Employee Share Option Schemes (ESOPs) are an effective way of incentivising directors and employees. They provide them with a sense of ownership in the business and allow them an opportunity to share in the successes of the business.
The incentive will to a large extent be lost, however, if the value of the underlying security (usually an ordinary share in the issued capital of the employer, or its parent) is less than the relevant exercise price. Such options are generally referred to as "Underwater" or "Out of the money".
Many ASX listed employers are finding themselves caught in deep water when it comes to their ESOPs following the volatility of the Australian stock markets which has caused major stock indices to fall by as much as 20% since January this year.
With the loss of this financial incentive, companies may be concerned that key employees might be more inclined to consider offers from other employers. To address this risk, directors have been seeking advice on what can be done to increase the value of employee options by, for example, amending the exercise price or extending the option term (that is, the period during which the option may be exercised).
Listing Rule restrictions
For unlisted companies, there may be scope to amend the ESOP terms in this way. The original terms will often provide a mechanism for variation.
However, for companies listed on the ASX, there is very little scope to address underwater options. ASX Listing Rule 6.23.3 prohibits any change to a company's options which has the effect of:
- reducing the exercise price;
- increasing the period for exercise; or
- increasing the number of securities received on exercising.
Unlike many restrictions placed on a company, this prohibition applies regardless of whether the company has received shareholder approval for the modification of the option terms.
Subject to the terms of the ESOP, a possible solution for listed companies is to cancel their underwater options for consideration. This will require the consent of the company's shareholders and the relevant employee. The consideration for the cancellation may take various forms (for example, a cash payment to the employee). There is no requirement that the value of the consideration equate with the options' economic value (which, for underwater options, can be minimal or nil, depending on the remaining term). If the consideration is to take the form of other options (i.e. on more favourable terms), the ASX is likely to take the view that the overall effect of the transaction constitutes a change in the terms of the options and therefore a breach of ASX Listing Rule 6.23.3. In any case, if there is any doubt, legal advice should be sought before committing to any particular plan of action.
It is also possible for a company to simply grant new options to employees without cancelling their existing underwater options. A company must be aware though of the possibility that both old and new options "come into the money" down the track, which might give rise to an unintended windfall gain to the employee.
Alternatives to ESOPs
While companies listed on the ASX are greatly constrained in their ability to amend ESOPs, alternatives remain for a company to provide incentives to its employees through alternative equity participation mechanisms. For example, a company could implement an employee share purchase plan which involves either restricted or unrestricted shares and would provide the company with greater flexibility in terms of amending the terms of the plan. "Phantom" share option plans are also becoming increasingly popular and allow a company to gain similar results to company share and option plans without issuing or transferring a single share. These plans act like traditional stock market-based schemes, where options are issued and exercised, and staff benefit from upward movement in the shares' value. The only difference is that no shares actually change hands. The plans are effectively long-term cash bonus schemes.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.