Page 438 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

424 The Complete Guide to Executive Compensation

price of two shares was indexed at 10 percent, the gain would only be $28.49 (i.e., $174.90
minus $146.41), or $56.98. Compare this with the $74.90 gain over a $100 fixed-price stock
option. Conversely, if the grant were indexed at 5 percent, the premium-priced option would
be worth $53.35 (i.e., $174.90 $121.55), or $106.70 for the two shares. This is $31.80 more
than one fixed-price option at $100 a share (i.e., $106.70 $74.90).
Stock Split. When a company makes a stock split, option prices must reflect the action. For
example, a two-for-one split should halve the price because the number of shares will be
doubled. The net effect is that the cost to exercise the total option is the same.
Number of Shares. While broad-based stock option plans (see Chapter 5) may grant the
same number of shares to all candidates, key person grants typically give the most shares to
the chair/CEO and then proportionately reduce the number as the program cascades down
through the organization. Determining the number of shares to give under option to each
executive defines the absolute amount of opportunity for appreciation for that executive
and the amount relative to other executives. The most shares are given to the CEO, while
executives at lower levels of management get successively smaller numbers of shares.
Classically, the CEO receives not only more shares than the next job down but also a greater
award relative to compensation.
Methodology. Essentially, seven possible methods may be used to determine the number
of shares: exercise cost, historical value, intrinsic value, future value, present value, stated
number of shares, and stated percentage of total shares.
The exercise-cost method, sometimes called investment cost, has historically been the most
prevalent method, although its popularity has dramatically decreased for reasons that will be
reviewed. The number of shares granted multiplied by the price per share equals the exercise
cost (or investment cost). If an option for 10,000 shares were granted at an option price of
$100 a share, the cost would be $1 million. Since the size of the grant is relative to pay,
the cost method requires assigning a value to pay to determine the size of the grant. More
specifically, pay times multiple divided by stock price equals the number of shares to be granted.
It is rather easy to determine a competitive multiple for a CEO using proxy data from
comparison companies. Multiply the number of shares granted by the grant price and divide
by the CEO’s salary—all three are reported in the proxy. The result is the stock option
multiple. Additional surveys and studies are available from consultants and others reporting
multiples at various pay levels. The old rule of thumb was that the cost to exercise the
annual grant should be equal to the CEO’s salary. However, today it is not unusual to see
exercise costs exceeding five times or more salary-plus-bonus.
Logically, the multiple for salary is higher than that for salary-plus-bonus (proportionate
to the ratio of salary alone to salary-plus-bonus). When using such data, it is useful to know
whether the average represented is the mean or the median; the former is often easier to
calculate, but it is subject to influence by a limited number of very high or low values.
Logically, reported multiples are subject to pressure to decrease during periods of falling
stock prices and to increase during periods of rising prices. Furthermore, higher multiples
are more typical of mature companies than of their growth counterparts (i.e., the lower the
presumed potential for increase, the higher the multiple).
In addition, an attempt should be made to separate companies relying solely on stock
options from those who combine stock options with other forms of long-term incentive
compensation. Presumably, the multiples for the first would be higher than the second. If the