Share options are said to be 'underwater' when exercise prices are higher than the current share price. The plans may also carry a condition that options can only be exercised when the company hits certain targets – targets that now seem unachievable. When markets turn south and staff can't cash in their options, share plans look bad.
It’s important to remember, though, that it is still worth doing something to motivate and reward your staff, and still worth doing it with shares. A 'dash to cash' – beefing up annual bonus potential, for example – might look attractive; but that will involve cash leaving the business and it is unlikely to lead to a long-term tie-in for key staff.
The first thing to do is to engage with the company's owners – the investors. Investors normally set a 'dilution limit' that caps the number of shares a company can use for its share plans. If they flex the dilution limit, this gives companies more scope to address the underwater options.
Whether investors are prepared to be flexible, of course, will depend on their outlook. Investors are quite rigid around dilution issues – this is the cost to the investor of a share plan. However, in some cases investors can see the benefit of having share plans that provide an effective incentive, even if this means some extra dilution.
One possibility is to amend existing performance conditions to more realistic targets, allowing existing share awards to vest. While this is possible, it’s a course likely to be followed by relatively few companies. Investors need to be persuaded that employees should be rewarded, even though targets have not been achieved.
There could be an advantage in making new awards but surrendering existing underwater options. This gives employees new awards granted at current share prices – which are typically lower – with the potential for future growth. Surrendering existing options makes more shares available for such awards but investors need to be persuaded to allow this flexibility, and they may not always be sympathetic to employees being able to 'start again' when this isn't available to the investors. Companies also need to work through the accounting consequences when they go down this route.
When investors aren't prepared to give any additional flexibility to a company, the company has to use what it has, in terms of shares available. It can make new awards, but stick within current dilution limits.
It may still be possible for companies to do quite a lot within these parameters. For example, if share plans aim to reward renewed growth from a new, lower share price, relatively fewer shares may be needed to deliver meaningful rewards.
Now may be the time to review allocation policies. Are companies spreading their share incentives too widely – and should grants be more carefully targeted at those individuals who are going to be key in delivering the company's strategy?
Granting awards more frequently can also give employees a range of option prices and vesting dates and removes some of the randomness involved with share options where a lot of the value depends on the initial share price at one option grant.
Also, you can manage available dilution. This can include what's known as 'budgeting' – using fixed numbers of shares for grants, rather than grants based on multiples of an individual's salary where share numbers get determined by share prices at award.
So there are ways to offer executives and employees continued incentives, and to keep key staff involved in the long term, without seeing cash leave the business – even in challenging economic times.
By Rory Cray. Rory is a partner specialising in share plans at Pinsent Masons, the law firm behind OUT-LAW.COM. He will be among the speakers at a forthcoming Share Plans Roadshow taking place this week in London, Birmingham, Leeds and Manchester. See: Full details.