SHARE options were widely used during Zimbabwe’s hyperinflationary period as a means of retaining senior executives.
Opinion by Brett Chulu
This is how share options work. A company gives a qualifying employee the right to buy in future a fixed number of shares at a fixed price. This fixed price is known as the exercise or strike price. Normally, the qualifying employee has to wait for at least three years from the date of grant before they can exercise this right. Ordinarily, when share options vest (become exercisable), the market price of shares is expected to have risen above the exercise price. When upon vesting the market price is higher than the exercise price the share options are said to be in the money. When the converse subsists, the share options are said to be under water. Thus when the share options are in the money, the employee can elect to exercise their right, as provided for in the share option agreement, and buy the shares at the lower exercise price and resell at the higher open market price. The employee cashes in the difference between the higher market and lower exercise price, net of tax and administrative charges.
Hyperinflationary period legacy
During hyperinflation, share options were guaranteed to be in the money. This had nothing to do with the company’s performance. As long as you were listed on the Zimbabwe Stock Exchange your company shares were guaranteed growth, albeit inflationary. Thus in reality, it did not make sense for share options granted during hyperinflation to have performance preconditions attached. To do so would be practically meaningless.
When we transitioned to the dollarised regime, serious challenges associated with share options surfaced to give boards headaches. Exercise prices had been fixed in Zimbabwe dollars. Now these had to be translated to US dollar terms.
The question became which exchange rate to use, the official or the ‘open market’ read ‘black market’? Using the official exchange rate would practically mean unreasonably high exercise prices, meaning it would be next to impossible for share options to be in the money. Use of the ‘open market’ exchange rate was equally challenging. Though an ‘open market’ rate would give lower exercise prices, the fact ‘open market’ rates were not officially documented made it difficult for boards to accept them as a basis for re-evaluating exercise prices. Even the use of an implied exchange rate based on comparing the share prices of dually-listed shares was equally problematic. Granted ‘open market’ exchange rates would give lower exercise prices as compared to the official exchange rate, the challenge was to convincingly counter accusations of setting too low an exercise price, which would make it easy for revalued share options to be in the money.
Perhaps dually-listed firms can argue that they can use the fair value of share options determined from the country of additional listing. That argument might be slightly plausible if the shares on both stock exchanges are fully fungible. This argument would be water-tight if the primary listing of the Zimbabwean company is not in Zimbabwe. If that is the case, it would make sense to use the discounting rates taken from the foreign Treasury Bill (TB) market. In cases where the primary listing is in Zimbabwe, taking discounting rates from the TB market of the country of secondary listing is not justifiable, even if the shares are fully fungible.
Share options in Zimbabwe suffer from a fundamental technical hitch.
As a pre-requisite to implementing a share option scheme, a company must estimate the fair value of the options being granted. This fair value is needed for accounting and financial reporting purposes. As it is practically impossible to determine the exact future open market price of shares, an acceptable method to estimate the future value of options is needed. Fortunately, from a technical perspective that problem was solved long ago. Two generally accepted valuation models for share options are the Black-Scholes and the lattice models (also known as the binomial valuation method). The Black-Scholes model is widely used in what is known as the European-style options, while the lattice model is widely used in American-style options. These two models use sophisticated financial mathematics modeling. One aspect common to these valuation models is the use of what is known as present values. The norm is to use a discounting factor to arrive at the present value of options. That discounting factor is generally taken to be the TB rate with a lifespan similar to the share options.
Since dollarisation of the Zimbabwean economy in February 2009, we have not, until late last year had an active TB market, which in many respects has not been fully embraced by the financial market. Without a fully mature TB market, it is virtually impossible for a company to pick a discounting rate that will qualify as credible to value its share options.
What makes the share options environment even the more untenable is the fact that the TB market the Reserve Bank of Zimbabwe is trying to resurrect is offering short-dated paper. Longer-term TBs of at least three years are needed to enable Zimbabwean companies mulling the introduction of share options to use the long-dated TB rate as a basis to input into either the Black-Scholes or the lattice share option valuation model.
These current challenges bring us to share options that were granted post February 2009.
A few Zimbabwe Stock Exchange-listed companies offered new share options in 2010, apparently to replace those that had been granted during the hyper-inflationary period. Given that two of the fundamental pillars of corporate governance are fairness and transparency, the new share options had to have a new fair value calculated. How was this value arrived at in the absence of an active TB market? We need not confuse the strike or exercise price with fair value. The strike price is set at the time of granting the share options and the current market price, as per accepted practice, is set as the strike price. Though the strike price is determined by the open market, it is not the fair value of the option. The fair value of an option is a future value to be estimated using probability or stochastic modeling. The point really, is the company cannot use the strike price as the fair value—it’s simply plain wrong.
So the questions remain: How did companies that gave share options post February 2009 arrive at a fair value that is needed for accounting purposes? Which discounting rate did they employ and where did they get it from?
Even if the discounting rate challenge was to vanish, there is still the challenge of liquidity. Where does one find the cash to exercise their options rights, given that companies are cash-hungry for recapitalisation?
Share options should be deferred until we have a fully operational TB market and improved liquidity.
Reflect on it
Talented people do not leave the organisation, they leave the manager. How can you apply this insight to your organisation to strengthen your retention strategies?
- Chulu is a strategic HR consultant who has worked with both listed and unlisted companies. — firstname.lastname@example.org.