July 08, 2010

Are Share Options Worth it?

I have in the past worked for a company that gave share options to its employees. The theory was that when the employees did well the company did well. When the company did well the shares did well and everyone benefited. For a number of years this was true. The shares vested at a price of around $30 and at one point the share price went up to $120. A lot of people made a lot of money on them (One employee working in an Eastern European affiliate apparently retired because the options made him so much money compared with his usual salary).

Then the next lot of shares were vested. They were priced at $70. The market was still at $120. Everyone was anticipating good things. People were rubbing their hands in glee and greed.

Then the company lost the exclusive patent on their biggest single product.

A cheaper company took 90% of their market share and the share price dropped to around $70. Since then the company has hit a number of issues - a lot of which are regulatory but some of which are just general downturns in the market - and the shares are now hovering around $30.

So where does this leave the employees who were gifted the share options? At the moment they are worthless. But still the senior management are using them as an incentive to try and encourage people to work harder. But what they don't see is that the hard work being put in by the employees is not having any impact on the share price. This is because the share price is not connected to the level of work put in by the employees. It never was. The correlation back in the early days was merely coincidental and not causal. But the management can't see that. Or won't see that

But here's the problem. This type of reward will start to encourage the wrong type of behaviour. Let's take a hypothetical example:

Assume I am working in a biopharmaceutical laboratory. My aim is to synthesise and test drug candidates before sending them out to market. One of these drug candidates could be the cure for cancer, or the next Prozac. It could be worth literally billions of dollars in profit. And profits like this will bump the share price - and hence my options value - into the stratosphere. But today I notice that the clinical trial results I am seeing indicate a severe adverse side effect caused by taking this candidate drug - people die.

I have two options:

  1. I can reveal the results as they are and effectively kill the drug, thereby causing the share price to drop again along with the values of my options.
  2. Or I can hide the results  massage them to not look as bad as they actually are. This will allow the drug to be put onto market and the profits will roll in. The share price will rise. My options will vest and I can then afford the new house/ kids education fund/ care home for my elderly mother that I dearly need money for.

Which option should I take?

The answer is obvious: I should take the morally correct choice and publish the full results.

Now which option will I take?

That answer is less than obvious. When a company rewards people according to certain criteria or standards then people will tend to ensure those criteria or standards are met. This is the same reason call centres will answer phones within x rings and deal with your query within y minutes. It isn't because they are efficient and want to help you, it's because they don't get paid if they don't meet the metrics.

So if my reward (in the form of a well performing share option) is based on good profits and these profits are dependent on candidate drugs coming to market, then the chances are that certain unfavourable information relating to a drug that will impact its marketability is going to get 'lost' or 'hidden' amongst other non related pieces of data. After all I want to be able to afford to send my kids to somewhere that will educate them correctly, so I need money to pay into their education fund. In a couple of years when the truth gets out about the adverse clinical trial events I will be either in a  completely different part of the company or I will have vested my options, cashed them in and left. There will be no personal accountability back to me. Sure, the company may get dinged, but by then my kids will be in good universities, or my mother will be in a comfortable, expensive care home, or my family will be living in the new designer home with pool, games room, wide screen TV and access to the best golf course in town.

(Before I go any further I just want to say that the above example is completely hypothetical. No link is implied to any company I have worked with or know about. It was purely an example to indicate the nature of the problem. Having said that there are several pharmaceutical companies that have recently been the perpetrators of (alleged) clinical trial cover-ups.)

Nevertheless, it is incumbent on senior management in any organisation to ensure that they are rewarding their employees in a manner which will not encourage unethical behaviour.

So, are share options worth it? Yes, if they genuinely reflect the state of the company and are not being used as a carrot to promote unethical behaviour - especially in a downturning market.

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