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Performance Shares or Options?
(by Alan Judes of Strategic Remuneration)
The introduction of an expense for options has levelled the playing field between options and performance shares as an instrument of executive remuneration strategy. For a given expense in the income statement, companies (and sometimes the participants themselves) can choose which instrument they would rather use.
Broadly speaking a performance share will give an executive the entire value of the share at no cost to the individual provided that the performance targets have been achieved, and dividends paid on the shares during the performance period would typically be rolled up and paid out when the shares vest in the hands of the participant. An option allows a partipant to acquire a share at a price fixed at the time of grant of the option. Usually the exercise price is the market value of a share on the day the option was granted. If the performance targets are achieved the option can be exercised by the participant who pays the fixed exercise price and in exchange receives the shares. Thus the option holder benefits from any increase in the share price between the grant date and exercise date. Dividends are not received by optionholders who only begin to get dividends once they have exercised the option and become shareholders.
So if your employer is offering you performance shares or options how do you decide? Well, here are the main factors to take into account:
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The relative value of each instrument and their rate of exchange between each other
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The likely growth rate of the share price in the future
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The likely dividend yield in the future
For ease of illustration I assume that each instrument has the same performance target of earnings per share growth and that this target is achieved.
The relative values will most probably be determined by valuing the option with an option pricing model and comparing it to the value of a share. You can find a spreadsheet model for a Black-Scholes valuation on-line, click here...
Typical values at present are 25% to 20% of the market value of a share. This means that a company might offer a rate of exchange of 4 or 5 options for each performance share.
Unless the share price increases, there will be no value in the option. However, for each 1p growth in the share price the option will deliver 4p or 5p of value while the performance share delivers 1p growth. Thus at a given growth rate the option achieves breakeven with the performance share and then accelerates above it.
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If the exchange rate is 4, the growth rate to breakeven is 33.3'%
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If the exchange rate is 5 the growth rate to breakeven is 25%
The dividend yield for performance shares will increase the breakeven as options do not receive a dividend but typically performance shares do.
Options typically have a life of ten years consisting of a performance period of three years and then a further seven year period to exercise the option. Performance shares usually have a three year performance period and some companies require a further two year holding period.
So if your company has offered you 10,000 performance shares or 50,000 option shares when the dividend yield is 3% what does your choice say about your share price growth expectations of the next five years?
Well, if you chose the options, you demonstrated your belief or hope that the share price growth will be greater than 28.75% over a five year period. This is because growth of that level is the breakeven for one restricted share plus five years of fixed dividends to produce a value of 1.4375 times the starting value of the share. The options will be worth the final value of the share less the starting value of the share multiplied by five or Growth x 5 which is 28.75% x 5 = 1.4375. For each one pence growth above the breakeven the performance share will grow in value by 1p and the options by 5p. A table showing growth and value of each instrument is below.
The above table assumes that the dividend does not change over time and that the performance targets for each instrument are the same. Unfortunately, these assumptions are a little simplistic for real life and will need modification. Changing the dividend is a simple matter, but unfortunately many UK companies have EPS performance measures for their option plans and comparative total shareholder return performance measures for their performance share plans. This means that the instruments are not directly comparable and assumptions about relative performance measures have to be taken into account. That can always be the subject of another article.
Notes
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IFRS2 (FRS 20) entitled Share-Based Payment is effective from 2005 onwards. Full details can be found at the Financial Reporting Council website, click here...
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Further helpful coverage is available from a number of accounting firms such as Deloitte IAS Plus website, click here...
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