Stock options should be given to management to incentivize their actions and to create the most shareholder value. But their exercise price should be set in such a way that shareholders can be sure it was not due to luck or any other external factor of management’s control. How is that done?
Let’s say we were the board of Coca-Cola and we had to design a stock option compensation programme. What should be the length, amount and exercise price? The length should be the average length of a business cycle which is around seven years. This allows enough time to see outcomes of decisions through various economic periods. The amount of stock options are a subjective matter but ultimately down to the person hired, the competitive landscape etc.. The exercise price is where things are rarely done correctly in our opinion.
If you took the share price performance from 2003-2014 as your baseline for Coca-Cola performance then the 2014 Equity Plan could set the exercise prices for various tranches of options at the 95% confidence interval on 1,000 simulated future stock price paths (shaded area). The orange line shows actual total return performance since the 2014 Equity Plan was made. Many would most likely say that it’s a tough goal to meet. Exactly that’s the entire point. Luck should play as little a role as possible in profitable handouts for performance. On the other hand, if the new CEO can actually deliver growth rate above this threshold then a large amount of wealth from stock options is justifiable.