Share options: demystified context and uses

Many share option plans in both the investment markets and employment markets are misunderstood, misused, and don’t deliver for at least one, if not both parties, what they expected.

This is the basic jargon:

What is an option? The right to buy or sell something at some future point in time.

What is a share? A proportionate interest in the assets owned by a company with the rights attached to that proportionate interest.

What is a put option? An option to sell something.

What is a call option? An option to buy something.

What is a share warrant? Another name for an option to buy, in other words, a call option. The term is generally used to differentiate investment grade options from employee and employment options.

What is an employee Share option? It is a call option granted by a company to call upon the company to issue shares (i.e., sell shares) to an employee.

What is an issuer? In this context, the party granting an option and, in the case of a share, the seller of the share.

What is a holder? In the context of an option, the person who holds it for its exercise or not. In the context of a share, the owner of that share.

What does the term exercised (or exercise) mean? That the holder of an option chooses to settle the consideration and take delivery of the asset.

What does the term vesting mean? The conditions that must be satisfied for the issuer’s benefit before the option becomes exercisable by the holder. If such conditions are not met, the option lapses or is cancelled.

What does liquidity mean? When a holder wants to sell, buyers buy what they want to sell at a fair price. Liquidity exists when buyer demand equals seller supply.

What is meant by the term Bull market? Generally, prices are rising. This is usually because there are more buyers for an asset than there are sellers wishing to sell for an extended period of time. Bull markets price the same earnings or assets at a higher price, making the cost of raising capital less for the company if they are raising money.

What is meant by the term Bear market? The opposite of a bull market, meaning there are more sellers of an asset than there are buyers.

Bull markets generally have high liquidity, and bear markets have low liquidity whether shares are listed on an exchange or otherwise.

Use of options in the market

• Most options are call options.
• Put options are sometimes used as part of a security arrangement that allows the holder of shares to convert their equity position into a debt position or cash. They are more common in situations where there is poor liquidity in the markets where the underlying asset trades.
• Options are not always described as such, but they are very common commercial instruments. For example, a conditional contract to buy a property is a call option. If the conditions are for the benefit of the vendor, e.g., buying another property before the vendor will sell to you, it is a put option.

Options are very common and not necessarily presented in the language of options. However, this article will focus on the use of options in share transactions and capital markets.

What is the fundamental value or cost of an option?

Let us start with the cost. There is a lot of accounting nonsense on Option valuations, and it is complex as hell, but it doesn’t get to the basics of it, and the numbers they produce don’t mean much at all, if anything, to real people.

Fundamentally, the cost to a company is the difference between the proposed exercise price of the option and the fair market value of the shares if issued today, plus the value of the time deferment before the holder has to pay the issue price.

If the option is not exercised prior to expiry, there is no cost nor value to either party. If it is exercised, it is usually only because it has value to the holder, i.e., the share price or value is greater than the exercise price.

For example, if an investor holds 10,000 options at $1 and, exercises those options and pays the company $10,000, and if the company could have issued those shares at fair market value on the day of exercise at $3 per share, the company has suffered a loss of $20,000. And each shareholder, other than the option holder, has suffered their proportion of that loss.

There are a number of decision makers around option transactions: the company, the shareholders, and the option holders. Each assess the value of these transactions, and each will have a different view. If the view is too wide, arguments may ensue.

At the outset, there is one common shared belief: The venture will succeed, and the share price will go up. It is counterintuitive for investors to invest in something that they think will fail and for companies to issue investment instruments believing that it will fail. Of course, all identify that it might fail; that is called risk.

Motivations and perceptions of warrants

Most warrants are for a fixed price, a fixed term, and a defined exercise date. It is rare for warrants to have conditions or vesting terms attached to them. Some warrants, in the context of succession planning, will have formulaic exercise prices. But at this point, I will ignore that complexity.

It usually starts with a company that wants to raise capital or a shareholder who wishes to sell shares.

The usual backdrop for the use of warrants:

• An inability to agree on a buy-now price and the company not wanting to lower the current share price. Often due to angst from existing shareholders or other commercial matters. For example, a debt-to-market value of an equity covenant with a lender. Another example is that employee share options are outstanding, and they want to keep the options in the money to keep the team motivated. And;
• The company is struggling to raise capital from its existing shareholders.

