Managing Overhang to Increase Shareholder Value

The heightened attention to the cost of companies accruing for compensation and measurements of a company’s stock overhang—the potential total dilution of a company’s stock if all participants exercised all of their stock options and earned all of the option grants available in the pool—and the firm’s burn rate—a calculation of the number of shares granted for the year over the total number of shares outstanding, according to a presentation delivered at the 13 ^th annual National Association of Stock Plan Professionals (NASPP) conference in Chicago.

“Costs have become the overwhelming focus for investors,” says Institutional Shareholder Services’ (ISS) Executive Vice President and Special Council Pat McGurn. “Investors are being focused on the value being delivered.” He adds: “We have tested the correlation between high burn rate and various risk measurements. What we found is that second highest combination of high risk and low performance is a high burn rate,” said McGurn. “This is not just a puritan effort.”

As the investors go, so goes the corporate boardroom, which as a group has begun to demand that their finance and treasury departments take steps to lower overhang levels and the associated cost of shares moving into employees’ hands and away from the markets, according to Beverly Aisenbrey, Managing Director of Frederic W. Cook & Co. Inc. The Chicago-based compensation consultancy notes that long term overhang is now down to 11.97% from 12.33% the previous year. For recent IPOs the average overhang level is now running between 10 – 15% from as high as 30% five years ago.

Levels Still High

“The levels are still quite high,” says Aisenbrey. “This is a result of the dot com years when everyone was giving away a lot of options. Today, there is still a lot of residue from underwater options, and I think these are going to be with us for a while.”

The high overhang rates are not just a cost for companies; they reduce the amount of shares outstanding to attract new investors. “When you have overhang in the 40% to 50% level, that is not a compensation plan, that is a going private strategy over time,” said McGurn. “Right now, investors are happy to see that shareholder transfer number going down.”

Offering those in attendance a strategy to reduce those levels even further, Aisenbrey said companies can offer shorter option terms or less generous post-retirement terms, encourage early option exercise to meet ownership guidelines, reduce the use of stock options, or grant other types of awards which will vest and come out of the overhang more quickly. “We see new grants looking to shorten option terms to five to seven years versus 10 years. With the short term, if the share prices are bad, you won’t have the unexercised options hanging around as long.”

However, Aisenbery notes that while share awards may be decreasing, the value of the grants are not declining that much due to more companies looking at alternative equity-based methods of compensating employees—such as restricted stock, performance shares and performance units—whereas before FAS 123(r) mandated expensing these methods may have been too expensive. In 2005, 80% of companies granted stock options, while 64% are granting restricted stock, 53% performance shares and 15% performance units.