Posts Tagged ‘Equity’

Are Relative TSR Plans “The Answer”?

Monday, May 6th, 2013

Are Relative TSR Plans “The Answer”?

Originally published at Board Member magazine 2013 Q1.

There has been a great deal of recent interest in performance share plans that use Total Shareholder Return (TSR) relative to a peer group as a measure of performance.  Clearly, these plans usually look good in a pay for performance comparison and can help secure favorable say-on-pay votes, but the additional questions Compensation Committees should be asking are:

  • Do they motivate executive performance?
  • Are they right for this particular company?
  • Does TSR reflect true executive performance?
  • Is this the only performance-linked program we should use?

Any discussion of total shareholder return must start with the understanding that TSR is a result of good management performance, not the performance itself.  The desired management performance is the production of great products/services, properly priced for consumer value, that deliver consistent financial returns commensurate with the riskiness of the required investment.  If the market sees this performance, share prices are bid up relative to peer companies and positive relative TSR results, assuming of course, other, exogenous events do not occur.

From a motivational perspective, the strongest incentives are those where a clear line of sight exists between the desired behaviors (performance) and the reward.  TSR plans may not provide as clear a linkage as plans tied to measures of operating performance.  Even though it may be very hard to do, executives know what it takes to raise net income by 10%; it is less clear what it takes to raise the stock price by 10%.  And the market is not necessarily rational, certainly not in the short term but also seemingly for the long term as well.  Thus plans tied to operating metrics more clearly convey performance expectations and behaviors.  However, executive pay is not just about incentives and motivation.  It’s also about sharing the risk and reward of ownership.  What then are the situations where risk sharing is more important than communicating performance expectations?  Although the following list is not exhaustive, it shows the areas where we think these plans have value.

Shareholder Relations Issues:  In cases where there have been historical issues with the pay for performance relationships, relative TSR plans alleviate that problem – in fact, better than outright share ownership.  By definition, the change in the value of executive shares owned has a 1 for 1 alignment with TSR.  TSR performance plans have a more exaggerated relationship, due to the fact that the value of the shares awarded as well as the number of shares themselves vary with TSR.  The value of these shares typically climbs faster and drops more quickly than total shareholder return itself does.

Change in Strategy/Turnarounds:  In these situations, it is difficult to set reasonable performance goals.  Success will likely be much different than current expectations.  But a successful turnaround will likely have a dramatic impact on TSR, as the market builds new expectations into the market price.  These kinds of awards are also useful in justifying the kind of above market grants that are typically required to attract new management required to effect the change in strategy/performance.

Technology/Life Sciences:  These industries are known for high risk/high reward – particularly in the pre-IPO stage, where large equity grants are the rule.  These grants are either very valuable or worthless.  (Executives that have worked in these industries often have enough worthless stock option certificates to wallpaper their office.)  Relative TSR plans can replicate this highly leveraged reward practice in the public company stage.  Very successful strategies produce high relative TSR, which these plans magnify into even larger reward.

In Conjunction with Other Plans:  When other long-term plans are in place that use other metrics, a TSR plan can be good for balancing the total plan so that a company doesn’t create negative perceptions that management gets very generously rewarded when shareholders don’t.

Are relative TSR plans “the answer”?  No, they are “an answer” that can be very appropriate in the right situations.

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Facebook’s Multi-Billion Dollar Tax Break

Monday, February 18th, 2013

Facebook’s Multi-Billion Dollar Tax Break

There has been a lot written recently about Facebook’s multi-billion dollar tax break from the tax deduction for the cost of executive stock options and share awards.  Stock awards such as these are taxed to executives as compensation based on their value at the time of exercise (options) or vesting (shares), and the employer gets a corresponding deduction for the compensation expense, even though no cash was expended.  Facebook’s phenomenal growth in value from its private company days (when most of these grants were made) makes the resulting deduction very large, particularly compared to its operating income.  The publicity regarding this little understood section of the tax code will likely lead to calls for limiting or eliminating these deductions.  In our opinion, this is treating the symptom, not the disease.

