Improve Stock Options for Executives

Stock options typically vest in three or four years and allow executives to realize the full increase in the share price above the strike price of the options. The problem is that share movements alone are a poor indicator of a manager’s performance, says Richard Dobbs, a consultant with McKinsey. A McKinsey analysis of the stocks of some 400 companies determined that since 1962, more than 40 percent of stock returns for the average company in any one-to-three-year period are attributable to movements in the stock of other companies in its sector and of the market as a whole.

A solution increasingly being embraced by European multinationals is to define criteria that isolate company share performance from stock price movements in the rest of the market. German chemical company BASF AG has undertaken one of the more creative plans to accomplish this. Each of the company’s top 800 executives in the plan is required to make an investment in BASF stock. “A major issue for our CEO and supervisory board was that executives had to bring some of their own money to the table,” says Robert Thomas, director of compensation and benefits. Eligible participants can invest between 10 percent and 30 percent of their variable compensation to buy shares at the market price the day after the annual shareholder meeting. The employee then receives four options per purchased share, each with two (A+B) subscription rights. Both rights vest after two years and can be exercised over the following six years, but BASF has designed both absolute and relative performance hurdles that determine how the options can be exercised. The A rights can be exercised as long as BASF stock appreciates at least 30 percent from the day the options were granted. The B rights provide participants with a relative hurdle: for every percentage point BASF stock outperforms the Dow Jones Global Chemical Index, holders can purchase shares at a discount of 2 percent from the market price when the options were granted. If both hurdles are met, an executive can exercise one option and get two shares.

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