Astronomical stock options
If you have paid any attention to executive pay news recently, you probably noticed the massive stock options some executives received.
The next highest-compensated executive in 2018, Axon (formerly Taser International) CEO Patrick W. Smith, received 99.97% of his $246 million pay in stock options.
Companies granted massive stock options in the past as well. For example, the highest compensated executive in 2015, NantKwest CEO Patrick Soon-Shiong, was awarded $132 million in stock options. Also, the highest compensated executive in 2012, Oracle CEO Lawrence J. Ellison, received $91 million in stock options, representing 94% of his total compensation.
Why do companies award executives such large number of stock options?
Stock options as awards
When stock options are granted to an executive, he receives the right to purchase a share of company stock at a particular price for a set period of time, typically ten years. The price at which the options may be exercised is usually the company's stock price when the options are granted. If the company performs well, the stock price will presumably increase over the exercise price, giving the options value and rewarding the executive for his role in the company's success.
An option award is therefore a long-term incentive, rewarding executives for achieving the company’s strategic objectives that would maximize shareholder value.
For Tesla CEO Mr. Musk, his $2.3 billion award “was designed to be entirely an incentive for future performance that would take many years, if at all, to be achieved,” said the company.
For Axon CEO Mr. Smith, his $246 million award was offered as “an incentive for future performance in the form of a high-risk, high-reward compensation plan,” according to Axon.
Awards with strings attached
Although an option award may seem a lot, it is not an instant cash payment. Often, an executive must achieve specific performance milestones before exercising the granted options and realizing the value of such awards.
This is the case for Mr. Musk and his company Tesla. The company divided Mr. Musk’s $2.3 billion option award into 12 tranches. In order to exercise each tranche each time, Mr. Musk will have to meet two requirements: 1) the company’s market capitalization increases to $100 billion for the first tranche, and by an additional $50 billion for each tranche thereafter; and 2) one of Tesla’s 16 operational milestones is attained.
These requirements are difficult to meet, making the granted options difficult to exercise.
As of April 2019, Mr. Musk hasn’t realized any value of these options, since he didn’t achieve any market capitalization milestones, even though he achieved two operational milestones, according to Tesla.
If any options are not exercised by the end of the award’s ten-year term, they will be forfeited.
Similarly, Mr. Smith’s company Axon said “no options will vest simply through the passage of time.”
Like Tesla, Axon also divides Mr. Smith’s option award into 12 tranches. Each tranche of options will only become exercisable each time if: 1) Mr. Smith attains one of sixteen specified operational goals, and 2) the company market capitalization increases by $1 billion.
As of April 2019, Mr. Smith hasn’t exercised any options, since none of the vesting milestones has been achieved, according to Axon.
The bottom line
At first glance, an option award may seem a lot. But it is not an instant cash payment. Often, granted options take time to become exercisable, if ever.
By awarding stock options - with strings attached - to an executive, the company hopes it can incentivize the executive to achieve the strategic objectives and maximize shareholder value.