The fundamental problem is that in the eyes of the IRS, stock grants are treated as compensation by the employer rather than as an investment by the executive.    In the example below we contrast tax treatment of a warrant issued by a company as a “sweetener” in a stock offering to a identical situation where a stock option is issued by the same company to an executive.  In both instance we assume the option is priced at $10 (strike price), exercised at $20, and with the underlying share sold after one year at $24.  For simplicity, we assume corporate tax of 35%, individual tax of 40% and capital gains of 20%.

Comparison of IRS Treatment: Investors vs. Employees
   

Employer Treatment

  

Investor/Executive

  

IRS
   

Deduction

Tax Impact

  

Ordinary Income

Capital Gains

Total Taxation

  

Net Taxation
Investor Model  

$0

$0.00

  

$0

$14

$2.80

  

$2.80
Employee Model  

$10

($3.50)

  

$10

$4

$4.80

  

$1.30

The company does not receive a deduction with warrants, and the warrant holder does not recognize any income.  Upon exercise of the warrant (share purchase) the capital gains holding period begins.  Upon sale of the share after completing the holding period for capital gains, their tax bill would be $2.80 per share (i.e., $14 gain x 20%).  In contrast, under the current IRS employee model, the employer realizes a $10 tax deduction for compensation expense (the gain at exercise), the employee recognizes the same amount as ordinary income.  Upon a later sale the employee qualifies for capital gains on the additional $4 gain. Thus the Treasury nets only $1.30 per share in revenue in the employee model compared to the investor model, where the IRS realizes $2.80 per share in revenue.

As we noted in an earlier blog entry treating corporate executives as shareholder/ investors for tax purposes would be beneficial to the Treasury by increasing revenue and simplifying taxation.  More importantly, it would align tax policy with social and economic objectives of encouraging long-term stock ownership as a deterrent to excessive risk taking and of making corporate and individual taxation more transparent.

- Paul McConnell is a Managing Director of Board Advisory, LLC

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Heads We Win, Tails You Lose

Thursday, August 27th, 2009

Heads We Win, Tails You Lose

Originally published at Board Member magazine.
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It is not surprising the public perceives that executive compensation is a “heads we win, tails you lose” proposition. For the past three decades, executive pay plans have grown like kudzu in a muddy Georgia field. In an attempt to balance performance, competitiveness, risk and rewards we have also increased the complexity of pay. Given our lack of success to date, it may be time we fundamentally rethought this process.

Each year, compensation committees spend a great deal of time determining appropriate levels and establishing incentives to provide executives wealth consistent with expected future investor gains. But the reality is that much of the eventual executive gain is determined by business cycles and the timing of option exercises and stock sales — items essentially independent of the long-term investors’ gains.

Recently, there has been a movement to reduce the impact of the timing of sales on executive pay by requiring that executives hold stock received until retirement. This is a powerful tool for aligning executive and shareholder interests, but it only solves part of the problem. In too many cases, the size of annual awards is largely driven by competitive considerations where a specific dollar amount of expected value is used to determine the number of shares or options granted annually. This produces the nonsensical result of increasing the number of shares granted when stock prices decline or decreasing them in response to superior performance.

A better and simpler approach would follow the lead of private equity and venture capital firms, where executive compensation is largely dictated by individuals with substantial personal capital at risk. In this approach executives would receive a one-time competitively sized grant of full-value shares when hired or promoted. This grant would vest over a long-period of time like a typical career (10 years) or until retirement – based on time vesting and/or by achieving performance goals. No further grants would be contemplated unless a promotion or significant business combination occurred. Thus, we introduce two concepts not frequently used by most companies: 1) one-time grant of full-value shares based on a percent of the outstanding shares of the company (rather than projected value), and 2) long term vesting and holding requirements that ensure management has an ongoing stake in the company.

