Stock options attractive but underused by mid-sized companies

Many Australian mid-caps are labouring under remuneration guidelines not suited for them, according to experts.

BlackRock Australia’s director Pru Bennett has voiced concerns about the way long-term incentives are used to compensate executives who head companies with valuations that put them in the 300 biggest on the ASX.

Mining and resource companies comprise about 44% of the 300 companies listed on the S&P/ASX 300 and many are yet to develop tangible assets, or still in the exploration phase.

”What we’ve got in executive remuneration at the moment just doesn’t work,” Bennett told Fairfax newspapers.

”These companies are finding it difficult to meet remuneration standards once they get into the [S&P/ASX 300] index,” she said. ”They just don’t meet the major proxy advisers’ guidelines because they are just not operational, their only revenue is interest.”

Advisers typically suggest that executives are rewarded for measures like ”earnings per share”, ”relative total shareholder return” and ”return on capital employed”, which Bennett singled out as unsuitable for companies yet to develop an income stream.

But avoiding such measures can prove difficult for companies quickly vaulted into the ASX300, as they draw the interest of the major proxy advisory firms and institutional investors, explains Guerdon Associates managing director Michael Robinson. This puts them under pressure to submit to certain expectations regarding their remuneration.

“Before they could do their own thing without too much interference, without being subject to guidelines, but all of a sudden they’re put in this new world where there are guidelines intended for companies with productive assets, earning cash on those assets, and in many cases paying dividends.”

“Yet these companies don’t have any cash earnings to speak of, except perhaps for money in the bank from their initial capital raisings. Otherwise, they are spenders of capital hoping to stumble over the right set of rocks or, if they’re a biotech, the best treatment. They’re hoping to develop a productive asset that generates cash.”

For such companies, Bennett said options might prove a better avenue for executive pay.

But options have fallen out of favour among Australian companies in recent years after they began to be taxed at a higher rate in 2009, says Robinson. (But he adds that for smaller companies, the tax bill isn’t likely to be prohibitive.)

“In larger companies, the value put on stock options by the taxman is considerable, so the tax bill could be considerable. But you haven’t earned anything from them yet, so they typically aren’t granted by larger companies.”

But in companies yet to develop an income stream, the stock may only be worth a few cents, and should the company succeed in developing assets that’ll grant it an income stream, the value of those stocks would jump.

Another benefit is that for speculative companies with limited cash, non-cash remuneration is attractive. “One of the ways you spend less cash is to provide people with equity. That reflects the more speculative nature of the company,” Robinson said.