What are Director Options?

When a company becomes listed through an Initial Public Offering, shares are issued and distributed to shareholders who are not the board of close management. There is often a conflict when this happens as the new shareholders wish to maximise the returns on their investment, whilst the directors may have other targets, such as to complete acquisitions. The result is that a gap can grow between the shareholders and the directors.

There are a number of methods available to reduce this gap, and re-align the interests of both the shareholders and the directors. One of these is through the use of Share Options which are commonly referred to as Director options. This method has gained popularity over time due to the flexibility of the method.

How do Director Options work?

An option related directly to a company's share price. Options are often used as part of a directors salary so that one percentage is in cash, and the remaining percentage in options. This is a favourable method for directors as they have a fall-back clause in terms of the cash. However, if a company is strapped for cash, this an alternative that will not drain their cash balance.

What is an option? Well, it's in the name. It's a method whereby a director can purchase shares at a pre-determined share price should the share price reach a higher level in the future. Therefore this system is reliant on incentives. The directors have the incentive to try to increase the share price up to the higher level (known as the exercise price) so that they can cash in their options by buying them at the exercise price. If the share price does not reach the exercise price over the time allotted, the options won't be exercised and they will lapse. Therefore the interests of the directors are supposedly aligned with that of the shareholders (i.e. both parties want a share price increase). The incentive for the directors is actually to get the share price to comfortably exceed the exercise price as that is where the profit lies (any positive gap between the exercise price and the future share price).

Here's an example from a 'Share Options Grant' RNS by pharmaceutical firm PuriCore (LSE:PURI).

There are a few points to note from the example above:
- The options are being issued to Non-Executive director Charles Spicer
- He is being granted 35,000 shares
- The shares have a vesting period. When a set of share options vests, the individual gains control of the options. Basically that means that Charles Spicer cannot exercise the first half of his options (17,500) until 09/08/2014. He cannot exercise the remaining 17,500 until 09/08/2015
- The options have a 5 year term over which they are valid
- The exercise price is 41p

That means that Charles Spicer can only exercise his options, and benefit from the cash they can bring if the share price surpasses 41p over the period, and he exercises them. To be clear, the options allow him to purchase the shares at 41p in the future. If in 3 years time the share price of PuriCore is 82p, he can exercise the shares at 41p and immediately be at a 100% profit. At this point he can sell the shares. Therefore there is a strong incentive for him to want the share price to rise, especially since 35,000 shares at 41p amounts to £14,350. If the share price does rise to 82p, that would net him a £14,350 profit that is in addition to his general salary.

However...

Share options schemes have come under fire for a number of reasons over the last few years:
- As the options were granted by the Board, overallocation became a problem, where the boards were granting themselves overly generous options packages
- Sometimes the exercise price is set too low in the minds of shareholders meaning that the incentive is not there. Taking the PuriCore example again, the exercise price was 41p over a 5 year term. When the options were granted, the share price was approximately 41p. I fail to see any incentive at all in that package which is disconcerting as it rewards neutral performance. It also shows no ambition although many investors would take it that the directors are abusing the share options system
- Some companies have introduced options schemes without reducing the salaries of the directors. That means that once again, the directors are exploiting the system as in some cases it has just led to an increase in the directors' wages
- If a company suffers from poor share price performance after the granting of options, some companies will simply re-structure them so that they have a lower exercise price. Of course, that will never happen in the case of a good share price performance. Therefore, does the system allow underperformance to be bypassed too easily?
- In the case of excessive options being granted, upon their exercise, dilution can weigh on the share price

Due to these factors, there needs to be a careful balance between the use of options and salaries within a company's remuneration system. If the options are too generous, the market's trust can be dented. The exercise price should be fair, and dependent upon the type of company, it should require a fair amount of effort to achieve. It should not be within 5-10% of the current share price for any circumstances, in my opinion. Of course, options will continue to be misused, but if used correctly by a company, it can be an effective way to align the interests of both directors and shareholders.