Taking stock of business

By Fiona Rotherham

Gone are the days when bosses just get paid cash for what they do.

The trend among New Zealand's top listed companies is to include executive stock options as part of the overall remuneration package.

Americans call it "having skin in the game."

The theory behind share options is that giving senior management part-ownership of the company aligns their interests with those of shareholders.

Options grant executives the right to buy some of a company's equity at an agreed price at a specified future date.

The benefits of options is they focus management attention on shareholder value and help drive down costs. They also cut the cash cost of attracting top employees by promising future wealth.

The trouble with them, as burnt 1980s investors will recall, is there is every reason in a bull market for the executive to hype up the share price on unproven and optimistic forecasts. Outside investors buying in at inflated prices carry the risk, while executives holding the options risk little and gain much.

In the United States options, combined with a buoyant stockmarket, have made millionaires of many managers. According to The Economist the top employees of big American firms now have a claim on more than 13 per cent of their firms' equity.

The latest New Zealand stock option schemes have mainly been performance-based. There are hurdles the executives have to lift the company over before they gain the options.

One of the most common hurdles is measuring the company's share price against the NZSE40 index. Options are granted only if the company's performance beats the index. Another common hurdle is an increase of, say, 25 per cent in the share price over three years.

Under stock exchange rules, listed companies are required to obtain shareholder approval before introducing stock options, providing more than 2 per cent of the issued capital is involved or if directors are recipients.

Last November opposition by small shareholders to Auckland International Airport's new share options scheme failed to ground it.

The option's exercise price was the market price of the airport's shares at the time of issue, pegged to movements in the NZSE40 index and adjusted for dividends paid. The options would be exercisable only three years after the issue date, lapsing after six years. Under the scheme, chief executive John Goulter gets up to 250,000 shares a year for the next four years.

Airport general manager corporate Chris Curley says shareholder opposition was based on a misunderstanding of how the scheme worked. "Whenever the word options is mentioned shareholders throw up their hands in horror and ask 'what are you giving away?'."

The airport's "plain vanilla" scheme was chosen to make it acceptable to institutional investors and other shareholders.

Barry Lindsay, chief investment officer for AXA NZ , says he has no qualms about the airport options. "Our own company has an options scheme similar to it. I can appreciate the attributes of it."

A market surveillance panel member, Mr Lindsay reckons the listing rules provide sufficient shareholder protection from any "outrageous" schemes.

Options impose a cost on shareholders by diluting a firm's existing equity. This transfer of wealth worsens if the strike price - the price executives pay for the options - is much below the current market price. The executive gains the value without doing anything.

For this reason Lion Nathan avoided stock options as part of its long-term incentive plans.

"There has been bad press in the US recently about companies not properly counting the cost of stock options. Microsoft is one with huge problems," says group human relations director Bob Barbour.

Even without stock options Lion Nathan's chief executive Gordon Cairns is New Zealand's top paid executive, on $2.29 million - and that's after a half million dollar pay cut last year.

Lion Nathan has adopted an executive performance share scheme starting to gain credence among top British companies in preference to stock options. The company buys back existing shares to hand out to staff rather than creating new shares. These are earned by executives over a three-year period derived from a percentage of their base pay and performance bonuses. If they don't make their bonuses, less goes into the pot for their free shares. The shares are not taxed, unlike the capital gain on options.

The Australian Shareholders Association - there is no NZ equivalent as yet - this week voiced concern about the number of share plans and fee increases granted to Australian company executives, regardless of performance.

Spokesman Stan Mather says options are becoming an add-on to executive salaries that in many cases is "taken for granted and not earned." It is not the idea of stock options he objects to. It is whether the company performance has to have improved and how those hurdles are measured.

The Investment and Financial Services Association (representing Australian institutional shareholders) introduced stock option policy guidelines a few years ago, saying its members would view favourably companies that followed them. These are currently under review.

Association chief executive Lynn Ralph says there has been investor concern that past performance hurdles had not been sufficiently rigorous.

The equivalent NZ group - the Investment Savings and Insurance Association - plays no similar watchdog role. It is left up to individual shareholders to examine the options schemes presented to them and vote accordingly when given the chance.

Remuneration consultant Edward Wright helped structure the Brierley Investments options scheme passed by shareholders in November.

Following on from 15 million options issued to BIL chairman Sir Selwyn Cushing, a further 54.5 million options were to be made available to senior executive staff who are not directors.

Unlike the options granted to Sir Selwyn, the management ones have hurdles. Split into three tranches, the exercise prices are 65c, 75c and 90c. The Brierley price must exceed 75c,130c and 150c respectively over a 30-day period before the executives can gain them.

If not designed appropriately, option schemes are a "free gift," Mr Wright says. They also need to be company specific.

"The BIL plan was designed for a specific situation. In the case of a company, say in the construction industry where it is typically cyclical, the relevant performance is comparing it to the basket of shares within that industry."

The pioneers of stock options were the knowledge-based start-up companies backed by venture capital. With the "dot.com" boom, potential employees in hot demand look to those companies with an attractive stock options package, or they go elsewhere. It means a firm with no bottom-line profit and little else can compete for staff head-to-head with the likes of IBM, simply by enticing top people through options. Silicon Valley is built on options for most staff, not just the bosses.

Accounting rules mean companies do not have to treat options as an expense, charged against reported profits, as they do with other forms of compensation. Thus options prove a cheap way to pay top staff.

In New Zealand, IT Capital last week gained shareholder approval to release up to 5 per cent of total shares for management options. Last August managing director Keith Phillips was granted 1.7 million options at 17c, the then market price. IT Capital's share price is trading around 78c.

Shareholders questioned, but approved, Mr Phillips' ability to cash in the options at will. Mr Phillips says the norm in US venture capital companies is to have 15 per cent of the firm's capital held in staff stock options.

"Because it can lead to substantial fortunes, it is what attracts talented people from their blue-chip, low-risk environment. This, in turn, has fuelled the success of technology and could even have contributed to the substantial economic growth in the US."

Shareholders showed no opposition at last year's AGM of sharemarket darling Advantage to the proposed issue of 27.5 million options - 15 per cent of the company's capital - to directors and staff. Yet the exercise price was below the market price.

KMPG Consulting, as part of its globalisation programme, is floating a new worldwide consulting company on the New York Stock Exchange mid-year.

In a bid to attract and retain key staff, the new company will issue 10-year options with a four-year vesting period to all existing staff, providing they have met performance criteria already in place. Up to 20 per cent of the US company's equity will be distributed in options. Some will be handed out immediately. Others linked to future performance come into force later.

Spare a thought for Cleveland shipping company executive John Lauer.

Fortune magazine reports Mr Lauer eschewed a salary, working solely for an options package that could earn him 8 per cent of the booming company's capital next year. Even then, the option price is linked to the company's long-term growth.