CHAPTER III: VALUE FOR “MONEYNESS”? 46
3.6. CONCLUSION 103
In recent times, executive compensation has reached unprecedented levels, largely due to the component of stock option compensation. As a result, several hypotheses have been developed to attempt to explain why these levels may be optimal or excessive as an incentive alignment tool. This chapter has added to the economic theory of the optimal contracting hypothesis from a holistic perspective, by incorporating the impact of the
various other costs and benefits resulting from granting options. These include numerous HR related benefits, such as attracting, sorting and retaining staff, as well as indirect benefits relating to a range of finance related issues, such as corporate governance, project selection, financing and tax issues. So while levels may have been the overall optimal solution, it is quite possible that levels were suboptimal or excessive from a traditional incentive alignment perspective.
As much research in this area has been retrospective, a lot of research has failed to differentiate between option premiums based on current stock prices and option premiums based on what stock prices would have been if employees had not granted options. By incorporating the impacts of the different costs and benefits resulting from granting stock options, a “what-if” framework was established to distinguish the value of the firm with and without options granted. Such a framework thus provides a basis to develop a clearer understanding of the revenues foregone.
The “what if” framework also allows for the comparison of the stock price (inclusive of benefits) post dilution with the corresponding stock price without options, with the expected difference being the dilution cost or gain to current stock holders. It is important to note that this dilution cost is calculated from the dilution of value which differs to
dilution of EPS, which implicitly ignores possible future increases in earnings from increased capital. Whereas dilution of EPS is minimised by restricted stock, minimisation of dilution of value is achieved through out-of-the-money options. Scenario analysis also helps to show that these dilution costs diminish marginally with respect to the number of options granted, but are linear with respect to the number of options per total number of shares (including new shares from option exercise).
Having established the appropriate foregone revenues combined with dilution costs, as well as tax implications, the overall economic opportunity cost of forgoing underwriting stock options can be calculated. On a simple theoretical basis, these factors provide an argument for the economic opportunity cost of granting stock options to be much lower than what is normally considered. Scenario analysis takes this further, showing that there are no expected profits from a typical company underwriting five year stock options unless new stocks from option grants were to exceed approximately 28% of the firm’s stock. If tax implications were considered, this breakeven point would be even greater.
Due to the required levels of grants to be unrealistically high, it is therefore argued that foregone profits from underwriting stock options should not be considered as the economic opportunity cost.
By grouping the aforementioned benefits into three categories based on the benefit’s relationship with moneyness, asimplified model of a firm was developed to analyse the impact of differing factors on dilution costs and the minimum required benefits for a firm to grant stock options.
The relationship between dilution costs and moneyness were found to differ depending on the number of options granted or underwritten. Firstly, the breakeven point was found to be independent of the state of the market, however, this may partially be due to how the different states of market were modelled. Then any firms granting more options than the breakeven point would generate more profits as moneyness increased, and firms granting less would incur greater losses. As moneyness would increase the option revenue, dilution costs must also have been increasing.
Required unconditional benefits received upon grant are found to have a positive relationship with volatility and number of options granted, however, like dilution costs, required unconditional benefits only need to increase at a diminishing marginal rate. Once taxes are introduced, required unconditional benefits decrease slightly. Lastly, just as dilution costs (below certain grant levels) increase with moneyness, so do the required unconditional benefits.
Analysis of required conditional benefits when there are no unconditional benefits and fixed grant levels, show that required conditional benefits increase with moneyness. This is perhaps counterintuitive as expected conditional benefits increase with moneyness, however, it is indicative of the high costs involved with dilution of value. However, if option grant values are fixed instead of option grant levels, then the required conditional benefits decrease with moneyness as a result of increased moneyness decreasing the required option grant levels. When unconditional benefits are also incorporated into the model, required conditional benefits drop almost proportionately to the level of additional unconditional benefits at a ratio of 1:1.67. Under the assumption of unconditional benefits being an approximate proxy for the value added through
incentives, this helps why a company with a lot of conditional and partially conditional benefits may have compensation packages which are excessive for incentive alignment purposes. Indirectly, this chapter also supports the premise that options are vital to small companies to grow, as many of the aforementioned benefits are more prevalent and have greater values at smaller firms with untapped potential for growth.
Finally, as mentioned earlier, the model used in this analysis was simplified, leaving opportunity for other researchers to improve on it. Among the key areas for further development are incorporating the modelling of employee effort, the impact of perceived value for non-diversified employees, different levels of risk aversion of recipients, improved modelling of the majority of the benefits, particularly partially conditional benefits, different exercise prices, alternative ways of modelling bearish and bullish market states, and expansion of the model from a single stage to a multi-stage model.