Nov 20

Stock option burn rate: Institutional Test

by David Harper, CFA, FRM, CIPM

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Institutional Shareholder Services (ISS), the largest institutional proxy advisory, just released their 2007 Update to US Corporate Governance Policies. When a public company makes a shareholder request for additional equity incentive plan shares, ISS applies two tests. The first is their longstanding calculation of shareholder value transfer (SVT).

The second was implemented only in 2005: a test of a company’s burn rate compared to its industry peers. The burn rate is given by:

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If, for example, a company granted 1 million options during FY 2006, while common shares outstanding (CSO) were 100 million, that is a 1% burn rate. What do they do if instead the company granted 600,000 restricted shares? That’s the point of the numerator expressed in option-equivalents. Depending on the stock’s volatility, the full-value awards are converted to 1.5 (high volatility), 2.0 (moderate volatility), or 4.0 (low volatility). So if our company’s stock volatility was moderate (i.e., between 25% and 52% inclusive), then 600,000 restricted shares is deemed to be worth 1.2 million option-equivalents and the burn rate is 1.2%.

Given a company’s three-year average burn rate, ISS does not want to see a company’s burn rate exceed one standard deviation above its industry peers. That is, they will vote against a share request unless the company commits to bringing burn rate within one standard deviation.

For example, among media companies, the mean burn rate was 1.78%. Add 0.92% for +1 standard deviation, and you get 2.7%. Therefore, ISS is likely to vote against a new plan request if that company is a media company with an average burn rate that exceeds 2.7%. Note there are separate tests for Russell 3000 and non-Russell companies; smaller companies tend to be more dilutive in percentage terms.

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The interesting trend for 2007 is that run rates declined markedly across the board. But more so among technolory-related sectors. The acceptable burn rates (i.e., mean plus one standard deviation) plummeted year-over-year for software (-2.18%), semiconductors (-2.27%) and technology hardware (-1.41%).

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