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The Problem with Messrs. Black and Scholes

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May 24, 2011 | Barbara Baksa

The Problem with Messrs. Black and Scholes

I'm sure many of you are familiar with the limitations of the Black-Scholes model when it comes to valuing stock options for accounting purposes. Today I write about the problems of using the Black-Scholes model to determine grant sizes.

How Much Did Your CEO Make Off the Financial Crisis?
A recent article in the Wall Street Journal ("Options Given During Crisis Spell Large Gains for CEOs" by Scott Thurm, April 26) discusses windfalls CEOs have seen in their stock options that were granted during the financial crisis. Many companies granted options to their CEOs when their stock price was at a low point. Because options are virtually always granted with a price equal to FMV (only 1% of respondents to the NASPP's 2010 Stock Plan Design Survey, co-sponsored by Deloitte, granted premium-priced options), this results in a low exercise price.

Further compounding the problem is the method most companies use to determine how many shares to grant. 70% of respondents to the NASPP survey determine grant sizes based on, at least in part, the value of the grant. And for 85% of those respondents, for stock options, that value is determined using an option pricing model, such as the Black-Scholes model. What happens to the option value computed under one of these models when the stock price is low? The option value will be low as well. The end result is a larger grant, assuming companies are trying to grant a specified value. In addition to having a nice low exercise price, options granted during the financial crisis were for many more shares that would normally have been granted.

The upshot is that when the stock price recovers, the options are worth a lot of money. A lot more money than options granted during times of economic abundance, which seems counter-intuitive. Generally, options with low exercise prices are coveted by employees and executives; it hardly seems necessary to make these options larger than comparatively higher-priced grants.

What Can You Do About It

Well, at this point, there may not be much that you can do about options that have already been granted--although see my May 13 blog ("Eleven and Counting") about GE and Lockheed Martin modifying options granted to their respective CEOs to vest based on performance. But you may be able to adjust your grant guidelines to address this sort of problem in the future. Here are some practices to consider:

  • Base grant guidelines on a set number of shares, rather than grant value. This number might be determined by the run rate or overhang the company desires to maintain.
  • Set a cap on the number of shares that can be granted to any one person, regardless of award value.
  • Base grant value on an average, rather than a spot value.
  • Cap the amount of gain that can be realized from option grants. Not only does this help address this problem but it can also reduce plan expense.
  • Grant premium-priced options, particularly when the FMV is unusually low.
  • Base grant sizes on projections of future gain for various possible growth scenarios.
  • Impose performance conditions on options granted to executives--this at least ensures that executives are performing, rather than merely benefiting from the general market recovery.

Be sure to tune into the NASPP's upcoming webcast, "Equity Values of a Different Flavor," which will discuss some of the problems with using option pricing models for compensation planning purposes and possible solutions.

Another Chance to Qualify for Survey Results
Due to overwhelming demand, we have extended the deadline to participate in NASPP's 2011 Domestic Stock Plan Administration Survey (co-sponsored by Deloitte) to June 10.  Issuers must complete the survey to qualify to receive the full survey results. Register to complete the survey today--there won't be any more extensions!

New "Early-Bird" Rate for the NASPP Conference
If you missed the first early-bird deadline for the 19th Annual NASPP Conference, you can still save $200 on the Conference if you register by June 24. This deadline will not be extended--register for the Conference today, so you don't miss out.

NASPP "To Do" List
We have so much going on here at the NASPP that it can be hard to keep track of it all, so I keep an ongoing "to do" list for you here in my blog. 

- Barbara 

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