Share options are said to be 'underwater' when exercise prices
are higher than the current share price. The plans may also carry a
condition that options can only be exercised when the company hits
certain targets – targets that now seem unachievable. When markets
turn south and staff can't cash in their options, share plans look
bad.
It’s important to remember, though, that it is still worth doing
something to motivate and reward your staff, and still worth doing
it with shares. A 'dash to cash' – beefing up annual bonus
potential, for example – might look attractive; but that will
involve cash leaving the business and it is unlikely to lead to a
long-term tie-in for key staff.
The first thing to do is to engage with the company's owners –
the investors. Investors normally set a 'dilution limit' that caps
the number of shares a company can use for its share plans. If they
flex the dilution limit, this gives companies more scope to address
the underwater options.
Whether investors are prepared to be flexible, of course, will
depend on their outlook. Investors are quite rigid around dilution
issues – this is the cost to the investor of a share plan. However,
in some cases investors can see the benefit of having share plans
that provide an effective incentive, even if this means some extra
dilution.
One possibility is to amend existing performance conditions to
more realistic targets, allowing existing share awards to vest.
While this is possible, it’s a course likely to be followed by
relatively few companies. Investors need to be persuaded that
employees should be rewarded, even though targets have not been
achieved.
There could be an advantage in making new awards but
surrendering existing underwater options. This gives employees new
awards granted at current share prices – which are typically lower
– with the potential for future growth. Surrendering existing
options makes more shares available for such awards but investors
need to be persuaded to allow this flexibility, and they may not
always be sympathetic to employees being able to 'start again' when
this isn't available to the investors. Companies also need to work
through the accounting consequences when they go down this
route.
When investors aren't prepared to give any additional
flexibility to a company, the company has to use what it has, in
terms of shares available. It can make new awards, but stick within
current dilution limits.
It may still be possible for companies to do quite a lot within
these parameters. For example, if share plans aim to reward renewed
growth from a new, lower share price, relatively fewer shares may
be needed to deliver meaningful rewards.
Now may be the time to review allocation policies. Are companies
spreading their share incentives too widely – and should grants be
more carefully targeted at those individuals who are going to be
key in delivering the company's strategy?
Granting awards more frequently can also give employees a range
of option prices and vesting dates and removes some of the
randomness involved with share options where a lot of the value
depends on the initial share price at one option grant.
Also, you can manage available dilution. This can include what's
known as 'budgeting' – using fixed numbers of shares for grants,
rather than grants based on multiples of an individual's salary
where share numbers get determined by share prices at award.
So there are ways to offer executives and employees continued
incentives, and to keep key staff involved in the long term,
without seeing cash leave the business – even in challenging
economic times.
By Rory Cray. Rory is a partner specialising in share
plans at Pinsent Masons, the law firm behind OUT-LAW.COM. He
will be among the speakers at a forthcoming Share Plans
Roadshow taking place this week in London, Birmingham,
Leeds and Manchester. See: Full
details.