This one-time grant approach to equity compensation, by definition, has a perfect correlation with shareholder wealth over the same period. In contrast, the competitive annual award process mutes the relationship by annually adjusting poor performers up and strong performers down. For example, looking back at the 10-year performance of companies that are currently still in the S&P 500, we find that a one-time grant would produce total wealth for executives in companies that perform at the 75th percentile that is about 3x that earned by the 25th percentile. With competitive annual awards, that ratio is about two times.

This one-time grant of full value shares approach has a number of other advantages:

  • Executive would have an appropriate level of “skin in the game” from day one instead of waiting 5-10 years until cumulative equity awards provided adequate net shares.
  • Illiquid full value shares balance risk and reward consistent with long-term investor, TARP and emerging Obama administration pay objectives. Options and other leveraged grants don’t have the same element of “loss” to balance risk-taking.
  • It would eliminate the need to provide severance if terminated without cause or following a change in control. Contractual vesting of a portion of the shares would provide executives with adequate security in a more shareholder friendly manner.
  • When tough economic conditions occur (like we are currently experiencing) reported compensation would be limited to base salary and bonus earned (if any). This would likely show a much clearer link between pay for executives and employees – particularly if companies annually reported the change in the market value of executive holdings.

By eliminating the concept of an annual “competitive” equity award, we will take an important step in changing the public perception that executive pay is a “heads we win, tails you lose” proposition. We believe that by isolating the ownership interest of management as a discrete, contractual incentive, boards of directors can better manage the cash incentives and salary of executives, providing a more coherent and transparent oversight process. If we want executive management to think and act like owners, we should pay them like owners – long-term owners.

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Aligning Tax Policy with Sound Executive Compensation Practices

Tuesday, May 26th, 2009

Aligning Tax Policy with Sound Executive Compensation Practices

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If we want executives to act and be rewarded like investors, we should tax them like investors.

As the chorus of public outrage over executive compensation rises to a new crescendo, it is understandable why the populist approach to “solve” executive pay is through regulatory pay limits. However, executive compensation experts and investor representatives alike agree that rather than limiting pay, the best thinking on the subject is focused on creating plans where executive wealth is tied to that of long-term investors – where they are unable to profit (or limit losses) from short-term changes in company performance or company stock price. There is much agreement that this linkage is best accomplished through executive equity arrangements with provisions such as “hold-till-retirement” requirements. However, in implementing these provisions boards of directors are now finding that federal tax policy is not aligned with what is arguably in the best interest of the public, not to mention shareholders.

We believe that minor changes to the tax code could facilitate these ownership provisions, thus providing greater alignment of executive pay with public interests. Further, these changes will also increase federal revenues by increasing the effective tax on executive pay without the adverse economic effect of broad rate increases. Simply put, we recommend that the tax code cease treating certain long-term executive equity incentives as annual “compensation”, and instead treat it like an investment.

Current Tax Law Rewards an Early Exit

The table below shows the current taxation of various popular executive equity compensation vehicles:

Vehicle Form of Income Timing
Restricted Stock or Performance Shares Full value is Compensation Vesting
Nonqualified Stock Option (NQSO) Gain is Compensation Exercise
Incentive Stock Option (ISO) Gain is Capital Gains Sale of shares

Any compensation value from an executive equity grant is also deductible to the employer (subject to the limits and performance rules of section 162(m)) and is subject to Medicare taxes (1.45% rate) from both the executive and the employer.

The net effect of this approach is that today’s executives have a powerful incentive to exercise stock options during favorable market cycles, then liquidate their positions to provide cash flow to execute the exercise, including withholding taxes. Since there is no further tax liability and typically little obligation beyond perhaps modest stock holding requirements, a rational executive/investor would clearly sell their ownership position and interests to diversify their overall portfolio. The existing tax treatment does not encourage long-term executive ownership nor penalize sale of stock during the executive’s career.

