An employee stock option (ESO) is commonly viewed as part of the employee’s remuneration package. Many companies use employee stock option plans to attract, compensate and retain employees. This is normally granted to the top tier employees of a company, who hope to profit by exercising their options to buy shares at the exercise price when the shares are trading at a price that is higher than the exercise price.
A ESO plan without proper performance hurdles will allow top executives to manipulate the scheme and profit from the upward movement of shares, without making an extraordinary effort. Top executives are normally paid a salary and perks for achieving the normal results as per budgets. In a good plan, the CEO must substantially raise the stock price, in a tight time period, before he can make big money from stock options. Only by beating the targets (or a stock index like S&P) should the CEO get to share in the gains. If an annual bonus is also part of the stock option then the hurdle can be lower than normal.
An example of performance vesting plan is given below;
Under Citicorp’s 1998 plan for CEO John Reed and over 50 other executives, that was $121 a share, and Citicorp gave Reed 300,000 options at that price. But there’s a catch. Reed and the other executives get to exercise their options–meaning they vest–only when and if the stock reaches a much higher target price. In Citicorp’s case, that’s $200, within only five years. Hence, if Reed were to raise the bank’s stock price only 10% per annum, to $194 a share by 2003, he’d forfeit all his options. On the other hand, if he only barely makes it, he gets the entire windfall of $23.7 million. For Reed, it’s a real nail-biter. The plan may be considered fair by all stakeholders. Whilst the CEO works hard to beat the target, the employees will get properly incentivized and the shareholders also would benefit from the share price movements.
The remuneration committees should ensure such hurdle rates are included into stock options so that all stakeholders could share in the growth.