Page 445 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

Chapter 8. Long-Term Incentives 431

Variable Cost Based
on Appreciation
Year Fixed Cost 5% 10%
10 $100.00 $162.84 $259.37
9 100.00 155.13 235.80
8 100.00 147.75 214.36
7 100.00 140.71 194.87
6 100.00 134.01 177.16
5 100.00 137.63 161.05
4 100.00 121.55 146.40
3 100.00 115.76 131.10
2 100.00 110.25 121.00
1 100.00 105.00 110.00
0 100.00 100.00 100.00

Table 8-18. Comparisons of fixed vs. variable option prices
growth rates. If market value increases more slowly than option price, there will be no
appreciation gain.
One solution is to increase the number of shares covered by the option by the same per-
centage as the increase in option price. Thus, in year 10, the 10,000-share option would have
increased to 16,284 (5 percent increase) or 25,937 (10 percent increase). The extent the option
was worth anything would still be a result of how much market price exceeded option price.
Another type of performance stock option is where the option price and number of
shares are unchanged. However, the option is not exercisable unless certain prescribed
financial targets have been met (e.g., a compound 15 percent increase in EPS beginning
after year three of the grant). A variation of this would be to introduce step targets (e.g.,
25 percent of the option for a compound 15 percent increase, 50 percent for 15 percent,
75 percent for 17.5 percent, and 100 percent for 20 percent or more).
The same type of analysis can be done for the more conservative one-time, premium-
adjustment grant. For example, if the premium were $5 for all years on a grant with fair
market value of $100 on grant date, the adjustment would be far less dramatic. In our
example, it would require 10,526 shares to equate to the $200 price with a $1,000,000 paper
gain after seven years [i.e., $1,000,000 divided by ($200 $105)]. If the balance point is a
$250 share price, it would require 10,345 shares with a $1,500,000 paper gain after 10 years
[i.e., $1,500,000 divided by ($250 $105)].
Capped-price stock options can significantly reduce the expense charge under an option
pricing model. It forces the exercise of the stock option when FMV reaches a certain price
(e.g., $125 on a $100 stock-price grant).
In-lieu-of options are in addition to normal stock option grants. The company decides to
permit executives to elect to forego a salary increase, receiving instead a stock option, prob-
ably a 10-year grant priced at current market value. A simple approach would be to equate
the present value of a salary adjustment with the present value of a 10-year, nondiscounted
stock option. It could be argued that the lost value of a salary increase to a 25-year-old is
substantially greater than for a 55-year-old, assuming both stay to age 65—perhaps a low