Alternative Tax Approach Creates Value from Holding to Retirement

An alternative approach is to treat executive equity awards as a sale of company stock on the date of grant, similar to any other investor purchasing shares for cash. Where there is a discount element (e.g., restricted stock or performance shares), the discount at grant would be treated as compensation to the executive and deductible to the company (subject to 162(m)). However, the tax on this compensation would not be due until it was both vested and sold. Thus a company could create a very favorable tax situation for its executives (and an incentive benefiting investors and the public alike) by requiring that they hold the stock until after they leave the company. Like other investors, any post-grant gain (or loss) would be taxed as a capital gain at the time of sale. Similarly, any dividends paid would be taxed at the 15% rate (under current law).

Vehicle Form of Income Timing
Restricted Stock or Performance Shares Value at grant is Compensation, any post-grant change is Capital Gain (Loss) Sale of Shares
Stock Options [1] Gain is Capital Gains Sale of shares

These proposed tax rules create a strong incentive for executives and Boards to design equity plans utilizing hold–till-retirement provisions. For example, without a hold-till-retirement provision a performance share grant would trigger immediate taxation for the full value at vesting. The executive would typically then sell shares to satisfy the withholding tax. With the benefit of a hold-till-retirement provision, the executive would not be liable for any tax until the shares were sold – at some point after retirement. This will result in more net shares remaining in the hands of executives, presumably providing a more significant incentive for delivering long-term results for investors and the public at large.

Curiously, although the executive would receive favorable tax treatment, the tax revenue gains to the government would be significant. Currently, the executive’s ordinary income tax and the corporate deduction largely offset each other. As a result, the executive’s basis in the stock is stepped up to the price at the date of vesting (for full value shares) or exercise (in the case of an option). Thus the net tax received by the federal government is limited to the capital gains tax calculated on any stock appreciation subsequent to vesting/exercise – and there is little incentive for executives to hold shares after vesting/exercise.

Under the proposed approach, the executive’s capital gains would be measured from the grant date price – as is the case with an investor purchase – with no offsetting tax deduction by the corporation. While this results in a lower tax rate for the executive, the effective taxation is increased by eliminating the employer’s tax deduction. Furthermore, the combination of hold-till-retirement covenants and supporting tax policy better aligns the executive performance incentive with the interests of investors and the public over time, rather than allowing an executive group to be rewarded for short term results. With a broad definition of equity incentive plans (i.e., including non-public company equity and equity-like vehicles), this approach can successfully apply regardless of company size or ownership structure (e.g., small businesses, joint ventures, subsidiaries, private equity and start-ups).

We believe this is an easily achievable first step toward aligning federal tax policy with public policy interests regarding executive compensation and corporation accountability. If we want executives to act and be rewarded like investors, we should tax them like investors.

- Paul McConnell

Paul McConnell works with a number of Board Advisory clients within the banking and related financial services arena on executive pay alignment, performance measurement, and executive performance issues. You can view Mr. McConnell’s bio here. If you have any question or comments on this article, or want to speak with Paul about any executive rewards, performance, or succession issue, he can be reached at pmcconnell@board-advisory.com, or at (407)876-7249.

[1] The tax code changes proposed in this article could be achieved by simply modifying existing ISO provisions in IRC sections 421 through 424, to reflect contemporary executive pay programs and hold-till-retirement obligations.

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Reconsidering Executive Equity: Separating Equity from Annual Compensation

Sunday, April 26th, 2009

Reconsidering Executive Equity: Separating Equity from Annual Compensation

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For the past three decades CEOs, Boards of Directors and compensation committees have allocated stock options and numerous other equity-based incentive arrangements based primarily on the annual competitive practice of peer companies.  In an effort to ensure equity was appropriately appreciated by the executives, companies went to great efforts to communicate the value of their annual equity award in present value terms, as part of a total annual pay package.  By treating equity as annual compensation, however, companies have created three significant disconnects between investor and executive interests.
First, when boards adopt a policy of providing competitive annual equity grants based solely upon the present value of the equity, they create the perverse phenomenon where stock price decreases (investor losses) result in granting more shares to management to maintain “competitive pay.”  When the stock price appreciates, the opposite result is found, as fewer shares are necessary to create the same “competitive” annual award value.  This contributed to the prevalent perception of a reward for failure, particularly evident in 2009.   Due to depressed equity values, boards were faced with the prospect of granting 60%-70% more shares just to maintain comparable equity “values” to 2008 [1].

