Following the big fall in the stock market this year, many employees find themselves holding options under employee option plans that are well out-of-the-money. Employee option plans play an important role in retaining and motivating staff and driving long-term business performance.
Employers considering ways to reinstate the value of these option plans will need to negotiate their way through their option plan rules, the Corporations Act, the ASX Listing Rules (in the case of listed companies) and the income tax legislation to avoid adverse tax consequences for their employees. Recent trends also suggest that a performance rights plan may be a better mechanism to motivate employees.
To assess the impact of the crash on employee option plans, Deacons recently undertook a survey to examine the role of options and other share-based plans in executive remuneration and the extent to which options issued under those plans are out-of-the-money. We examined a sample of 50 of the 200 companies from the S&P/ASX Small Ordinaries. We found that:
- 64% have options on issue under either current or expired employee option plans.
- The exercise price of the options issued under those plans since 2003 is on average 49% below the current share price for those companies and 88% of the option tranches issued since 2003 are out-of-the-money.
- Only 26% have performance rights plans (10% have only performance rights plans and 16% have both employee option plans and performance rights plans). See below for a discussion of the difference between an option scheme and a performance rights scheme.
Our sample of Small Ordinaries companies shows that the reliance on option schemes rather than performance rights schemes could have an adverse impact on the ability to retain and motivate key employees. A more detailed outline of this survey is available from our website, including information on the methodology and limitations of the survey.
Options vs Performance Rights
Options granted under employee option plans typically have an exercise price which is at or around the market price of the share at the date of grant of the option. There is then a period after the grant (usually between 2 and 4 years) before the options vest in the employees (that is, before the employees become entitled to exercise the options). Vesting of the options is commonly subject to conditions and/or performance hurdles. Following the vesting of the options, the employee then has a period of time (typically a few years) in which to exercise the options.
In contrast, performance rights have a nil exercise price and are contractual rights to receive shares in the future. As with options, there is a period of time before these rights vest and vesting is dependant on certain conditions and/or performance hurdles being met. Following vesting, there is a period of time (typically a few years) during which the employee can exercise the rights. For the purposes of our analysis, we classified zero exercise price options (ZEPOs) as performance rights as they have a similar economic effect. Performance hurdles generally involve comparing a company's total shareholder return against a group of similar companies. Provided that the company matches or outperforms its peers, these rights can vest even in a falling market.
The important difference between options and performance rights is that vested performance rights still have value to an employee even where the company's share price has dropped well below the share price at the time those rights were granted. For example, if the number of performance rights to be granted to an employee was determined based on a fair value of $20 and the employee was issued 1,000 performance rights (i.e. they have a notional value of $20,000), even if the company's share price has dropped to $10 at the time at which the rights vest, the employee will still be entitled to be issued with 1,000 shares (with a value of $10,000) after vesting without having to make any payment (as there is no exercise price).
However, if, in the same scenario, the employee had been granted options (instead of performance rights) with an exercise price of $20, the share price would need to recover to $20.01 before those options had any value to the employee.
Dealing with out-of-the-money options
In order to amend employee incentive schemes to rectify a situation where employee options are out-of-the money, the following methods can be used:
- amend the scheme to reduce the option exercise price so that it better reflects the current share price;
- cancel the existing options and issue new options;
- issue new options without cancelling the existing options; and
- implement a performance rights plan.
Each method requires a consideration of the option plan rules, the Corporations Act, the ASX Listing Rules (in the case of listed companies) and the income tax legislation. For a fuller discussion of the issues involved in each option, follow this link.
What does this mean for you?
Employers considering ways to reinstate the value of their employee option plans should be aware that there are a number of different methods that can be used which have varying implications under the Corporations Act, ASX Listing Rules and income tax legislation. For employers that decide not to do anything, it may be worthwhile to remind employees that have paid tax under the up-front method that they should be entitled to a refund of tax if their options are still out-of-the-money at the end of the exercise window.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.