Corporate boards have failed in stock option compensation

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.

We have to remember that when a CEO is hired the person is standing on the shoulders of cumulative decisions, investments and strategies that have created business with an intrinsic wealth path. If the new CEO cannot statistically deliver share price performance above the threshold of mere randomness or chance then why give the person handsome stock option compensation? Coca-Cola’s total return annualized in the period 2003-2014 is 7.7% and the 95% upper threshold on 1,000 simulated paths is 13.2% annualized. Statistically there is a 5% probability that Coca-Cola’s share price could deliver a higher annualized return than 13.2% given its historical path. Why reward anything that cannot beat randomness? By focusing on share price alone and only give stock options to the executive management team with exercise prices set based on simulated future paths many shareholders in companies such as Coca-Cola would get a better deal and much less complexity.

As we can observe from Coca-Cola’s 2018 annual report there are already 114 million exercisable stock options with a weighted-average exercise price of $35.74. This clearly shows that a lot of stock options have been rewarded to employees since the 2014 Equity Plan was activated at levels that mean that these options have a very high probability of being in-the-money simply based on randomness. Waste of shareholder money.