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The paradox of options

Atalaya Mining (ATYM) is a Cyprus-domiciled company, quoted on Aim, that produces copper in Spain. Two executives each sold over £1mn-worth of shares in February, which featured on the Director Deals page of this magazine. It’s easy to assume that this indicated a loss of confidence by insiders. But did it?

The sales were linked to market-based share options, which give executives the right to buy their company shares at a future date at the share price when each option was granted.  This means they have a built-in performance condition – they only have value if the share price goes up.  They’re 'options' because participants can choose whether or not to buy them, and they suit companies that need to invest all the cash they can muster for future growth.

Atalaya had negative cash flows for years while its mine and processing plant were developed, and in 2017 Cesar Sanchez, Atalaya’s chief financial officer, was granted an option when the share price was 144p.  Three more were granted to him in the following years at prices of 201.5p, 147.5p and 309p, and in total, he had 650,000 shares under option.  Atalaya has been in profit since 2020, and to exercise these four options earlier this year, he had to find £1.25mn.  The share price at the time was 440p, and to fund the purchase, he simultaneously sold 300,000 shares, which raised £1.3mn.  His purchase fixed a taxable gain of about £1.6mn, and left him owning 350,000 shares – so far from indicating a loss of confidence, here was a director’s sale flagging an increased stake in his company. 

A drawback of share options is that nobody can predict the outcome.  They could end up being worth nothing or, as with Persimmon’s (PSN) 2012 grant, generate windfall gains greater than ever envisaged.  In terms of profit, prior to 2005 options came for free, but then the accounting profession began treating them as a benefit, like an insurance policy, with the notional cost deducted each year.  But how much is this benefit worth?  Valuation methods can only estimate this.  Some methods can be counter-intuitive: a higher share price on grant date will make an option more expensive to exercise, so you’d think it would be worth less.  But Black Scholes says that it’s worth more because higher share prices indicate increased volatility.  Whatever the valuation, it’s likely to differ from the true cost as recorded in the balance sheet.

Atalaya created 1.62mn new shares for all the executive share options exercised in February, which diluted the value of the company for shareholders. But not by much. When Sanchez received his first option in 2017, Atalaya had a market value of £170mn.  By the time its executives exercised their options, 1,398 million shares were in issue, and the company was worth over £600mn.  By creating the shares, the company had effectively made a mini-discounted-rights issue: it received cash of about £3mn for issuing those shares, which had a market value of £7mn.  The net dilution was less than 0.1 per cent – investors are unlikely to begrudge sacrificing £4mn in return for an increase of value that (even after a share placement) was about a hundred times as much.

UK options have safeguards that the US lacks, such as guidance on dilution that restricts newly created shares for options to no more than 10 per cent of those shares already in issue (over a rolling 10-year period).  It’s considered sharp practice here to re-price options after they’ve been granted if the share price falls, although it is okay to scrap the option and start afresh by granting a new one with similar terms and conditions.  And option prices should be set at no less than the market price on the grant date, although, perversely, options with a 100 per cent discount (ie that cost nothing to exercise) are allowed.  These nil-cost options are share awards by any other name, and participants prefer them because they’re more flexible – share awards fix when shares are transferred to participants; whereas nil-cost options enable them to choose a date that can be as long as 10 years away.

Now that Atalaya has reached profitability, some of its increase in shareholder value will be delivered through dividends rather than the share price, which makes paying with market-based options less attractive.  Like other companies that mature from being cash burners to more stable cash generators, it might soon find that share awards (or nil-cost options) become more appropriate.  Participants have to pay to exercise market-based options but awarded shares cost them nothing, so fewer shares need to be involved. 

The question then is: how many fewer shares?  Since valuation methods are no more than a guide, decisions about this are a judgement call. It’s a nice problem to have.