1. Long-Term Incentive Opportunity & Mix

If annual incentive design could serve as the basis for a book of its own, then long-term incentive design could be a multi-volume set. Long-term incentive design raises complicated questions about accounting, tax treatment, shareholder approval, plan administration, and governance. Fortunately, compensation committees have the management team and external advisors to help in addressing the technical aspects of long-term incentive design. For the purposes of our discussion, we will provide a brief overview of the different vehicles and how they address the company’s compensation objectives, while only glossing over the more technical aspects.

a. Long-Term Incentive Opportunity

Most companies have an overall target compensation structure composed of base salary, target annual incentive, and an annual grant of long-term incentives. As the base salary and annual incentive are generally denominated in cash, it is straightforward to put a monetary value on them. For simplicity, most companies will also establish a dollar value for long-term incentives, often equal to a multiple of base salary (e.g., 150% of base salary) or a dollar amount (e.g., $500,000).

Like annual incentive opportunities, covered in the previous chapter, long-term incentives are often tiered by executive level, with the most senior executives having the highest percentage of their total pay in the form of long-term incentives. The table below demonstrates illustrative opportunities for a company with revenue in the range of $2B-$10B.

b. Long-Term Incentive Mix

Public companies typically use three long-term incentive vehicle categories:

• Stock Options or Stock Appreciation Rights (SARs): Provides value to executives based on appreciation in the stock price, subject to vesting criteria
• Restricted Stock or Restricted Stock Units (RSUs): Provides executives with the full value of a company share, subject to vesting criteria
• Performance Plans: Function like an annual incentive plan, but with actual performance measured and/or award vested over multiple years. Performance plans can be granted as performance shares with a target opportunity denominated in shares or as performance cash/units, with a target value established independent of the stock price

Most of the CAP 120 use at least two of the above vehicles, and 38% use all three of them.

While stock options and performance shares are commonly used for senior executives, lower-level executives and individual contributors are more likely to receive a higher portion of their long-term incentive in the form of time-based restricted stock.

Source: CAP 120

c. Determining the Number of Shares to Grant

To determine how many stock options, RSUs, or performance shares to grant to employees, the target long-term incentive opportunity is typically first divided into component parts. For example, an executive with a $1,000,000 annual long-term incentive target opportunity and a vehicle mix of 25% stock options, 25% RSUs, and 50% performance shares would expect to receive a grant value of $250,000 in stock options, $250,000 in RSUs, and $500,000 in performance shares. The executive’s target long-term incentive values then need to be converted into a number of shares for each of the vehicles.

Stock options are usually assigned a dollar value based on an option valuation model (e.g., Black-Scholes or binomial). This amount is typically thought of as a percentage of the current market price of the stock because an option value will always be less than a price of the underlying stock. Since the company must account for stock options in its income statement, most companies use the accounting value of stock options as used for disclosure purposes in converting target option values into the number of options to grant. For example, if the company’s stock price on the date of an option grant was $20, a representative stock option Black-Scholes value could be $5.00 (or 25% of the stock price value on the date of grant). In order to provide $250,000 in stock option value, the company would need to grant 50,000 stock options.

The following table describes how fluctuations in input factors change the option value:

The accounting value for RSUs is determined based on the closing stock price on the date of grant. To provide $250,000 in value with a stock price of $20, the company would need to grant 12,500 shares of RSUs. To smooth out stock price volatility, companies may use an average stock price over a period of time (e.g., 10 trading days) leading up to the date of grant to determine the number of shares. In these cases, the value used to determine the number of shares to grant will not be equal to the accounting value of the shares, and as a result, the value of the grant as communicated to the employee may differ from the value disclosed to shareholders.

The accounting value of performance plans will in most cases be equal to the target number of shares granted multiplied by the closing stock price on the date of grant. This means that in order to provide an executive with a target value of $500,000 at a stock price of $20, the company will grant the executive 25,000 shares. It should be noted that when the performance measure is based on the company’s stock price (e.g., in a performance share plan based on relative total shareholder return), the determination of the accounting value will be more involved and will likely be different than the closing stock price on the date of grant.