanisms to detect deliberate manipulation of bear market (stock market with tumbling prices) episodes to fix rock-bottom exercise prices.  Business rationality demands paying the right price. From a performance management standpoint you would want to reward both the right results and right behaviour.  As the excess of the fair market value over the fixed exercise price is what is expensed, it is in the best interest of business not to accept “inflated” expenses arising from a porous performance management system — granting options in a bear market being a case in point. Re-pricing of options should be considered to increase the exercise price to correct “suspiciously low” exercise prices. Such re-pricing practice is allowed. However, a legal expert who should be part of a balanced Remco should give apt advice.
The fourth principal question revolves around the possible redenomination of our currency in 2012. Vesting periods typically span three years. Share options granted in 2010 may vest in 2012. This ushers an element of exchange rate risk, which can work either in favour or to the detriment of the options contract parties. An option, being a contract, are provisions being made to clearly specify who will bear the risk of a change in exchange rate, with respect to options granted under the US dollar regime?  As this can snowball into financial and reputational risk, a competent Remco should budget for this risk event.
Finally, is a three-year vesting period long enough for senior executives to create meaningful value? In my opinion, short-tenured share options risk becoming get-rich-quick schemes. The idea of “career shares” is being mooted to reflect the ultimate value an executive creates during their entire career.
Share options are more than just a “please-please-don’t-go” scheme. Presence and essence must meet.
Telescope bits
UK’s revised corporate governance code, renamed UK Code from Combined Code, came into effect in June. Are share options appropriate given current uncertain economic situation? Share at brettchulu@consultant.com.

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