Practical Advice on Executive Compensation
In a Difficult Environment (10/11/07)

By George B. Paulin, Chairman and CEO, Frederic W. Cook & Co., Inc.

What Makes It a Difficult Environment?

Positive forces to strengthen pay-for-performance and the governance process around executive compensation at U.S. public companies continue to be countered by negatives. Progress is being made, but it is incremental.

The positives include board compensation committees that are more involved and working more independently from management. Disclosure is comprehensive and extends far beyond that of any other industrialized country in the world—which is not to say that it is clear. Accounting is now generally fair for different forms of equity compensation. And most importantly, watchful critics in the business press, unions, government, and activist investor groups are knowledgeable to identify abuses and empowered to hold people accountable.

On the negative side, there is an entitlement attitude among many executives that multi-million-dollar compensation goes with the job, regardless of performance. There are also many questionable legacy practices carried over from the recent past when the process was weaker than now, which are often backed by legal commitments and are hard to change. Finally, there are potentially more lucrative pay models in private equity, hedge funds, etc., where compensation is not just a return on human capital, it is also participation in the return on infinitely leveraged financial capital.

Actions to Consider

I attend at least ten board compensation committee meetings a month. I struggle with these issues day after day, alongside board members and management who generally want to do what is right for the long-term economic interests of the companies they represent. Here are seven suggestions that may be of interest if you are one of these people:

1. Only have an above-market executive pay philosophy if there is a strong and defensible rationale. A 75th percentile competitive pay structure may be justified for a company with low cash; no perks, severance, or defined benefit pensions; and equity grants with high performance risk such as stock options. The justification is less so when cash, perks, severance, and pensions are high; and equity is in time-based restricted stock.

2. Avoid a best-of-all-worlds outcome if you mix different pay models. Some public companies are attempting to emulate the executive-pay model used by private equity companies. Private equity typically provides much higher stock-based compensation. On the other hand, cash is lower, peripheral compensation (i.e., pensions, perks, severance) is limited to non-existent, incentives are based on absolute results, executives are required to invest their own funds to buy a portion of the stock, and the stock is virtually all granted up-front with no annual price averaging to moderate volatility. It is a mistake to combine the higher stock-compensation from the private-equity model with the other existing features of the public-company model, which may seem obvious. However, this is what happened repeatedly in the mid-1990s when established, more-mature companies attempted to pay like the internet and technology companies.

3. Growing your own is best, but do not to overpay if you go outside. Big recruiting packages have been a major source of recent inflation in executive compensation, especially at the CEO level. To avoid this in the future, think in terms of three distinct pay elements if you are structuring a recruiting package for a high-level executive: (1) ongoing compensation, (2) buy out, and (3) inducement. The ongoing compensation should reflect the company’s competitive pay philosophy and internal-equity considerations, so you do not end up having to give everyone else a raise because of how much you paid the new guy. The buy out should no-more than match forfeited value from the prior employer, with the form and timing as close to the same as possible. If the ongoing compensation and buy out are not enough to attract the candidate, then—and only then—do you need an inducement. Most inducements are additional stock options or restricted stock, but there are other approaches. For example, the package for the new CEO at Gap front-loaded four-years of equity grants at time of hire and stipulated that there would be no new regular grants for the next three years. This provided an opportunity for appreciation on more shares from a presumably low turnaround price and did not grant additional compensation value.

4. Recognize the limitations of using time-based equity grants for retention. Companies often look at an executive’s unvested equity value and decide that it is not enough to retain the person. The common response is to make a special restricted stock grant. These special grants can be several times annual compensation, and they may be warranted to recognize high performers. But experience is clear that they do not work for retention, because the amounts are seldom large enough that another company will not buy them out as part of a recruiting package. All that the special grants do is transfer wealth to the executives who will get the money by staying or leaving.

5. Get more serious about ownership. I believe that financial risk is a necessary part of financial incentives, and that an effective way to balance rewards and risk in executive incentives is through ownership. Today’s typical ownership guidelines of 5x salary for CEOs and 1x-to3x salary for the senior executives are too low. They date back to a time when equity grant values were not as high, and when most equity was in stock options that resulted in erratic ownership accumulation. Many companies are now granting enough full-value shares restricted and performance shares to meet their guidelines in just a couple of years, with no ongoing stock retention requirements beyond the guidelines once they are met. As a real-time example, take the executives who ran the sub-prime lending companies that are now struggling or out of business. They would not have walked away with the same wealth accumulation if they had been required to retain a significant portion of their equity compensation.

6. Use Shareholder Value Transfer (SVT) as the primary competitive reference point determining aggregate equity budgets, not share usage and dilution. Traditional calculations of share usage and dilution became largely irrelevant after 2002 when companies started to shift long-term grant value out of stock options and into full-value shares. At many companies, four stock options have the same grant value and cost as one restricted share. Assume that such a company was granting stock options and switched to restricted stock at a ratio of one restricted share for two option shares. The company would cut its share usage--and eventually its dilution overhang--in half, while doubling its grant value. ISS saw this problem before anyone else, and developed the SVT methodology as the basis for voting on new stock-plan share authorization requests. SVT is grant value as a percentage of company market-capitalization value. The number of shares is not important, only the value of the grants in relation to the value of the company. In my opinion, SVT is the best way for companies to determine their aggregate annual equity budgets. It equates different grant types, neutralizes the effect of price fluctuations, and provides a common relative basis for comparing costs between companies.

7. Take another look at stock options if you thought they were too expensive. Many companies switched from options before the final FASB rules were adopted under the impression that Black-Scholes values would be unrealistically high in relation to other grant types. As it turned out, from an expense standpoint, options are often not a bad deal because the final FASB rules provided significant flexibility in setting the assumptions that determine the option valuations. An option that costs 30% of the grant price would pay out more than the expense at about 2.5% compound annual appreciation over a ten-year term. Meanwhile, the resulting pay delivery would be more closely aligned with long-term shareholder value creation than if you granted the same cost in restricted stock.