Stock option programmes as a value orientated management instrument

Content

List of abbreviations

1. Introduction

2. Definitions
2.1. Agency theory
2.2. Details about stock option programs
2.2.1. General idea
2.2.2. Categorisation

3. Analysis stock option programs
3.1. Discussion
3.2. Advantages of stock option programs
3.2.1. War for talents
3.2.2. Solution for the agency problem
3.2.3. Stock option programs in young, fast growing companies
3.2.4. Stock option programs and value creation
3.2.5. Further advantages
3.3. Critic on the common stock option programs
3.3.1. Windfall profits
3.3.2. Repricing
3.3.3. Masking of costs of the program
3.3.4. Wrong incentive
3.3.5. Different time horizons
3.3.6. Abuse
3.4. Valuation of stock option programs

4. Development of an optimal stock option program

5. Examination of the stock option program from SAP AG

6. Conclusion

Appendix

Sources

List of abbreviations

illustration not visible in this excerpt

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 sector^[7] 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 “st ock 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.

The stock appreciation rights work more or less like “phantom stocks”, and after the end of the program the manager obtains the difference between current value and original value. But the manager can also use the option to buy the share for the original price and keep the shares.

The other possibilities are real programs. In these management receives so called “naked options”, which means that the management receives options for the direct subscription of shares. This is the normal procedure in Anglo-Saxon countries. Also in Germany this procedure becomes more famous, since the changes in the law “KonTraG” allow it.^[11] The use of convertible debentures or optional bonds does lead to transaction costs. Because of that and their complexity we do not give here further explanations. Their use instead of “naked options” is still low and will become less important.^[12]

Connected with real programs is also the question where the capital comes from to pay for the SOP. While with virtual instruments the costs are directly located in the company and lead to a cash outflow, the real programs demand:

- to buy shares back from the market (in Germany not practiced^[13]) or
- to buy options for own shares from banks^[14] or
- use of shares from the property of old shareholders (mostly founders or huge shareholders)^[15] or
- subscription of new shares

The subscription of new shares can in Germany be done with a conditional capital increase or authorized capital increase. The latter one has the disadvantage (form the view of the company) that it gives all shareholders the right for option on new stocks. Therefore the conditional capital increase is preferred, because there exists no right for the option on new stocks. The shares can be used for the management only. In that case, the later explained “watering effect” appears.

An overview about possible structures of SOP can be seen in the following graphic:

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Possible structures of SOP^[16]

The use of SOP should be done frequently, in the best case every year, because only then the management receives a long term and continuous incentive.

The categorization and the details could be further explained, but this is not the sense of the paper. Summarized it should be clear that SOP allow different ways to shape the programs. Wenger indicates that at least 256 variations are possible.^[17] It depends on the company and their shareholders which model they want to create.

But all models have the same intention, which are described in the next chapter.

3. Analysis stock option programs

3.1. Discussion

Weather SOP have advantages or disadvantages can not clearly be said. It often depends on the situation and the view the supporters or critics have. While the manager in Germany still argue that their option plans are far too low valued compared to their colleagues from the United States, thinks the majority of the population that the managers are overpaid and that the stock option plan have the only goal in making the manager richer.^[18] But this is mostly a discussion of feelings, not of facts. The following parts about advantages and disadvantages of SOP should give a clear view on the SOP, which is based on facts and experience with this program.

As advantages it will be discussed how far the SOP influence the following points:

- War for talents
- Solution for the agency problem (Incentive instrument for the management)
- Cash saving instrument
- Value increasing instrument
- Advantages through different program options
- Further advantages

As disadvantages these points will be described:

- Windfall profits
- Repricing
- Masking of costs
- No solution of the Agency problem
- Wrong incentive for the management
- Abuse of the program through the management

3.2. Advantages of stock option programs

3.2.1. War for talents

The so called “war for talents”^[19] refers to the circumstance that more and more companies fight to get the best heads for their own companies. With begin of the internet boom also young companies began to attract high educated personal. These companies did not attract with a fixed, high salary. But they promised to share the wealth from the stock development with the new employees, which could in some cases much more than they could ever earn in other companies with no SOP. The aggressive use of that instruments leaded in the recent years to a chain reaction, because established companies had to compete with the young companies through also offering SOP.^[20]

The salary is, together with a high challenging company, good future prospects the main reason for employees to work for a company.

One example for the contrary is the German company SAP AG: In 1998, their CEO Hasso Plattner refused to pay his management from the US-subsidiaries with SOP. He argued that in Germany there is another way of thinking in paying management. The result was that he lost over 200 executives.^[21] It was said that analysts and experts laughed a lot about this narrow-minded opinion. Moreover, it is international usual to pay executives with SOP.^[22] Nowadays the SAP AG has huge SOP for employees and for the management. Their system is explained in chapter 5.

But SOP are not only a way to attract managers to work for the own company. They are seen from the hired managers as a way to motivate themselves. Managers see SOP as a motivating instrument. It should increase their efforts to do the best for the company, because they will also receive a gain out of an additional success. This also leads to the conclusion that managers are willing to take more risks, which will be explained later.

Over all, it can be said that especially German companies have a backlog demand in offering and paying SOP. The spread of SOP is in Germany far less behind the U.S., because the culture of investing in stock and the laws to allow that are different in the U.S. than in Germany. Law changes in Germany in the last years made it easier to work with SOP.^[23] Also the value of German SOP is far behind Values in the U.S.^[24]

So the companies try to win the best employees for their companies through. The “war for talents” is reason and advantage of SOP simultaneously.

3.2.2. Solution for the agency problem

The agency conflict was explained in Chapter 2.1. With SOP the interest of the management and the shareholders can be combined, because both are interested in the increase of the value of the company.^[25] It is said that it is a system that brings management and investors together.^[26] When this goal is reached, all efforts from the managers are concentrated on the increase of the value of the company (the question how this can be measured will be discussed later). The executives think more like entrepreneurs, when they are paid with stock options. This is very important, because “entrepreneurial thinking” counts as a very important point of success.^[27] With the SOP, the executives should think long-term orientated. Investments should be done in that field that offers the best return. Every part of the company has to be searched for improvements. In some cases, it is recommended to close or sell parts of the company. Value destroying expansions will be prevented.^[28] This is very important under the fact that about 70% to 80% of all mergers and acquisitions do not offer additional value.^[29] More, they often destroy value. This can be reduced with 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

^[11] See Weber, M. (2000), p. 32

^[12] See Weber, M. (2000), p. 33

^[13] See Achleitner, A.K. / Wichels, D. (2000), p. 19

^[14] See Schruff, W. (1999), p. 619

^[15] See Winter, S. (2000), p. 553

^[16] Self-provided

^[17] See Wenger, E. (1999), p. 569

^[18] See Palan, D. / Papendick, U. (2004), p. 46-52

^[19] Loewe, C. / Sieber, U.D. (1999), p. 48

^[20] See Loewe, C. / Sieber, U.D. (1999), p. 59

^[21] Walsh, I. (2000), p. 16

^[22] Wenger, E. (1999), p. 565

^[23] See Schruff, W. (1999), p. 616

^[24] See Boyens, W. F. (2003), S. 108; see Achleitner, A.K. / Wichels, D. (2000), p. 13

^[25] See Wenger, E. (1999), p. 565

^[26] See Stern, H.J. / Peck, S. (2003), p. 19

^[27] See Achleitner, A.K. / Wichels, D. (2000), p. 13

^[28] See Weiß, D.M. (1999), p. 82

^[29] See Selden, L. / Geoffrey, C. (2003), p. 51