2. Long-Term Incentive Vehicles

Long-Term Incentive Vehicles

a. Stock Options

Stock options used to be the most prevalent long-term incentive vehicle for senior executives. Why did stock options first become a common form of long-term incentive? Investors viewed stock options as a way to achieve the goals of pay-for-performance and alignment with shareholders through a single, long-term incentive vehicle. Options are inherently performance-based in that the executive can only realize value from the options if the stock price at the date of exercise exceeds the exercise price, which is typically set to be equal to the market price on the date of grant. In other words, executives only realize gains from stock options to the extent that they increase the stock price for shareholders. Another practical advantage of stock options is that the company and the board do not need to set specific goals for the executive and can therefore avoid having to predict future results. The implicit goal is to increase the stock price and the more it increases, the more value executives receive. Through the bull market of the 1990s, stock options became more prevalent and CEO compensation levels increased dramatically as a result. Another historical advantage of stock options was that they did not impact earnings on the income statement due to the accounting treatment for stock options at that time. As a result, stock options were a long-term incentive vehicle that helped to align management with shareholders, pay-for-performance, and avoid all accounting cost to the company.

However, companies began to move away from stock option in the late 2000s due to several changes in the market and reporting practice. The bursting of the dot-com bubble in the early 2000s started the move away from stock options. While options were enormously popular in a bull market when stock prices were consistently increasing, in the new bear market, many stock options were underwater (i.e., the exercise price was well above the current market price) and provided little or no motivational value to management to increase the stock price. The trend away from stock options was given another push in 2004 with the publication of accounting standard FAS123R, now ASC 718, which required that stock options be expensed on the income statement. Once stock options were put on an equal footing with other long-term incentive vehicles, it became less compelling for companies to continue to use them to such a large extent.

Following both the dot-com bubble and the financial crisis of 2008–2009, critics of stock options raised concerns about the asymmetrical incentives they created. Stock options align management and shareholders on the upside, but an executive is less sensitive to incremental declines in the stock price below the exercise price. In fact, when an option is underwater, executives potentially have incentives to take risks with low expected returns but high variability in results. As a result, shareholder advisory groups now view a long-term incentive program that is overly dependent on stock options as potentially putting the company at risk of losses or, in extreme cases, bankruptcy, by encouraging executives to take on risky strategies.

While not a major driver of the move away from stock options, the options “backdating” scandal of the 2000s also harmed the reputation of the vehicle. Many investors and other observers formed the impression that executives were using options as a tool to line their pockets rather than receiving them as a reward for performance.

Today, stock options continue to be used, in most cases in combination with a performance plan or time-vested RSUs that can balance the risks of stock options. Companies are more likely to use stock options when the management team is optimistic about future stock price appreciation, the company has difficulty establishing multi-year performance objectives, and the option cost is viewed as comparable to the perceived value of the award. Certain industries that are viewed as high growth (e.g., biotechnology and software) may be more likely to use stock options as a major component of the long-term incentive program.

Key Questions for Committee Members to Ask:

Would using stock options send a signal to shareholders that the company is optimistic about the stock price?
Do the management team and other long-term incentive plan participants value stock options highly or do they have concerns about stock price appreciation and/or volatility?
Are a significant number of stock options from past grants underwater?

b. Time-Vested Restricted Stock/Restricted Stock Units (RSUs)

Time-vested RSUs continue to be used by most large public companies. The vehicle is frequently criticized as “pay for pulse” or a “giveaway,” as no performance goals need to be achieved in order for executives to realize value from restricted stock. If the compensation committee’s only goal was to ensure that the company has a strong pay-for-performance relationship, it is hard to argue that restricted stock belongs in an executive compensation program.

Despite concerns about their efficacy from a pay-for-performance perspective, time-vested restricted stock is very effective in attracting and retaining talent and therefore is an excellent tool for aligning management with shareholders’ interests. From an executive’s perspective, unvested restricted stock is a strong incentive to stay with the company and accumulate more wealth. The amount of wealth will move with the stock price, but it is unlikely that it will decrease significantly unless market conditions or company performance are very poor.

From a shareholder’s perspective, restricted stock has the advantage of focusing management not only on increasing the stock price of the company, but also on avoiding reductions in the stock price. This is a key difference between stock options and restricted stock: restricted stock encourages management to limit the downside risk to the company. Concerns about risk mitigation, along with a desire to attract and retain talent, can serve as the rationale for including restricted stock in the long-term incentive program.