In short, the company wants a premium over what it can get in the marketplace today for the issue of shares, and it grants warrants as a means to discount that price.

The size of the discount is, from the company’s point of view, effectively its cost of capital over the term to the date of exercise.

So, let’s take an example. The company issues one share for $1 today and grants the investor a warrant to buy one additional share at the same price in three year’s time. Let’s also assume that the company’s cost of capital is 10%, or at least the board believes that is the company’s cost of capital!

In that case, the warrant has a Net present value to the company today of 75c, assuming it is exercised, which will only occur if the shares are still worth $1 or more in three years.

If the company had instead issued two shares for a combined price of $1.75, the company would have been in the same position. In effect, the first share has been discounted by 12.5c and the true price of the shares in the company is 87.5c.

What the company gets out of this structure is a higher headline price for its equity and offers investors an invisible discount to obtain cash now, along with the chance of a captive investor in three years’ time giving them more, which is useful in a fast-growing company.

What do the shareholders get and suffer? Firstly, they run the risk of getting more cash over three years than they actually need and thus becoming overdiluted, i.e., two shares are issued instead of one. They surrender upside share price gains from two shares instead of one.

What does the new investor get? The new investor is the most optimistic; he has to be, as he is parting with cash. He will see a bigger discount than the company or the shareholders. For example, he may believe the share price will be $2 in three years. He sees his discount on the second share as a full $1, which is 50c a share across both.

Based on the buyer’s inflated view of future value, he perceives fair value at 50c and thinks that is what he paid. The seller perceives they got a fair value of 87.5c, and the company received $1. A wide spread of perception masks the true price and the emotions around that.

These differences in perception of value are common in illiquid markets.

So, to sum up, a share warrant is just a discount to the issue price of the share bought on day one. How each party analyses this consciously or subconsciously is consistent, they are all valuing the discount.

If you are an investor or a shareholder, ask yourself this: if the company has to discount in a sublime manner such as this, is the company worth investing in?

In terms of my involvement as a Director, I rarely use warrants to raise capital for this reason; the signal is that we lack confidence in our headline price. I have, however, used warrants in rights issues to existing shareholders.

Having said this, I have, as an investor, bought shares with warrants attached. In short, I overvalued the discount I was getting and the risk I was taking, and bugger it, I should know what I am doing! In the three cases I did so, the companies failed. Small anecdotal sample for sure.

How, as an investor, do you value such companies when options or warrants are outstanding?

If I own shares in a company that has granted warrants, I will first add the total warrants to the number of shares issued to arrive at the total claims on the equity of the business (this is called a fully diluted valuation). I will then add the amount payable if the warrant is exercised to the value of the company and restate the share price.

I generally only do this when the warrant is in the money, i.e., the share price or value is above the exercise price. If the options are in the money, I will assume they are all exercised; however, the reality is not all are. Similar to voucher vending companies. With investor warrants the exercise rate is quite high, around 90% if in the money.

So should investors or, for that matter, boards factor this into their valuation of the company?

Don’t assume that investors are stupid, distracted, or unable to pay the price to exercise options.

When you are valuing to buy (or hold), you want to assess the lowest valuation that will ever occur in these circumstances, and then you can make a call on the premium that you can pay or request above that.

Assumptions about stupidity are usually wrong, and stupid assumptions make for stupid decisions.

Recording the earnings effect

In my simple world, I would accrue the initial discount, if any, and add to the cost each year the cost of capital at a constant rate. When they expire, mark the options to the market price of the share when issued and adjust the cost out or in at the end, based on how many warrants are exercised, and shares are actually issued. This however does not align with International Financial Reporting Standards (IFRS).

Employee share option plans

This is where capital market practice, and shareholder and investor behaviour, converge with worker behaviour and motivations, intermingled with operational management of people (HR).

They are useful in bull markets, albeit expensive compared to cash if you have it. However, they tend to build up risk to the company, usually manifesting in a bear market.

The primary difference of substance between options and warrants is the vesting conditions that must be satisfied prior to the options granted becoming exercisable.

 Current HR practices or beliefs that drive some of these conditions

• There is a belief that some businesses have to offer equity just to get people, i.e., the candidates want equity.
• There is a belief that by offering equity, you get better employee engagement, create a deeper sense of belonging, and get employees to behave like owners.
• There is a belief that equity plans share the benefits of success well with the team and act well as a long-term incentive.
• There is a belief that incentives, short and long term (STI/LTI), are useful to lead tactical behaviours, and reward people for doing what is needed short term. LTI is used to guide the team to achieve the big goals in the long term.

