What is Overhang?
Overhang is a measure of the potential dilution to which common shareholders are exposed as a result of the possible allocation of stock-based compensation. It is generally represented as a percentage and is calculated as the stock options granted, plus the remaining options to be granted divided by the total number of shares outstanding.
Understanding the overhang
There is no rule of thumb for determining the level of overhang of options harmful to common shareholders, but as a general rule, the higher the number, the higher the risk. The overhang of options decreases after a public offering because the number of shares in circulation increases. If a company has a very high overhang of options, it must generate even higher levels of growth and profits to compensate for the dilutive effects of the overhang on earnings per share and therefore investor returns.
In turn, this can lead managers to take more risks, pay less in dividends and go into more debt. This can lead to greater volatility in the company’s stock prices. On the other hand, companies with high employee shareholding generally have better financial performance, pay higher dividends and see less volatility in stock prices.
According to a 2020 study by executive compensation consultant F.W. Cook & Co., small cap companies grant a considerably higher percentage of their stock options to executives compared to large cap companies. Technology companies also have the lowest share of executive awards, while the energy and industrial sectors have the highest.
Key points to remember
- The overhang is the total dilution for common shareholders due to the grant of stock options to employees. It is generally expressed as a percentage.
- The higher the number of overhangs, the higher the risk.
Reduce the impact of the overhang
Because an overhang of options can have a negative effect on the price of a share, entrepreneurs and company management generally develop HR strategies to mitigate its impact. Performance-based options are part of these strategies. The changes in which an employee will exercise performance-based options are less than the traditional non-performance stock options that are almost certain to be exercised after their vesting period.
Example of overhang
The simplest way to calculate the option overhang is to add the existing and future option issues divided by the total number of shares outstanding. For example, suppose a company has already issued 50,000 options and plans to distribute 50,000 more. Assuming the company has 1 million shares outstanding, the total overhang is (50,000 + 50,000) / 1,000,000 = 10%.