Page 444 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

430 The Complete Guide to Executive Compensation

a function of future stock price. It is without value only if the future market price is equal to
or less than the current price.
The stated number of shares is often the result of earlier use of exercise-cost, future-value,
or present-value methodology. Unfortunately, unless the stock price moves at a progression
similar to the other four elements, it will result in either over- or undervaluing this portion
of the pay program.
The stated percentage of total shares, as indicated earlier in this book, is a typical approach
for companies in the threshold stage, especially pre-IPO. It would not be atypical to give the
CEO a grant equal to 5 percent of the total shares optioned. However, as the company
matures it will shift to one of the other approaches described.
Updating guidelines is important. If the guidelines are not periodically adjusted, over time
their value relationship to other pay elements will change as a result of stock-price movement
relative to increases in the other pay elements. This changed relationship may be desirable,
but it should be planned and not the result of lack of review. Given the likelihood that stock-
price changes over time will not be a smooth progression, it would probably be inappropriate
to change the guidelines based on annual stock-price changes. However, it might be very
appropriate to adjust them annually, based on a trailing average of say three to five years,
thereby smoothing out annual swings. Yearly averages based on daily prices would be better
than simply taking a year-ending number.

Other Considerations. Having decided on an appropriate methodology to determine the
number of shares to be granted for the normal stock option grant, next consider other aspects
of the grant. These include performance and index options; in-lieu-of options; share-deposit
options; dividend rights; mega-grants; cancel-and-reissue grants; and option reloads. Let’s
take a look, starting with the performance and index grants.
If the stock option is tied to either a performance or index, as described earlier, it would
be logical to grant more shares than one would with a simple market-value grant, as the
former have higher exercise costs and therefore less appreciation opportunity per share. This
is illustrated in Table 8-18, where a grant at market value (i.e., $100 in this example) is
contrasted to grants with 5 percent and 10 percent appreciation rates (either as the result of
preset or indexed values). Look what happens after seven years if the stock is trading at $200
a share. An executive with an option on 10,000 shares at $100 a share has a paper profit of
$1,000,000 [i.e., ($200 $100) 10,000]. An optionee holding 10,000 at $140.71 a share
would have a paper profit of $592,900 [i.e., {$200 $140.71) 10,000], or $407,000, less
than the person with a grant at $100 a share. For a paper profit of $1,000,000, the second
optionee would have to have an option on 16,866 shares [i.e., $1,000,000 ($200
$140.71)]. The third optionee is in an even worse position, having a paper profit of
only $51,300 [i.e., ($200 $194.87) 10,000]. For a paper profit of $1,000,000, the third
optionee would need a grant of 194,932 shares [i.e., $1,000,000 ($200 $194.87)]. Thus,
in determining how many additional shares to grant, one must make an assumption on the
break even point in the future. For example, in year 10, if the price is $250 a share, 10,000
options at $100 would have an appreciation of $1,500,000 [i.e., ($250 $100) 10,000],
whereas the second optionee with a grant of 16,866 shares would have a paper profit of
$1,470,041 [i.e., ($250 $162.84) 16,866 shares]. The third optionee would have no gain,
since the option cost ($259.37) is greater than the market value ($250).
The point is simple: if market value increases faster than option cost, the option will
have value; the amount of value is dependent upon the degree of spread between the two