These beliefs then result in the designing of the vesting conditions.

Some option plans have vesting conditions based on short term deliverables that are individually targeted. This is a classic STI design. It was more common in times when the fashion was to incent individual behaviours. It is more common these days to use collective performance metrics, e.g. sales, customer numbers, margin profit and so on for the whole team (these are sometimes also used in LTI metrics). This is at least an attempt to align incentives with the metrics that measure strategic success. Now, even this level of targeting is not that common. Instead, the board forms the view that the share price will reflect all these things anyway.

The most common vesting condition is survivorship, i.e., staying the distance.

So why are these options granted based on time rather than success in most businesses?

The first motivation is that the ESOP (Employee Stock/Share Ownership Plan) has to look like everyone else’s or else the talent won’t be able to compare you and make an informed choice i.e., the fear of looking bad, fear of missing out, herd behaviour. All emotions driven by fear rather than confidence. Hence my instinct finds such motivation weak in terms of signalling a winning opportunity.

The second is a bit more rational. If you hire the right people and have great HR processes for driving performance, frankly, just keeping them is the fundamental thing you want to do. As a result, vesting conditions are used almost exclusively now as retention tools.

The third is even more rational, you haven’t got the cash to pay what someone is worth, so you need to pay more in absolute terms and have a big chunk of it at risk. The economics of this exchange, in terms of the company’s cost, are the same as for warrants.

In short, the terms of the option are bought by the employee from the company with a salary forfeiture. The upside return on that salary forfeiture is the gain on the equity value of the business above the exercise price.

And the final factor is another assumption: that the share price will reflect the performance of the business, and thus, value success.

So, fundamentally, options or equity are just a different way to buy people mixed up with raising capital. The key thing to understand is the cost and what you get in return no matter which seat you are sitting in at the table (not unlike warrants but with three dimensions instead of two).

Know your numbers before you negotiate.

First up, you should start with an assessment of the position you are hiring for based on a total employment cost basis to determine what you would have got to part with in cash to acquire the talent you need. Let’s say that is $300,000 (base, STI and LTI, everything).

Let’s say your current share value is $1.05 and assume your cost of capital is the average market cost of capital for the market in general, i.e. the risk-free rate plus the equity premium, which makes 12% p.a. Let’s also assume you plan to issue this candidate 120,000 options (40,000 a year) for three years at a strike price of 80c and post vesting which is, over three years, a 10-year exercise period (i.e., a total deferment of 13 years).

So, the discount to current market price is $30,000. The amount payable, in up to 13 years, is $96,000 to exercise the options. The compound interest on $96,000 for 13 years amounts to $323,000. That is an at-risk portion of the total salary of $117,000 p.a. for three years. On that basis, the base benefits and salary package, including any cash incentives, should not exceed $183k.

What if you have to pay more in cash and give the same number of options?

What, in effect, is that hire saying to you economically?

It means he and you believe that the forward rate of return is lower than the average for the market as a whole. Hardly an optimistic stance. Now, of course, both will be optimistic and probably the most optimistic will be the shareholders and the existing owners, especially if more shareholders are buying than selling (a bull market). So, if, in fact, you all believe that the company is great and yet you have to pay more than you want to, it’s counterintuitive.

It means you either misjudged the market price of the talent, or the shares, or the board are useless negotiators.

But what else do shareholders get? Retention.

If the employees cease to work in the business and leave, they lose the forward options that are not vested and usually have to stump up the $96k and the tax on the difference or fold and lose everything.

Now, everyone in the room, the company, the multiple shareholders, and the aspiring executives will all believe the company over 13 years will produce more than 12%.

Rationally, the shareholders should prefer the board to pay cash instead of equity to buy this person and, if necessary, subscribe to new shares at $1.05 to fund that cash requirement.

In capital markets, if this were the case, the price would go up. So, one way to redress the shareholder angst from options is to increase the exercise price annually based on cost of capita, and/or at the front end on the exercise price. Once the deal is done, risk and reward play out.

What does that look like for each party on the upside and the downside?

