Devil's Advocate: The cost of share options

Ever wondered how useful share options really are, to employer and employee? How about the wider cost to other shareholders or the wider economy? Martin Brampton takes a 30,000ft view...

We've been trying to figure out how IT people can hope to secure an income after they retire from the hurly burly of technology. The state is shirking its responsibilities and is not even discussing the issues in an open way. Although investment in companies looks like one of the few practical ways we can preserve value, we ought to look at the threat posed by share options.

Share options have been a well-known financial instrument for many years. They involve a contract to buy or sell some shares for a fixed price at some future date. There is no obligation to complete the transaction, though. So, if one owns an option to buy shares in the future, at the critical date a profit will be made if the shares are then worth more than the price set in the option. If no profit will be made, the option will not be exercised.

Recently, this has been adapted as a means of rewarding company executives and sometimes employees generally. There is some logic to this. If the company prospers, shares will be worth more and options will show a profit, rewarding those who have developed the company. It seems as if directors and staff are thus motivated to act in a way that benefits the shareholders.

Unfortunately, the true situation is more complicated. Share options are not cost free, yet the granting of options is not included in the company's profit and loss account. Where options are used extensively to reward staff whose salary is otherwise inadequate, the extreme result can be that a company appears to show a profit, while the reality is that it is loss making.

If the cost of share options is not shown in the profit and loss account, how does it show up? One possibility is that when the options are exercised, the company buys shares in the market and hands them over at the agreed price. Naturally, if the beneficiary of the option is showing a profit, the company will bear an equal loss by buying the shares at the high market price and selling them to the individual at the low price agreed in the option. This is not, however, treated as a trading loss.

Even less obvious is the situation where the company simply issues more shares. This confuses matters even further. The company may not issue shares at a discount, so it is likely to lose some money selling the new shares at the option price. Existing shareholders now also own a smaller proportion of the company. Since the company's profitability has not increased proportionately, the general run of shareholders are thus worse off.

Companies that have committed large numbers of options thus have a liability hanging over them that is not clearly recorded in published accounts. As stock markets grow increasingly pessimistic, more attention is paid to such matters, and the fall in share prices is liable to be accentuated.

All this supposes that share options are granted at a fixed price and the beneficiary has to take whatever movements in share prices yield. In fact, when share prices have not been rising rapidly, company executives have often insisted that options have the 'fixed' price reviewed to guarantee them a profit.

Now we are up against economic reality. The real economy grows slowly, rarely more than two per cent per year. Executive pay has been growing for a number of years at around 10 times that rate. This is only achievable if executives receive a growing proportion of the national income. That they can do this seems to derive from the fact that most shares are owned by mutual funds such as pension schemes and unit trusts. The people whose money is invested do not have any rights as shareholders, since it is the fund that is the shareholder.

The obvious soft target to provide the wealth that feeds growth in executive remuneration is the stake in the economy that belongs to future pensioners. It follows that if you want a decent pension, you may well need to campaign vigorously for far reaching reforms in company and financial law. Will you do it?

** Martin Brampton is a director and founder of Black Sheep Research (www.black-sheep-research.co.uk ), an independent consultancy providing research, writing and speaking services on a wide range of business and technology subjects. Martin was previously a director at Bloor Research, and has worked with IT as a user and analyst for over 20 years. He has been a frequent contributor to silicon.com's Behind the Headlines TV programme and can be contacted at silicon@black-sheep-research.co.uk .