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Long term incentives: share options - Coggle Diagram
Long term incentives: share options
Share options may be given to executive directors and other senior managers as part of a long term incentive scheme
The award of share options is usually conditional on the director or senior executive meeting certain performance targets
Each options gives the holder a right to buy a new share in the company at a fixed price on after a specified date in the future (typically 3 years after the options were issued) provided that the individual still works for the company at that time
A director who is granted 2,000 options will have the right to subscribe for 2,000 shares
The purchase price for the new shares under the option is known as the exercise price, this will typically be the market value of the shares when the option was issued
Under the Listing Rules, the exercise price for options given to directors must not be less than the current market price for the shares on the date that the options are granted
If the market price of the company's shares goes up in the period between the issue of the options and the exercise date, the option holder will be able to make an immediate profit by exercising the options and selling the shares that they receive
Options do not normally have to be exercised immediately. The executive can hold on to the share options and exercise them later when the share price may have risen even further. However they must be exercised within a maximum period after they have been granted, typically 10 years, otherwise they will lapse
Grants of shares
An alternative to a share option scheme is a grant of shares
These are sometimes referred to as performance shares
Directors and senior executives canoe rewarded by the grant of existing shares in the company (which the company has brought back from other shareholders) provided that they are still in their jobs after a specified period of time, typically 3 years
At the time of the grant, the director will not actually receive the shares or acquire ownership of them. This will not happened until the shares vest which will be conditional on the achievement of certain performance targets during that time
Grants of shares under such schemes are usually made on an annual basis
With share options, the executive gets no benefit if the share price remains below the exercise price. With share grant schemes, the executive benefits even if the share price falls because the shares still have some value
Drawbacks of share option schemes
Share options reward holders for increases in the share price. Although shareholders also benefit from a rising share price, some might prefer higher dividends. Option holders do not benefit from dividend payouts. Accordingly if they hold share options, the exectuvie directors may have a personal interest in keeping the dividends low
When stock markets have a bull run, share prices tend to rise regardless of the underlying strength of a company's business. In these circumstances, the profits that option holders can make may significantly outweigh any increase in performance
On the other hand, when the stock markets are in bear run and prices are declining, share options lose value and may even become worthless. This may happen even though the company performed well in comparison with its peers
If a market price of a company's shares falls below the exercise price for its share options, those options will have lost all their value, unless and until the share price recovers. It would be foolish for directors to exercise their options if they could buy the shares more cheaply on the market. If it is clear that the share price will not recover during the life of the scheme, the options will no longer act as an incentive for the directors. In these circumstances, the remuneration committee may seek to re-price the options or to issue replacement options at a lower exercise price. Institutional investors do not like companies doing this as it protects the directors against the downside risk of a falling share price which shareholders themselves cannot avoid
Executive directors may prefer a long term incentive scheme involving the grant of shares since the shares will always have some value once they have vested
IFRS requires companies to recognise the award of share options as an expense, chargeable against the company's profits from the time that the share options are granted. This may have discouraged some companies from using options as an incentive