The Issue: Should shareholders approve a new or amended stock option plan?
Recommendation: Vote against any plan that (1) lacks meaningful performance measures, (2) dilutes existing shares by more than 5% to 10% of the outstanding shares or (3) has repricing provisions contained in the plan.
Stock option plans were created as a way incentivize employees, most often executives and directors, to do a good job. Unlike the rest of us, who are expected to perform well in our jobs as a condition to earning a weekly paycheck, executives (like dogs and trained seals) need incentives to perform their best.
The basic idea behind stock options is that when they are granted to an executive, they have an exercise price of say, $30 a share. The executive is entitled to buy that stock option at that price and if the stock value goes up (presumably because the executive has done something to help boost the value of the company), then he reaps a nice profit on his options. So for example, the executive receives 100,000 stock options at the $30 option price. A year later, the value of the company stock has risen to $50 a share. Assuming that the executive's options have vested, that is, he can cash them in, then he reaps a nice profit.
This simple concept has been complicated beyond comprehension for most investors. There is a not-so-small industry that has developed in both creating excruciatingly complicated plans that boards award to executives as well as another industry devoted to deciphering what the stock option plans do and their impact on shareholders. Our intention here is to offer a couple of relatively simple ways to consider whether you as a shareholder should approve a stock option plan should management deem it appropriate for its shareholders to have a say on the matter.
Proposals can take a number of different forms, including (1) creating new plans, (2) amending existing plans in order to change the terms of the plan or add additional stock options to the plan. At this juncture, we recommend that you consider just a few factors when deciding to vote for the approval of the plan.
First, does the plan have sufficient performance measures attached to it?
Buried in the proxy statement is a discussion of the plan and often a detailed description of the plan itself. You should look for a discussion about how the board evaluates performance as a pre-condition to awarding stock options. Keep in mind that simply listing performance criteria is not sufficient. There should be some specificity with regard to what good performance is, not just a laundry list of possible factors that the board can pick and choose from when deciding on option awards.
Second, the plan, along with all of the other stock option plans, should not distribute so much stock that it overly dilutes the value of existing shares held by ordinary shareholders. Let's say that a company has 1 billion outstanding shares of stock. It has an option plan that authorizes the granting of 150 million shares to company executives covered under the plan. This means that there is significant dilution of existing shares of approximately 13%. Not so good for investors. A reasonable threshold should be somewhere between 5 and 10% dilution of existing shares. More than that and things are getting out of hand on the option front.
Third, beware of repricing! Though fewer companies try to pull this stunt, it still happens on occasion. Basically, repricing occurs when the underlying price of a company's stock drops below its exercise price. When this happens, plans with repricing provisions allow the company to reset the exercise price at the lower level. That way, executives receiving options are not out of the money. That is, their stock options still have some value. For example, the strike price of the stock is $30 a share. The company does poorly, thanks in part to lousy leadership at the company. The stock option plan has a repricing provision that allows the exercise price - that is the price that executives must pay for the stock - to drop to the new level.
Bingo! The executives exercise their options at the new lower price point. Then, they work really hard and get the stock price to rise up to, oh say $30 a share, again! They realize their profits while shareholders see no appreciable improvement in the value of their investments. If you think this is a good idea, by all means, vote plans with these provisions. Otherwise, vote against the plan.
Consider all three of these factors when voting for or against any stock option plan, be it for directors or officers of the company in question.
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