Bulls bear liquidity and angst from the decisions you make today to create and issue ESOP shares.

The purpose of this section is to create awareness of future consequences and how you react in each case drives further risks.

To the extent I quantify outcomes and consequences, I will use the same option package I outlined above: 120,000 shares over three years, 10 years to exercise or one year if the employee exits early, strike price 80c.

Liquidity

Having access to a broad base of buyers and sellers, in theory, means that they efficiently process all information to determine the true value of an asset or share. This is called efficient market theory, and it is from this theory that much of modern finance theory emanates.

Certainly, over the long term, markets are efficient, but in real time, they are trading in fear, hope, greed and every other emotion of humans. On any day or week, a market represents the emotions of buyers and sellers, and bull and bear markets emerge as long upward and downward price trends emerge. The emotional swings of a market can be instant and irrational, i.e., the herd gets to a tipping point and then dives the other way.

In terms of an incentive plan for executives, the options are like appointing a manic-depressive, erratic, irrational HR manager called Mr Market.

The share price on any day does not represent the value created by the team, and in a bear market, it doesn’t even represent the relative value created by the market as a whole.

Sometimes, markets are dominated by a few very large players, and everyone else is ignored. This results in a company’s share price declining even when its real performance is increasing.

A reward system anchored on the market value of shares usually fails to recognise the actual achievements of a team. This fundamental misalignment of incentive with intrinsic improvement delivered seems, to me, to be an HR 101 failure at a grand level, but that is just me.

Bear market risk impacts and the usual management response

So, on a downswing, when the options are underwater, i.e., the price on the market is less than the exercise price. No matter how long the team have to go before they have to exercise, depression and demotivation sets in.

If in part the depressed share price is in fact attributable to slowing growth or dropping profits, having a disengaged team and or a depressed team with a manic-depressive HR manager, Mr Market, will make it harder not easier to dig in to dig out. Your best staff will leave to pursue a more shinny toy and higher hopes for a big pay day, and their unvested options will be cancelled.

The ones remaining will include a reasonable number of the useless that are dragging the ship down. The better of the remaining will resent the useless, and the team will know who are useless before the CEO and board does and do what teams do with habitual piss takers that are costing them money. Personal grievances will multiply, and executive time is consumed defending and dealing with this instead of increasing revenue.

Retrenchment and settlements with the team that need to be exited occur. These are harder when options are outstanding especially if there is a personal grievance element to the exit.

So what do boards and management do to deal with this stuff?

A common first move is to reprice options so that the exercise price is below the market price, in an attempt to give the team the motivation to perform by an increased share of the inevitable upward momentum.

With underperforming exiting employees, to get them to go, boards usually waive vesting criteria as part of the settlement and pay out any in-the-money options in full, whether vested or not, or worse, allow the extended exercise period to run to its term.

 In short, bad behaviour and poor performance gets rewarded. As I have said before that which you reward, you get more of, so the acceleration of the decline continues.

When options are repriced, exercise terms are extended, or conditions get waived and golden parachutes get paid out shareholders generally react badly, on the basis of ‘a deals a deal.’

Confidence in the board drops, the share price drops further, and often below the reset option price. At that point, the board usually gets it and doesn’t drop again.

Thus, a bear market and share prices falling dramatically increase the risk to businesses of being unable to turn around an adverse trend.

Bull Markets and liquidity

When there is plenty and everyone is being fed well with profit, dividends and share price growth most are blinded to the building up hubris and debt that booms and bull markets create. Heading into a bear market with debt and high expectations bred by the behaviours of the bull market makes it harder to survive a bear market.

Why are people blind to the risk accumulating in a bull market? Hope, and transactional behaviour anchored in the day they are currently living in. Shortsightedness perhaps.

You know hope is near its end when the mantra is ‘this is a new paradigm!’ Translated, this means boards, employees, and shareholders all think the party can go on forever, and there will never be a hangover. Then, the rush of the lemmings to the cliff climaxes, and they don’t know how to act in a world they have not seen before. The shock and anxiety are everywhere, even among leaders.

What tends to happen in liquid markets is employees exercise options early, a good thing sort of, and immediately sell at least enough shares to pay the exercise price and the tax on the gain, but usually they sell the lot and take the cash.

In Listed public markets, the cash-out rate is over 90%.