Companies use time-vested restricted stock in three different ways:

Part of Annual Long-Term Incentive Programs: Restricted stock is included as part of the annual long-term incentive program, typically comprises less than 1/3 of the total value provided to executives, and vests over 3–5 years. For example, if a CEO receives $3,000,000 of long-term incentive value each year, $1,000,000 might be provided in the form of time-vested restricted stock vesting at the end of 3 years.
Sign-on Grant Upon Hire: Restricted stock is given as a special, one-time grant upon hire to help attract the executive to the company and retain the executive for a longer period. It often serves the dual purposes of making the executive “whole” for forfeited equity from a prior employer and provides the executive with an initial equity stake to encourage alignment with shareholders’ interests.
Special Grants of Restricted Stock: Some companies do not include time-vested restricted stock as part of their ongoing, annual, long-term incentive program. Instead, they use targeted grants of restricted stock to support the retention of executives that are at risk of being recruited away. Under this approach, restricted stock is typically an “add-on” to an already market-competitive compensation program and can be the basis for criticism of the company’s pay practices if used too often.

Key Questions for Committee Members to Ask:

Has the company been challenged in attracting executives to the company?
Has the company had difficulty retaining executives? Has compensation been cited as an issue in any unwanted executive departures?
If the company’s stock options are underwater and/or one or more performance plan cycles are unlikely to pay out, does the company have effective retention tools in place?
Does the stock price tend to be volatile (e.g., in a cyclical industry) where stock price movements are often driven by factors outside company control?
Has the company been criticized by shareholders or shareholder advisory groups for excessive use of time-vested restricted stock or a weak pay-for-performance relationship?

c. Performance Plans

Performance plans are similar to annual bonus plans, except that performance and/or vesting is typically determined over a multi-year time frame rather than within a single year. These plans have become increasingly popular over the past 5–10 years, as they tend to be well received by executives and shareholders alike. Executives like performance plans because they can be customized to company-specific objectives, and shareholders like them because they have a more explicit pay-for-performance structure than stock options or time-vested restricted stock.

Another attractive quality of performance plans is the flexibility they provide in accommodating a multitude of design objectives. Plan designs vary in the denomination of awards (cash vs. shares), performance periods, performance measures (both absolute and relative), vesting periods, and forms of payment. Companies can tailor these designs to meet their strategic objectives and specific context. While there may be some redundancy with the design decisions for annual incentive plans, we will review the key design decisions involved in performance plans and highlight the differences from annual incentive plans.

Denomination of Award

While annual incentive plans are generally denominated as a cash opportunity, performance plans can be denominated as a cash/cash unit target or a share/share unit target. Executives prefer cash performance plans that keep them focused on the achievement of the specific performance objectives identified under the plan and insulate them from the impact of stock price movements. While this may not support the objective of alignment with shareholders as effectively as a share-based plan, another reason cash payouts tend to be favored by executives is that they do not need to sell shares to realize value from these awards. Given the insider trading rules that restrict an executive’s ability to sell shares and the scrutiny that investors apply to insider sales, a cash-based plan has obvious advantages. Since stock options and time-vested restricted stock are both stock denominated, performance plans are frequently the only cash-based, long-term incentive offered by publicly traded companies. In addition, companies that have had high levels of shareholder dilution from stock-based compensation may prefer a cash-based, long-term incentive, as they do not need shareholder approval to fund shares for awards.

Key Questions for Committee Members to Ask:

Do we have adequate shares available under our shareholder-approved plan to fund awards if delivered in shares? Will it reduce the number of years of long-term incentive plan awards that we can make under the existing reserve?
Are executive plan participants’ liquidity constrained? Would they benefit substantially from a plan design feature that improves liquidity?
Do executives have enough “skin in the game”?

Performance Period

The decision on the performance period is frequently intertwined with the selection of performance measures. Approximately 80% of performance plans use a three-year performance period. For companies that use financial performance metrics, this usually aligns with the length of time that the companies project future performance in their mid-term/long-term financial plans. For companies that use stock price-based metrics, such as TSR, though there is no obvious reason for a three-year performance period, it remains the most common practice. Regardless of the denomination used, very few companies use performance periods that extend beyond three years. For financial performance objectives, this is likely due to the difficulty of making long-term projections. For stock-price based measures, the performance period is likely selected to ensure that the award feels tangible to executives. Given the diminished role of stock options in long-term incentive designs, there may be pressure over time to lengthen performance periods for relative TSR plans given the emphasis most shareholders place on long-term performance.

A minority of companies — approximately 10% — use a one-year or two-year performance period and will typically have additional vesting of 2–3 years on the award to ensure that executives cannot get paid until at least three years from the grant date. The rationale for this approach is that these companies do not have confidence in projecting financial performance objectives three years out. Additional vesting beyond the performance period is added to assure shareholders that the award is intended to reward for the long term, even if the performance objectives are short term in nature. Shareholder advisory firms prefer that companies commit to multi-year performance goals and view one-year goals as problematic, particularly if they overlap substantially with the annual incentive performance goals.

Key Questions for Committee Members to Ask:

Does the company have a credible mid-term financial plan that can be used as the basis for setting long-term performance objectives?
What is the appropriate period of time for assessing whether or not management is making progress in achieving its strategic objectives?
Will the program be externally credible with the performance period we have selected?