The first of many BEE deals drowning

Moneyweb’s article on Barlow’s re-striking of BEE options echos my earlier post on the trouble of underwater incentive options.

The sense of the article is that this sets a bad precedent. Of course, the precedent has been set years ago – I’ve personally calculated the additional costs under IFRS2 for BEE deals in danger of expiring worthless because the share price didn’t perform as expected. I’ve also seen deals where performance conditions for BEE partners have been massively relaxed because the performance was massively below the original targets.

But more than that, what choice do companies have? I’ll quote my comments on the Moneyweb article below:

Company’s issue the share options in order to improve their black shareholding for BEE purposes. The cost of this was born by shareholders, presumably because the alternative was more costly. (One can argue “right” and “wrong” but here we are talking economics not politics.)

Now, if the options expire out of the money, then the company loses the BEE points. In that case, providing the cost of issuing new options is still less than the cost of not being appropriately BEE rated, then the rational choice is to issue new options. Re-striking existing options is just a pragmatic approach of achieving the same end.

IFRS2, the accounting standard that governs the measurement of the expenses of issuing share options to employees or BEE partners, will require the increase in the value of the options to be expensed. Thus, the economic cost of issuing the options will be recorded in the income statement as well as being a true economic cost.

If the BEE partners had been given shares rather than options, then there would be no chance of them expiring out of the money. They would then experience upside and downside just like ordinary shareholders. However, to achieve the same % black ownership, the expense incurred would have been greater.

The company took a gamble that the share price would rise, hoping to save a buck. Market turned against them, and now they have to dip back into their pockets to pay a little more. Does it make sense for a company to gamble on its own share price? Wouldn’t it be better to take the hit upfront, with no fuzzy option-like liabilities floating around, half-hidden on the balance sheet?

The really frustrating thing is that often the utility cost of the issue options (to the current shareholders) is greater than the utility benefit gained by the BEE partners due to the restrictions on sale and concerns around concentration of risk.

Share options issued by companies for various purposes have many hidden dangers. If you’re planning to use them, it might be worthwhile getting a second or third opinion on:

  1. How to structure it
  2. How much it will cost under a range of scenarios
  3. What impact it will have on the financial statements
  4. How much it will cost to be valued for each financial period as well as audited
  5. Whether it will incentivise the desired behaviour
  6. Whether the beneficiaries understand and appreciate the structure, so that utility discounts are limited
  7. How the costs and benefits of the chosen approach compare against alternatives

Each of these 7 points requires careful thought, experience and training. A little consideration and planning can give dramatically better results.

Published by David Kirk

The opinions expressed on this site are those of the author and other commenters and are not necessarily those of his employer or any other organisation. David Kirk runs Milliman’s actuarial consulting practice in Africa. He is an actuary and is the creator of New Business Margin on Revenue. He specialises in risk and capital management, regulatory change and insurance strategy . He also has extensive experience in embedded value reporting, insurance-related IFRS and share option valuation.

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