When you’re underwater, what’s the incentive?

Employee Share Options became popular during the tech boom of the last millenium. They were used before, but the explosion across more companies, across more levels of employees and as an expected part of executive remuneration was a product of the Silicon Valley boom.

There are pros and cons for share options. Used correctly, they help to align management’s interests with those of shareholders, share profits objectively and allow startup companies to attract heavy hitting staff without needing to reach deep into pockets for cash salaries and bonuses – especially when the cash doesn’t exist yet. The complexities, abuses, high cost, relatively low perceived value, warped risk taking motivations and difficulty in understanding the workings outweigh these benefits in many cases.

A specific problem is that of underwater options. If the share price decline significantly below the original issue price (commonly used as the strike price), the incentives created by the options are changed. Typically, the incentives either:

  • disappear since management isn’t confident of being able to turn the problems around before the options expire; or
  • management take on excessive risk in an attempt to benefit from the upside of successful gambles while being largely protected from failure.

In the case of Old Mutual’s Black Economic Empowerment (BEE) deal, the situation is a little different. Direct managerial control is limited, which reduces the problems of the second point. However, the first point will likely lead to polite requests for sweeter deals, restriking or the issue of additional instruments. All in all not a great deal for shareholders.

If nothing is done, and if the share price continues on its current trajectory, it’s likely the deal could expire without the permanent transfer of ordinary shares to BEE shareholders with grave consequences for Old Mutual’s BEE deal.

I’ve used Old Mutual purely as an example. There are many other companies facing similar problems given the state of the stock market and the higher interest rates (to which notional loans are often linked). I’m also not aware of all the details of Old Mutual’s deals and arrangements.