Rights or Options or both?
Increasingly clients are seeking advice on long term incentive (LTI) plan design, particularly which equity instrument is appropriate in this new operating environment. The focus is flexibility to not only recognise and address changing business context, it is also about adapting to participant preferences. Greater plan flexibility is a gradual trend we’ve been noting over the past couple of years, and with the COVID-19 pandemic driving share price volatility this will no doubt heighten the need for companies to rethink LTI plan design.
In recent years, Performance Rights (also known as zero exercise priced options ZEPOs) have been adopted by most ASX listed companies with share Options plans running a distant second. Interestingly over the past 12 months, companies we’ve worked with on LTI design have introduced Options plans or developed structures which include both Options and Performance Rights.
Client Example – Choice of Options and/or Performance Rights:
Under the LTI Plan, Performance Rights were offered that vest based on strategic hurdles whilst Options were offered which vest based on a premium price hurdle. Depending on the participant preference, Options were selected (typically those individuals with greater appetite for risk and able to influence Company share price) and/or Performance Rights chosen (typically those individuals who are more risk adverse).
While Performance Rights still remain the most prevalent LTI vehicle, our data indicates a growing trend of companies deploying multiple LTI instruments e.g., Rights and Options. This trend has been observed generally and within the Resources sector specifically. Between 2019 and 2020, the use of multiple LTI vehicles increased from 6% to 14% in the Metals and Mining sector and from 6% to 18% in the General Market. See Figure 1.
Figure 1 – LTI vehicle prevalence
Data source: Market insights based on analysis of a sample of 90 ASX companies from the TRP database, representative of large, mid and small cap.
“But what about the tax implications?”
Fortunately, since 2015 tax is now less of a factor when considering Options vs Rights. Legislative changes have resolved the adverse tax outcomes of Option plans, which makes them a viable LTI alternative particularly for small to mid-cap companies with large potential share price growth.
Options may be the preferred vehicle over Rights for some participants based on the potential leverage (typically a higher quantum), concessional tax treatment and overall economic benefit. Figure 2 below compares the economic outcomes (after income tax) between the two vehicles based on a starting share price of 40c. Based on an exercise price of 60c and a quantum of 4 times as many Performance Rights (equivalent accounting values), Options hold greater value to the participant once the share price reaches 69c i.e., a 73% share price growth.
Figure 2 – Economic benefit of rights vs Options
So which LTI vehicle is right for your company?
Given the current remuneration landscape, now is the time to consider LTI design for the new financial year. LTI vehicles should no longer simply default to Performance Rights. Management and Boards should take into account broader considerations when determining the most effective LTI vehicle(s) such as:
- Risk profile of the participant – who is eligible to participate and what is their appetite for risk
- Share price volatility – the potential for share price growth over the medium to long term
- Company value drivers – what performance measures encourage the right behaviours to driver company value and how can participants influence them
If you would like to explore LTI design in more detail, our article on Designing Employee Incentives for ROI is a useful resource.
The Reward Practice specialises in helping companies analyse their current state, current practices and strategic goals and then helps to design practical remuneration structures that promote sustainable growth and provide both short and long– term benefits for the company, employees and stakeholders.
With many companies preparing revised remuneration programs for the new year, now is the right time to review incentive schemes to ensure they provide optimal outcomes for all stakeholders. If you are interested to find out how we can help future-proof your remuneration and reward structure, please contact us for a no obligation discussion.