The facts certainly don’t support the belief that workers can be turned into owners, nor that they want equity for its own sake. The behaviour around liquid market options is that employees favour cash and will take it when it is on the table.

Over time the number of shares on issue increase significantly.

One study in the early 2000’s observed that in the US over 80% of the shares on issue in the US Nasdaq market arose from the Issue of employee share options and observed that this was the greatest wealth transfer outside of revolution in human history.

Since the 2000s this trend has in part reversed. In the interim it was masked through corporates also now buying back their own shares. Shareholders are happy with this, as buying pressure pushes share prices up. In short, it extends the Bull run.

Of course, this requires the corporation to have cash. So, the response is to suppress dividends, curtail real investment in assets and growth, and increase corporate debt.

While this cash leaves the business to buy back shares, which is effectively paying the employees LTI incentives none of this is recorded in the Financial Statements at its true cost enabling the game to go on longer.

Sometimes, the true cost of option plans is greater than the profits generated, yet we think we have a company with a profitable business. When the music stops, 1929, 1987, 2008, 2023, and so on, the debt gets counted, and the weak perish.

So, to summarise, while it is masked, corporates, shareholders, and employees’ behaviour around such plans dramatically increases the risk to the sustainability of the businesses that run ESOP plans. It also damages investor belief in our capital markets in general. There are many reasons for the rise in Private equity investing, of which, this is a factor.

The demise of capital markets also damages pension funds and causes wider social consequences.

I don’t blame wealth concentration, the damage to wealth distribution and opportunity and the rise of private capital for the intermingling of capital allocation and human resource management through the use of options, but it would be foolish to ignore it as a factor.

What about the illiquid markets, the start-up tech sector?

Early start-ups will use options over equity grants to raise capital and attract talent. The front-end loaded tax advantages and kicking the tax can down the road are powerful drivers of the use of options in this sector.

Issuing fully paid-up shares in lieu of wages involve paying the tax on the wages and parting with cash to pay the tax.

On failure, there is no cost at all using options; they are not exercised, and it all unwinds.

On success the tax outcomes are symmetric, now. The employees have to pay tax on the gain and the company gets an equivalent tax deduction.

All good and well. However, in many cases, the deduction is on a day before the sale of the company, and the losses shelter the current year’s earnings up to the close of business on the day control changes. Any unused losses may be at risk after a change in control.

Also note that while a deduction is available, there is no equivalent cash relief to the tax paid by the employee unless the company is making profits and paying tax.

In short, a lot of moving bits, lots of complexity and plenty of potential for tax shrinkage. Albeit much better than it was.

If success is not via a trade sale or takeover, the issues are identical to those for listed entities, provided a liquidity mechanism exists. That can occur when there are shareholders who are prepared to buy or through the company running a share buyback program.

However, if such mechanisms are not developed and approved by shareholders in the time frame for the employees to exercise their options and pay for their shares, the tax cost on the difference between fair value and exercise price has to be paid along with the exercise price without access to a marketplace to fund it.

This hard money cost results in a fair number of those options lapsing even when they are in the money.

Boards rarely ask themselves if this is morally right. They are also blind to the consequences for their future HR issues when the team understand they actually had a Catch-22 Milo Minderbender share. (Catch 22 , Joseph Heller a worthwhile amusing read for Xmas.)

Summing up

Options create many moral and ethical hazards, including an incentive to mislead and manipulate capital markets, and yes, that does happen. By linking exec remuneration with capital markets, we create a new HR manager, Mr Market, outside of the business. Further, if these plans run too long, we pile on corporate debt and risk the whole business going into a downturn.

While they have their place, they are not a universal panacea. Long-run data on options and employee behaviours in major capital markets largely disprove the assumptions made by the business’s HR teams that these plans are needed. Most will value an offer of shares at some point but will value the offer more than the actual share if faced with cash. If options are used, most will sell the shares at the earliest moment for cash.

In the words of Kevin Gilligan, GS co-founder, ‘When you are at a BBQ, the chef’s involved but the pig is committed.’

About the only time options make sense is when a company has its back to the wall and can’t raise cash to pay people fairly (usually early stage).

If you are open to new ways of doing things and want to stand out from the general undifferentiated option plans of others, talk to us. These plans are just one tool in the business toolbox. Thoughtful and considered action is better than following the crowd.