Page 137 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

Chapter 4. The Stakeholders 123

Overhang, or potential dilution, is calculated by adding the total number of shares available
for award/grant to the unvested stock awards and unexercised stock options, and dividing by
the total number of shares outstanding, using the above-described treasury stock method.
Further increasing the numerator with the addition of shares requested for use (and the same
denominator) equals total potential dilution. Once the options have been exercised, forfeited,
or lapsed, and the restrictions removed from the stock award, they are no longer included in
the numerator and, if exercised, are now in the denominator outstanding (having been added
to the shares outstanding), thereby having a two-fold dampening effect on future dilution
calculations.
With ever increasing overhang percentages, companies are mortgaging more and more
of their future with stock-option plans. Companies that buy back optioned shares are doing
so at a price. Namely, they are selling low and buying back high. It also means the proceeds
are unavailable for investment purposes.
Shareholders traditionally vote on additional stock requests for executive pay in terms of
the 5-10 rule. If the increase in dilution over 10 years is 5 percent or under, vote “yes” (there-
by assuming 1/2 percent a year use); if it is more than 5 percent but less than 10 percent, look
to its terms before deciding to vote for or against the proposal; and if 10 percent or more,
vote “no.” With the increased use of company stock throughout the organization, the annu-
al rate is more like 1 to 2 percent. Therefore, many argue for a new 10-20 rule, with the same
actions applying to now higher percentages. Furthermore, companies in the threshold
market stage may have percentages twice as high because of their heavy reliance on stock
option plans.
To oversimplify, shareholders prefer indexed and performance-priced stock options to
option prices locked in at time of grant. In addition, they do not like stock options that are
either repriced or reloaded with new options after exercise. They do not like stock awards
without performance vesting features but do like such awards based on increases in share-
holder value. They typically do not like internally based financial performance plans that do
not take into account shareholder value. However, if they had a choice, they would prefer
some form of economic profit plan (that would require income to exceed the cost of capital
before any incentive payments could begin) to a performance-unit or similar type financial
plan. This is illustrated in Table 4-6.

Type Plan Dislike Like

External (market) Reloaded and repriced Indexed and performance-
stock options priced stock options
Plain stock awards Shareholder value awards
Internal (financial) Performance units Economic profit
Table 4-6. Shareholder interest in incentive plans

Investment Decisions
Some say that to make money buying and selling stock, you only have to be right 60 percent
of the time. Why then does an investor decide to buy stock of a particular company? While
different reasons motivate different investors, high on the list has to be the belief of a good
return on investment, either short and/or long term, through dividends and/or stock-price