Boards Shorten Option Terms
11/01/04
Boards Alert
Companies are starting to replace their traditional 10-year option grants with options grants with options that expire substantially earlier. They’re doing so in anticipation of stock option expensing, and also because of pressure from governance activists who want to see less stock dilution.
In recent months, Alcoa and Reebok shortened their option grants from 10 years to six. They join other companies, such as Lucent, 3Com and Hyperion, that began granting five-to seven-year options in 2002 and 2003. And compensation consultants say they’re examining the issue with an increasing number of clients.
“There is some discussion on that now, whereas it was taken for granted befor that it was automatically 10 years,” says Paul Dorf, managing director of consultancy Compensation Resources.
So far, 10-year options are still by far the norm. But alternatives are becoming ever more popular. According to research firm Equilar, 74.1% of option grants made in July were for 10 years. By comparison, 10-year grants made up 81% of all grants in 2003. Almost 10% of grants this July had seven year terms, while five-and six-year grants accounted for around 3% each. Last year, seven-year grants made up less than 7% of the total. The figures for five- and six-year grants are largely unchanged.
A major reason for the change is that the length of an option grant will have an effect on the charge a company must take to earnings.
In March, FASB suggested that it viewed the lattice model as the best way to estimate the value of an option. Under the model, the accounting cost to a company of the option decreases as its term gets shorter because there’s less time for its value to rise before it must exercised. A similar principle holds with the more common Black-Scholes model. While the final rules on option expensing aren’t clear, experts agree that some type of mandatory expensing in likely next year.
Another advantage to shorter option grants is that they can help reduce overhang. Overhang is the ratio of options granted plus options remaining to grant to total shares outstanding. When overhang rises, many investors get fearful because it can lead to a dilution of their share ownership if those options are exercised.
That’s why proxy advisor Institutional Shareholder Services and other governance activists set limits for the amount of overhang they’ll tolerate before voting against a comp plan. ISS, for example, doesn’t like to see a company’s overhang levels substantially exceed those of its competitors in a given industry.
Furthermore, since the stock market crash in 2000, many companies have been sitting on lots of underwater options, whose value is below the exercise price. Those options likely won’t be exercised, but their existence leads to high overhang numbers. By shortening the life of option grants, companies hope to prevent this problem in the future. Making six-year grants instead of 10-year ones gets hopelessly underwater stock options out of the system four years earlier.
“If you had a seven-year term, they’re going to expire more quickly, so they’re going to come out of your dilution analysis more quickly,” says Mike Sorenson, a senior consultant with Hewitt Associates.
The pressure to comply with the parameters of ISS and its counterpart, Glass Lewis, is increasing. Mutual funds must now disclose their proxy voting policies. Since many funds don’t have the resources to investigate each issue, they’re simply following proxy advisors’ recommendations.
That fact helped push Hyperion to issue six-year options, says Linda Snyder, the firm’s director of investor relations. “Almost all of our shares are held by institutional investors, and more and more of them are deferring their votes to organizations like ISS,” she says.
One irony of stock option valuations is that, while shortening the term of a grant can significantly reduce its cost to the company, employees don’t tend to see a concomitant loss in value. They’re more likely to focus on the absolute number of options received rather than on the loss of a few years’ earning potential.
But there’s a limit to how short companies can reasonably make their option grants. Most grants vest in equal chunks over three or four years. Once that’s over, executives need time to plan their finances. For top officers, it’s even more complicated because they’re not allowed to trade their company stock during certain periods, such as in the fun-up to an earnings release.
That’s why Jan Koors, a managing director with comp consultancy Pearl Meyer & Partners, says six years is the shortest option grant that’s really feasible. “With blackout periods and the number of times that they can’t exercise, you’ve got to give [executives] sufficient time after the option has vested to exercise it,” she says.
