Perspective - Summer 2009

The Underwater Options Dilemma

A fictional Mr. Chan illustrates current Hong Kong perspectives

By Alex Forrest

Mr. CHAN LOOKED at his executive earnings statement again and re-checked the math scribbled on the margins. When his math once again proved true, he shook his head, breathed a heavy sigh, folded and placed the papers back into his briefcase and stared blankly at the darkening Hong Kong skyline outside his office window, quietly contemplating the depressing reality before him.

Mr. Chan had joined a Hong Kong industrial giant nearly four years prior as a Vice President of Operations. Over this period he had overseen tremendous growth for the company, with booming economies all across Asia and particularly China helping to drive revenues up. His company, conservative with cash due to an aggressive expansion strategy, had primarily rewarded Mr. Chan with increasingly large stock option grants. Just a few months earlier these had been worth millions of dollars. Now, however, just as his first grant of options were about to vest, they had zero intrinsic value. In fact, as Mr. Chan's math showed, the company would need to grow share price an average of 50 percent each year over the next three years before his soon-to-vest options could be redeemed for any value and before these options expired. Frustrated over four years of labor lost, Mr. Chan tried in vain to convince himself there were reasons to keep working hard.

His stock options were underwater, and was Mr. Chan felt like he was drowning.

What are underwater stock options?
Stock options soared in popularity during the past several decades as companies wishing to align management's interests with those of shareholders made large grants to employees. These grants could lead to very large pay-days, but only if share price increased, therefore benefiting investors.

Although the outsized use of stock option incentives has been tempered recently by stock option abuses such as "backdating" and revised accounting standards, requiring all awards to be accounted for as an expense, stock options are nevertheless a prominent and important incentive tool for a majority of publicly-listed companies.

In 2007 alone, stock option incentives worth HK$6.1 billion were granted within the 300 largest companies listed on the Hong Kong Stock Exchange. Most of this value was used to motivate key talent and executives. For instance, a typical Hong Kong Chief Executive Officer might have received one quarter or more of his or her total pay opportunity in the form of stock options. In 2007, this amounted to approximately HK$4 million worth of stock options for a large company CEO. If the stock price remains stable or decrease, the entire grant value could be lost.

Typically, because share prices that subsequently fall below the price on the date of the stock option grant deliver no value to the recipients of the options, stock options are seen as an effective long-term incentive vehicle. Underwater options, as they are called, punish employee option-holders who were unable to make tangible improvements to the company that would have translated into positive market sentiment and increased the share price above the grant price. Stock option proponents call this true pay for performance and shareholder alignment.

Sometimes, however, stock prices and market sentiments change dramatically through no fault of employees. Case in point may be the current global recession, where stock prices have plummeted and outstanding options have lost billions of dollars in value. In this case, options that were once fantastic incentives for staff members are now entirely discounted and perhaps even viewed as de-motivational awards.

Mr. Chan's Dilemma: Management's Perspective
Directly above Mr. Chan's office, Mr. Li started pacing the room. He was uncharacteristically early for the meeting – a clear indication of his anxiety.

Mr. Li was the CEO of Mr. Chan's company and he too was concerned.  The global recession had dried up his immediate business pipeline but he had confidence in the long-term potential of his industry and strategy for his company. He had a large shareholding in the company and was the committed to be its leader for many more years to come.  His concern, however, was retention and motivation of his staff. Many of his key employees had been rewarded with stock options that were now underwater.  With many of his senior management at or nearing retirement age, he feared a mass exodus of talent, one that would severely hamper the company's growth potential.

While his initial reaction was to simply grant more options, he knew this would be expensive, use up many shares out of his already low share reserves, and would require a four year vesting term – too long to keep executives waiting. He wondered if there was anything the company could do outside of granting new options and summoned his Head of Human Resources for a meeting. She had assured him on the phone that there were a variety of alternatives.

Also concerning Mr. Li was the expense that the company was incurring for the options that had previously been granted. While the stock options saved the company's cash, their accounting "fair value", as the Chief Financial Officer had called it, was a direct hit to the income statement and had reduced the company's annual profit numbers. Mr. Li wanted to see if there was any way to get rid of the expense of the now underwater options and reduce the cost of future grants.  For these reasons he had also invited the CFO to the meeting.

The three executives discussed the advantages and disadvantages of possible strategic alternatives with respect to stock option grants. While each executive wanted nothing more than to go home, they each knew that finding a solution to their underwater stock option problem would be vital for the short-term retention of talent and long-term success of the company.

What can companies do with underwater options?
To varying degrees, most companies that made stock option grants over the past several years are struggling with the issue of underwater options. In Hong Kong, this includes over 50 percent of all publicly-listed companies. As of late 2008, nearly 70 percent of Fortune 500 companies had outstanding options with a weighted-average exercise price greater than their current stock price.  In certain industries (e.g. US telecom) all companies faced this underwater dilemma while in others (e.g. US energy) less than half were affected.

Even though many outstanding grants are unlikely to deliver any value to recipients, the company must continue to realize the expense of the granted options over the remaining vesting term according to the original fair value calculation. This fact has prompted many companies to pursue what is popularly known as a "repricing", or option exchange.

Often viewed negatively by investors in the past, option exchanges have been proposed and completed successfully in recent months even at some of the world's largest companies. In January 2009, industry giants Starbucks and Google announced that they would pursue option exchange programs for their employees.

At the heart of an option exchange is the desire to give employees something they perceive as greater value in exchange for something they perceive as little or no value. For instance, a company may offer to exchange an employee's ten stock options, granted at $10, for three stock options, at the current stock price of $5. While the number of options the employee holds has been reduced, the perceived value of receiving options at the current market price rather than $5 underwater may be viewed positively.

Option exchanges can take the form of an option-for-option exchange (similar to that of our example), a restricted stock exchange (in which options are exchanged for full value shares), or a cash repurchase. Each of these may be welcomed by de-motivated employees and can be implemented with little or no additional expense beyond the original expense of the option grant, benefiting both the employees and the company.

The benefits and costs of an option exchange must be weighed carefully as there are various legal, accounting, and implementation ramifications, and shareholders must often be solicited for approval, however, simply because stock options are largely underwater does not mean that they are worthless. Many companies are recognizing this and are acting accordingly.

Mr. Chan's Dilemma: Conclusion
When Mr. Chan reached his desk in the morning he discovered a memo from the CEO addressed to all employees:

"We recognize that many of our employees have at least some stock options that are underwater and we plan to offer an opportunity for some of these outstanding stock options to be exchanged. Further details of our Option Exchange Program will be forthcoming in the next several days.  We are keenly aware of the importance of keeping a motivated and engaged workforce and will continue to provide reward opportunities that properly reflect employee contributions. Thank you for your continued service and efforts."

Mr. Chan was jubilant. All was not lost after all and he appreciated the company's offer, even if it still meant a significant reduction in his realizable pay from several months earlier.

Underneath the initial memo he uncovered a second. This one from the Head of HR, addressed only to him:

"Dear Mr. Chan, as a member of management and key employee we would like to invite you to participate in a newly formed committee exploring the possibility of restricted stock and/or performance stock grants. More information will be forthcoming in the following days."

"Restricted stock?" thought Mr. Chan. "Hmm. This could be interesting."