Once in a while we want to look at themes outside the weekly churn in financial markets. In today’s special edition equity update we look at stock option compensation and how corporate boards have utterly failed in doing it correctly.
The talk is always about bureaucracy in the public sector but the private sector has its fair share of bureaucracy and opaque rules. When it comes to stock option compensation it’s no different. Take Coca-Cola as an example. Their current 2014 Equity Plan is the guiding document setting the rules for stock-based compensation in the company. According to Article 11.2 (see picture) there are multiple ways an employee can qualify for stock options. This long list leaves a great deal of bureaucracy and discretionary decisions across the entire business. Way too complicated.
Stock options
should be given to management to incentivize their actions and to create the
most shareholder value. But their exercise price should be set in such a way
that shareholders can be sure it was not due to luck or any other external
factor of management’s control. How is that done?
Let’s say
we were the board of Coca-Cola and we had to design a stock option compensation
programme. What should be the length, amount and exercise price? The length should
be the average length of a business cycle which is around seven years. This
allows enough time to see outcomes of decisions through various economic periods.
The amount of stock options are a subjective matter but ultimately down to the
person hired, the competitive landscape etc.. The exercise price is where
things are rarely done correctly in our opinion.
If you took
the share price performance from 2003-2014 as your baseline for Coca-Cola performance
then the 2014 Equity Plan could set the exercise prices for various tranches of
options at the 95% confidence interval on 1,000 simulated future stock price
paths (shaded area). The orange line shows actual total return performance
since the 2014 Equity Plan was made. Many would most likely say that it’s a
tough goal to meet. Exactly that’s the entire point. Luck should play as little
a role as possible in profitable handouts for performance. On the other hand,
if the new CEO can actually deliver growth rate above this threshold then a large
amount of wealth from stock options is justifiable.
We have to
remember that when a CEO is hired the person is standing on the shoulders of
cumulative decisions, investments and strategies that have created business
with an intrinsic wealth path. If the new CEO cannot statistically deliver
share price performance above the threshold of mere randomness or chance then
why give the person handsome stock option compensation? Coca-Cola’s total
return annualized in the period 2003-2014 is 7.7% and the 95% upper threshold
on 1,000 simulated paths is 13.2% annualized. Statistically there is a 5%
probability that Coca-Cola’s share price could deliver a higher annualized
return than 13.2% given its historical path. Why reward anything that cannot beat
randomness? By focusing on share price alone and only give stock options to the
executive management team with exercise prices set based on simulated future
paths many shareholders in companies such as Coca-Cola would get a better deal
and much less complexity.
As we can observe
from Coca-Cola’s 2018 annual report there are already 114 million exercisable
stock options with a weighted-average exercise price of $35.74. This clearly
shows that a lot of stock options have been rewarded to employees since the
2014 Equity Plan was activated at levels that mean that these options have a
very high probability of being in-the-money simply based on randomness. Waste
of shareholder money.
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