Page 428 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

414 The Complete Guide to Executive Compensation

with the SEC before proceeding. The advantage of market models compared with academic
formulas is that market models result in significantly lower valuations which translates into
lower charges to the earnings statement. But there is a downside.
The auction system for valuing stock options has an inverse relationship between
acquired capital and earnings. A high stock price results in a favorable increase in capital for
the company, but also reduced earnings because of a high expense charge. The reverse is true
with a low price for stock sold in the auction: less capital received, but higher earnings.
FAS 123R makes it clear that stock options are an expense to the corporation and must be
reflected in the income statement. But this is really a double whammy to earnings per share
(EPS) because the number of shares outstanding is increased when the option is exercised. In
other words, there is a decrease in the numerator and an increase in the denominator. This is
the real cost of stock options. To the extent that EPS is a reflector of stock price, the double
whammy is felt by the stockholders.
Optionee Eligibility

Executives. Who should receive a stock option? Typically, options are given to the CEO and
other highly positioned executives. Beyond that, as with short-term incentive plans, candidates
may be determined by base salary, job title, job grade (or job evaluation points), organization
level, a banding of comparable level positions, or on a job-by-job selection basis. The degree
of organization penetration from the CEO down is normally not as deep as with short-term
incentives (except for previously described broad-based plans), although the extent of cover-
age is a function of corporate objectives. Very limited participation corresponds to the view
that only a limited few can have sufficient impact on corporate earnings.
Rather broad coverage is consistent with a desire to place a large number of executives and
managers “at risk” with stock price and thus more closely associated with other shareholders.
Admittedly, individuals further down in the organization may not have the same impact on
corporate performance, but they may be more interested in effecting economies and improv-
ing performance if they are part owners. The price for broader coverage is greater dilution
to shareholder equity since more shares must be placed under option and, in accord with FAS
123R, greater company expense. (Broad-based plans were reviewed in Chapter 5.)
If the company has a broad-based stock-option plan (extending eligibility to many if not
virtually all employees in the organization), it must determine whether or not those execu-
tives selected for key grants should be included. The argument for inclusion of executives is
that a broad-based plan is by definition an all-employee program. The argument for exclu-
sion is that executives have their own plan and therefore should not be greedy. In addition,
exclusion permits shares that would have been granted to executives to be available for the
all-employee grant).

Other Eligible Employees. Additionally, companies might make a grant to new hires as a
hiring incentive, perhaps to offset in part forfeited future compensation from previous
employment. Stock option grants may also be made to an employee for an outstanding
contribution and/or future potential. Table 8-7 shows a possible array of performance and
future potential ratings. In this example, the two ratings are added together for a combined
score. For example, a “very good” performance (value of 2) and an “excellent” promotability
assessment (value of 2) would be added together for a rating of 4. These will be used later
when we review size of the stock option grant.