Stock option programmes as a value
orientated management instrument

von: Armin Gruwe

Content

1. Introduction  1

2. Definitions  2

2.1. Agency theory  2
2.2. Details about stock option programs  2

2.2.1. General idea  2
2.2.2. Categorisation  3

3. Analysis stock option programs 6

3.1. Discussion 6
3.2. Advantages of stock option programs 6

3.2.1. War for talents  6
3.2.2. Solution for the agency problem  7
3.2.3. Stock option programs in young, fast growing companies 9
3.2.4. Stock option programs and value creation 11
3.2.5. Further advantages  11

3.3. Critic on the common stock option programs  12

3.3.1. Windfall profits  12
3.3.2. Repricing 14
3.3.3. Masking of costs of the program 15
3.3.4. Wrong incentive 16
3.3.5. Different time horizons  17
3.3.6. Abuse 18

3.4. Valuation of stock option programs 19

4. Development of an optimal stock option program  20

5. Examination of the stock option program from SAP AG 23

6. Conclusion  26

Appendix  27

Sources 32
 

1. Introduction

Stock option programs (SOP) are known as a salary instrument for executives in companies. They are established in the United States and became popular in recent years also in Europe. This paper is concentrated on the use of stock option programs in German companies. Also it is only concentrated on stock option programs for the management as an incentive to increase the company performance. Stock option programs for employees became more common in the last year, but they are not part of this paper. Chapter 2 gives a definition of the agency theory and why incentives for the management are necessary. An overview over stock option programs is also given. Both definitions are essential for the rest of the analysis. Chapter 3 explains detailed the advantages and disadvantages of the stock option programs. It shows theory and what modifications are possible in the reality. Examples from different companies like Daimler-Chrysler, SAP AG and Google Incorporation. are included to support. Tax advantages through SOP and accounting rules that are connected with SOP are not part of this paper, because the focus is to show how the stock options program can be used as an incentive instrument for the management to increase the shareholder value. Chapter 4 describes an optimal model for SOP as far as it is possible to develop a program that is appropriate for different companies. In chapter 5 it is examined on the basis of the results of chapter 3 and 4 how appropriate the SOP of the company SAP AG is. Chapter 6 summaries the work and gives an outlook for the future development.

2. Definitions

2.1. Agency theory

The agency theory, also known as principal agency theory, describes the difference between the interest of a principal and an agent. The principal should be in our case the owner of stocks of a company, while the agent is an executive in that company.1 The objectives of both groups can differ.2 One example could be that the management is less risk-averse than the owners. But this would lead to the situation that the management benefits on the expense of the owners, because the owners interest is not fulfilled by their own agents. So the owners have to find a way that the management acts in the owner’s interest, and not in their own interest. One way to solve this problem can be the use of stock options, because the (liberal) use of stock option programs could decrease this conflict and encourage the management to think like shareholders.3 So the agency theory is a theory about motivation, setting the right incentives, but also finding ways to measure success and to control the agent. More general, it is the theory about finding solution in conflicts between different parties. Some headwords in this context are the Shareholder Value Maximation (SVA) or the Economic Value Added (EVA).4

2.2. Details about stock option programs

2.2.1. General idea

The general idea of SOP is the solution for the agency conflict through setting an incentive for the management to act in the way the shareholders would also act if they were in the position of the management. The ground model of stock option programs is easy. It is assumed that the shareholder value is increased with every positive development of the stock price. If the management can participate when the stock price is increased, both interests are the same. In the stock option theory receives the manager the option to buy the stock of the company to a specific price during a period of time. This price is called the exercise price. If the stock value increases, it is worth for the manager to use the option, because the difference between the price for the options to receive a stock and the market price of the share is the gain. If the stock shows no positive development, the option becomes worthless. But the manager does not receive a loss when the share decreases like the owner of a stock. Because of the incentive of a high profit through the stock options it is likely that the increase of the stock is in the interest of the management.5 Roger L. Martin formulates that with the use of the SOP the shareholders expect that the management acts like the first-mentioned expect.6 SOP are therefore an instrument to lead and control the management through paying a salary that depends on the success of the management. The SOP is only one part of the salary of the management, but it can be an enormous one. In the reality, the model is more complex. Advantages and Disadvantages are discussed in chapter 3.

2.2.2. Categorisation

Stock option programs can be categorized by different facts:

§ Indicator of the performance measurement
§ Real or virtual programs
§ Limit of the program (maximum)
§ New or old shares for the program
§ Frequently or only one time used programs

The indicator for the performance can be, at first, the share only for itself. But as it will be described later in chapter 3.3.1 is the development of a share often not the result of the management. Booms in the economy or other effects, described as windfall profits, can increase the value of a company without good management performance. This can also go into the opposite direction, even if the management has done a good job. Therefore the measurement of the performance is nowadays more and more often orientated on the development of a suitable indicator like the index of a qualified industrial sector7 or the development of other financial investments.

So the management can only achieve the gain of the options if they have created value in comparison to other financial instruments. The categorization on real or virtual programs refers to the idea that it is not necessary to give the management “real” options. With so called “phantom stocks” or “stock appreciation rights (SAR)” the process of an SOP is only built in theory. The exercise price does exist, but the management receives no options. After the duration of the vesting period the management receives the gain of the program directly in cash from the company. No other transactions are necessary. No shares or options are traded in that model. The total costs for the program can be seen in the profit and loss statement of the company, which is not in all cases of SOP possible. The costs are booked as “expenditures on personal”. To avoid a theoretical possible unlimited outflow of cash, the virtual programs are often limited to a special maximum.8 For phantom stocks two different models are possible: The management receives “phantoms stocks” that are booked into a separate account. Every year dividends which are paid to the shareholders are also booked into that account. With that model the managements becomes a shareholder. After the end of the vesting periods two different ways can be gone, but they have to be decided before the set up of the program. First would be that the manager receives the difference between the current value of the account and the originally price of the shares.9 Another version would be that the management receives the whole value of the account.10 But we do not recommend the latter version, because there is no reward for an improvement of the share. The manager would also receive a price of the share is under the price when the program was set up. In an extreme example, the manager would receive an income as long as the stock price is more worth than zero! But this can not be the intention of a SOP.

[...]

1 See Schneck, O. (1998), p. 575

2 See van Horne, J.C. (2001), p. 4

3 See Eitemann, D. / Moffett, M. / Stonehill, A. (2001), p. 7

4 See Bühner, R. (2001), p. 16

5 See Achleitner, A.K. / Wichels, D. (2000), p. 12

6 See Martin, R.L. (2003), p. 12

7 See Achleitner, A.K. / Wichels, D. (2000), p. 18

8 See Winter, S. (2000), p. 554

9 See Schruff, W. (1999), p. 621

10 See Schruff, W. (1999), p. 621