For the past three decades CEOs, Boards of Directors and compensation committees have allocated stock options and numerous other equity-based incentive rewards to executives based primarily on the annual competitive practice of peer companies. In an effort to ensure equity rewards were 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 executives with 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 .
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 .
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 firstname.lastname@example.org, or at (904) 306-0907.
 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.
 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.