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Discussion Paper:   

A flexible Approach to Share Options - an ITNEA presentation

Background

Following participation in an ITNEA meeting, Victor Basta kindly agreed to the following article to be reproduced here.  It was first published in the Financial Times on 22 March 2002.

Canceling share options and reissuing them at a lower price can make sense for shareholders and managers - if backed by strong corporate governance.

A Flexible Approach

In Europe there appears to be very little debate over re-pricing share options, where companies reduce the exercise price of executive options when their share price drops significantly. Many influential shareholders, particularly in the UK , have taken a "just say no" approach.

This is not only wrong, but it risks damaging many younger companies. A variation of re-pricing - canceling options and issuing new ones at today's lower prices - combined with strong corporate governance, can make sense for shareholders and managers. It is time to establish clear guidelines directors and shareholders can use to determine when such re-pricing makes sense.

Certain technology and telecommunications companies have recently seen their share prices decline by 90 per cent or more in less than a year. This makes senior managers feel their share options are effectively worthless, which risks demoralising the very people who shareholders most want to see energised.

In response, concerned non-executive directors see lowering the strike price of options as a way to make them "worth something" to the senior managers charged with leading the company through difficult times.

But for many companies this possibility is never presented to the shareholders at large. Because such a change requires shareholder approval, directors need the backing of their most important institutional shareholders, many of which are opposed to any re-pricing.

These shareholders argue management should share the pain of a plummeting share price with other shareholders, and that it is especially unfair that the same people who presided over the share price collapse should now benefit from even a modest rebound.

Options last for many years, they say, and companies can issue new options at lower prices, so why should anyone need to change the terms for options already issued? For many, Marconi's highly publicised failure to get the backing of its institutional shareholders when it tried to re-price options now seems to be the last word on the subject.

But in the US , where a more entrenched equity ownership and reward culture has supported the development of key growth sectors for decades, re-pricing has been a consistent feature of the landscape.

During the 1990s, 31 per cent of public technology companies re-priced their options, according to PwC, the accountants *. While US re-pricings all but disappeared for two years during the bull market and after a US accounting change, with NASDAQ’s collapse they began to reappear.

During 2001, Webmethods and Ariba, among others, announced a re-pricing through canceling existing options and issuing new ones, under a more attractive US accounting approach. When required, US boards and shareholders have been prepared to support re-pricing in general, even amid constant concern from US investors about the fairness of such actions.

In Europe , there is no similar history of re-pricings. But in today's volatile markets, companies need committed, experienced management more than ever.

This talent pool in growth sectors such as information technology and biotechnology is far shallower in Europe than the US . The costs and risks of replacing management are consequently higher in Europe in these fast-growing sectors.

If anything, this requires a more serious consideration of re-pricing. But boards and shareholders should go even further; they should use re-pricing as a unique opportunity to evaluate management performance and build long-term shareholder value.

If boards exercise strong corporate governance under clear guidelines, investors should be supportive of any proposed re-pricing. After all, it is also not in their interests to have demoralised management running a weakened company.

There are a number of guidelines for re-pricing. First, a company's board must have sufficiently strong corporate governance to be credible with big institutions. A guideline would be at least two, preferably three truly independent non-executive directors. A former chief executive who is now chairman would not be deemed truly independent.

Second, non-executive directors should consider cancelling existing options and reissuing new ones, rather than lowering the strike price of existing options. By starting afresh, directors have full flexibility to reward better managers.

Also, because the vesting clock starts at zero on all new options, they are even better long-term incentives, according to Jane Tozer , co-founder of  ITNEA, the IT non-executive directors' association. Just changing the strike price keeps the old vesting clock ticking, making them less valuable to shareholders as a motivation and retention tool.

Third, directors must follow clear guidelines. They must work with outside advisers to conduct a performance review of senior managers affected by the option change. Outside advisers need to be hired by the non-executives, not the CEO, and work for them directly.

Any new options issued must differentiate among senior management as evidence that the performance review has been done thoroughly. The new options should be based on performance, not the number of options already held. Boards would want to keep some managers and fire others. Shareholders have to be satisfied that non-execs have truly "re-hired" senior management.

The only reason for canceling and issuing new options is a share price drop in line with similar companies or a valid index, not because of the company's own relatively poor performance. Proper benchmarking will give shareholders comfort that this change is driven by market forces rather than management's failures.

Non-executives need to consider if issuing new options alone will address the motivation issue. If they believe there are enough options that can still be issued, there may be no need for any re-pricing. In Marconi's case, for example, shareholders believed there was more than enough "head-room" to motivate management.

Finally, new options should vest over at least three years to make them a sufficiently long-term motivation and retention tool. Where necessary, canceling and issuing new options can provide companies with the management stability and motivation, usually required to navigate difficult markets and to underpin shareholder value.

Guidelines adopted by non-executives and approved by key shareholders form a logical basis for considering re-pricing options. To do so would be to do right by the next generation of European companies.

* Bringing Stock Plan Strategies To Light, 2000

The writer is a former executive chairman of Broadview International, the merger advisory firm.

Victor Basta:    vlbasta@hotmail.com