Second, most compensation policies strive to provide competitive equity awards in terms of annual equity grants, but not in terms of aggregate equity ownership.  Thus, a new CEO and a very senior CEO, all other things being equal, would be provided comparable equity awards.  As a result, we find ourselves in the somewhat irrational position of delaying 5-7 years before a significant level of cumulative incentive is delivered to the executive.  Keep in mind the median tenure of a CEO today is 5.5 years.

Lastly, executive stock holding guidelines typically allow the executive to sell vested shares to the extent the executives’ holdings exceed a nominal ownership requirement.  This reduces the executive’s wealth ratio (the ratio between a change in company value and the change in the executive’s total wealth), diminishing the overall strength of the incentive and diminishing the alignment with investors.  Perhaps more importantly, the ability to sell shares allows the executive to effectively time the markets, potentially capitalizing on excessive risk taking and minimizing losses.  In addition, by allowing executives to divest shares prior to retirement, companies reduce or eliminate the shared interest in the orderly succession of management within the company.

One solution for resolving these disconnects can be found by changing our fundamental view of long-term incentives.  As an alternative to treating equity as part of a competitive annual reward package, companies can treat equity as a distinct, non-compensation investment incentive.  In this sense, annual compensation (salary and annual cash bonuses) is liquid and driven by individual skills and responsibilities and annual results achieved.  It is generally managed within the range of easily-established competitive practice at peer firms.  In contrast, executive equity is a career-based investment made on behalf of investors for the benefit of the executive, to align executives’ wealth creation goals with the long-term interest of the investor and payable only when investors realize their investment objectives.  To distinguish equity from annual compensation companies can:

  • Manage cash compensation (base salary, annual incentives and other annual cash value) consistent with the practices of peer companies, adjusted for individual performance.  This takes advantage of excellent peer data that is easily compared on the basis of company size, complexity and performance.
  • Establish a competitive ownership percentage for each key executive officer position based upon the percentage of beneficial ownership attributable to fully tenured peer executives at similar companies, balancing the level of incentive needed to achieve performance with the additional performance burden caused by the incremental dilution.  Define ownership percentages in terms of percent of total shares outstanding rather than specific present value, which is prone to dramatic short-term fluctuations.
  • Create a substantial equity position for executive officers early in their tenure through aggressive grants, but set actual vesting based upon performance outcomes realized by investors.   Suspend or limit awards once the competitive ownership/incentive level is achieved.
  • Treat long-term equity as a career investment on behalf of the executive, no longer subject to liquidation in order to buy the vacation home.  Specifically, limit the transferability of all equity granted until two years following retirement, eliminating any appearance of market timing and require the executive to also have a shared interest in the near-term success of the succession program [2].

This alternative approach to executive pay can correct for the misalignment of actual equity grant practices with investor outcomes – eliminating what is perceived by some as a reward for failure. While this approach may be too aggressive for many organizations, it rightfully places the focus of boards and compensation committees’ attention on determining the appropriate level or strength of incentive necessary to achieve objectives rather than focusing on simply emulating peer behavior.   Lastly, by separating equity from the annual “competitive” compensation program, boards can take an important step in changing the public perception that executive pay is a “heads we win, tails you lose” proposition.

- Jeff McCutcheon

Jeff McCutcheon works with a number of public and private Board Advisory clients on executive compensation, succession and performance issues.  You can view Mr. McCutcheon’s bio here.  If you have any question or comments on this article, or want to speak with Jeff about any executive rewards, performance, or succession issue, he can be reached at jmccutcheon@board-advisory.com, or at (904) 306-0907.

[1] Based upon a 40% reduction in equity values of 40% across the S&P 500, companies had to grant 67% more shares to maintain the same grant value as the prior year.
[2] See Board Advisory, LLC website for “Current Issues for Compensation Committees” for an analysis of proposed tax policy changes in support of “hold-till-retirement” equity programs.

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