If you are indifferent between two products, you choose the one with a lower price. That's substitution effect. Building on the same argument, if the price of two products is the same and you prefer A over B, then A must be more valuable. Isn't it? Can this basic micro economic theory be applied to Stock-based Compensation?
Until now, LTI has almost been synonymous with Stock Options. The decision to use Stock Options over full value instruments (or deep discounted ESOPs) has also been fairly intuitive. They reward employees only for incremental value created for the shareholders, tie the interest of the management with those of investors (partly solving the principal-agent problem), do not lead to cash outflow and are easy to understand and communicate to employees. Until FY 2016, Stock Options did not even lead to any P&L cost to the company due to intrinsic value accounting! What's not to like?
What has changed?
Expensing of share-based payments in India has changed upon convergence with International Financial Reporting Standards (IFRS) / IND-AS. IND-AS mandates fair-value expensing of Stock Options instead of intrinsic value accounting. Previously, under intrinsic value accounting, if a company granted Stock Options at market price, there was no expense to be booked as their intrinsic value was zero. In contrast, companies granting Stock Options now need to book expense basis fair value of the options computed by an option pricing model - typically the Black-Scholes model. This value usually lies between 30% and 50% of the share price. So if your company grants 10 lakh Stock Options when the stock price is Rs 1,000, under fair value accounting, you could take a P&L hit between Rs 30 crore to Rs 50 crore compared to zero previously! This expense isn't tax deductible either. Speak with any CFO about this and they will tell you how much it hurts.
What are companies doing?
Most companies have now gone back to the drawing board to review their LTI strategy. Everything is being reconsidered, from eligibility to quantum and most importantly, choice of LTI instrument. Now that Stock Options suddenly seem less attractive (due to the rise in cost), its other limitations are being highlighted and debated. We tackle some of the most popularly quoted disadvantages of Stock Options that are being used as rationale to justify a switch to full value instruments like Restricted Stock and Performance Shares.
Stock Options have a lower retention value: If the share price drops below the exercise price, Stock Options do not have any value to the employees. The inbuilt performance condition in Stock Options is that the share price must rise from the date of grant for employees to make any money. This is the key difference between Stock Options and full value instruments. For example, if you grant Restricted Stock when the stock price is INR 1,000, even if the stock price drops to INR 500, employees still make money. The downside for employees is protected in full value instruments - adding to the retention element. In our view, all stock based plans are "long-term" plans. These plans usually have a 3 to 4 years vesting period followed by another 4 to 5 years for exercise. 8 years is a long time (think about what you were doing in your life 8 years back to put things in perspective). Also, retention value not only comes from protected downside but also from earning potential of a plan. For companies in a growth phase, gains from Stock Options easily outperform the gains from full value instruments in long term.
Stock Options are the most dilutive of all LTI instruments: It's true. Stock Options are the most dilutive. But if you want to dilute less, simply grant fewer options per employee or to fewer employees. Companies grant LTI and dilute their equity based on what they believe is right for their company and what they can afford. Also, the secondary market purchase route (where companies buy stock through a trust to settle employee Stock Options) is always available. Also, retail shareholders, in particular, don't mind diluting equity as long as the share price is going up and the company is performing well consistently.
Stock Options potentially encourage excessive risk taking: To be fair, this criticism can be applied to all stock based instruments and not just Stock Options. There is some merit to the argument as well. Executives may think more "medium term" than truly long term with focus more on beefing up the share price rather than building a sustainable business with a quality array of products and satisfied consumers. Another big risk is that the leadership team does not take any risk at all as they may be uncertain about how the stock market may react in the short term which will impact their gains. This is where these plans have to be looked at from a long term lens and the plan participants need to understand the same. Also, this is exactly why having a strong Board and well-functioning committees is essential to keep the company doing what is right for the truly long term shareholders.
Stock Options are expensive: Well...this is similar to the argument that Stock Options are more dilutive. If you cannot afford to grant Stock Options from a P&L perspective, simply grant fewer options. This will bring down your expense (at the cost of being less competitive, however). Also, full value instruments also lead to the same debit in the income statement as Stock Options. As far as cost is concerned, all stock instruments have become cost neutral. In fact, if you are granting options via the secondary market purchase route, full value instruments lead to a huge net cash outflow for the company compared to Stock Options which are cash neutral (only opportunity cost of money is lost).
Is the grass greener on the other side?
Let's assume you make the switch from Stock Options to full value LTI instruments or are considering it. But are you aware of the challenges they pose? Let's start with Restricted Stock. While we agree, they are a great retention tool for trustworthy executives, they can inculcate a feeling of entitlement and even lack of accountability over time. Therefore, it is extremely important that the performance of recipients of such awards is tracked closely to ensure that the LTI plan is not leading to complacency. Also, its coverage must be extremely selective. Moving on to Performance Shares that work the same way as restricted stock but with a performance condition on vesting. Such awards require long term targets to be set and the size of the award that vests depends on actual performance vis-a-vis the targets. Performance Share Plans are the hardest to design. There are a lot of assumptions required. For example: What should be my long term performance metrics? How many such metrics should I have? What weight should I assign to each performance metric? What should be my target for each metric? What should be my performance period? Can I even set reliable long term targets? Who decides how much stretch there is in a target? How should I ascertain my threshold and maximum levels of both performance and payouts? Not easy. They work wonderfully well if a company is in a position to answer all these questions with a fair degree of confidence. Unfortunately, most companies aren't.
What to do?
This article is not a rant against full value instruments. Nor is it supposed to be an endorsement for Stock Options. We often come across a question in client meetings and trainings - "Which LTI instrument is the best?" Unfortunately, we have to resort to the boring but correct answer - "It depends". It depends on what you are trying to achieve through the LTI plan. It depends on your company and industry context. If your sole measure of long term success is share price performance, stick to Stock Options. If your objective is primarily retention, Restricted Stock work pretty well. If you can answer all questions related to long term target setting and want the management to focus on internal business performance and not be affected by the volatility of the stock market, choose Performance Shares. Switching from Stock Options to other instruments is not a bad thing at all as long as you switch for the right reasons. Different LTI instruments are not perfect substitutes. They are more complimentary in nature.
The writer is Senior Consultant (Executive Compensation) at Aon Consulting-India