A Different Approach to Stock Option Grants - Stock Option/Pay Multiple
Formula*
By Frederic W. Cook, Chair of Frederic W. Cook & Co.
Premise: Senior executives should own and hold for their careers a
minimum of 5-10 times their salary in company stock. This should be earned
through equity incentive plans and held either (1) after payment of tax, or (2)
pre-tax in a deferred compensation account. It should not be expected that the
executives would actually buy the shares on the market with their own after-tax
money. It should be sufficient for the executive to commit to hold shares
earned by performance after payment of taxes.
Question: How much in equity incentive grants, either in the form of
stock options/SARs or in full-value restricted performance shares, should be
sufficient to achieve the above ownership goal assuming good company and market
performance?
Stock Options/SARs
Grants with an aggregate current face value(1)
of 30 times salary should be sufficient to achieve the goal.
These could be annual grants over a 10-year period, with each grant having a
face value of three times (3X) salary, or less frequent but larger grants.
If company stock appreciated within a range of 5-10% per year, at the end of
seven (7) years the net after-tax profit(2)
from cumulative grants of 30 times salary would be from six to fifteen times
(6X-15X) current salary in owned stock (5-12X future salary at 3% annual
increase):
|
Appreciation |
7-Year |
After-Tax |
Effect of 30X |
|
Rate/Yr. |
Appreciation |
Gain(2) |
Salary Grant |
| |
|
|
|
|
10% |
100% |
50% |
15X |
|
5% |
40% |
20% |
6X |
Full-Value Shares
Grants of time-restricted or performance-restricted shares with an aggregate
face value(1) of 10 times salary should be sufficient to achieve the
goal
These could be annual grants over a 10-year period, with each grant having a
face value of one times (1X) salary, or less frequent but larger grants.
If company stock appreciated within a range of 5-10% per year, at the end of
five (5) years the net after-tax profit from cumulative grants of ten (10) times
salary would be from six to eight times (6X-8X) current salary in owned stock
(5-7X future salary at 3% annual increase):
|
Appreciation |
5-Year |
After-Tax |
Effect of |
|
Rate/Year |
Stock Value |
Value(2) |
10X Salary Grant |
| |
|
|
|
|
10% |
161% |
80% |
8X |
|
5% |
128% |
64% |
6X |
Front-Load or Annual Grants?
Administering the above salary-multiple equity grants requires a decision
whether the target-multiple grant should be (1) front-loaded (i.e., large grant
made early, with smaller or no grants made subsequently), or (2) spread out in
smaller bites over a multiple-year period, for example 10 years.
Repetitive Grants
These equity grants should have long vesting, e.g., spread over 3-5 years,
particularly if new grants are not made every year.
At the end of a defined period, e.g., 10 years, the grants made 10 years ago
should be dropped from the calculation (e.g., the 30-times salary grant
multiple). While arguably this is not necessary to sustain motivation and
alignment with shareholders' interests, the executive could too easily say,
"Well, they've given me all the equity they're going to give me here; I might as
well move on."
Ownership Guidelines and Stock Retention
There is near unanimity in the corporate community of directors and
executives that stock ownership guidelines for senior management are a good
thing. There is far less consensus, however, on how to do it, with practices
ranging from (1) fixed guideline multiples of salary, e.g., 600% of salary for
the CEO in stock value, with five years to achieve the goal, to (2) what we call
"retention ratios," for example, hold 75% of the shares remaining after payment
of option exercise price and taxes for the remainder of your career with the
company.
In the first case (ownership multiples), once the executive reaches the goal,
presumably he or she is free to sell any new shares received from company plans
so long as company trading policies are observed.
In the second case (retention ratios), there is no need for an ownership
guideline. There is no goal that, once achieved, you are free to sell. The
more you get, the more you have to keep.
What is the best approach? Frankly we favor a hybrid: (2) a more modest
"ownership multiple," for example, 400% of salary for the CEO, scaling down in
tiers for other executive levels, which should be met within five years if
performance is good, and then held for the executive's career, combined with (2)
a 100% "retention ratio" that only runs for a short period after stock
acquisition, for example six or 12 months. This prevents "flipping" the stock
for profit and the attendant suspicion that it was done based on inside
information.
In both aspects of the hybrid approach (ownership multiple and retention
ratio), it is important that the requirements transcend termination of
employment. Stock held to satisfy the ownership multiple cannot be sold for six
or 12 months after termination of employment. And the six to 12 months
retention requirement for new shares is not waived by retirement or other
terminations (death is a reasonable exception). The reason for this "best
practice" rule is to avoid an "Enron" situation where an executive quits in
advance of pending bad news to get out from under insider trading rules.
* This
Reference Paper B accompanies a speech delivered by Frederic W. Cook to the
Stanford Directors' College on June 20, 2005, and webcast on June 21, 2005 to
members of CompensationStandards.com
(1) "Face
Value" is shares times market value at time of measurement, assuming in the case
of options/SARs the option price is 100% of market price at grant, and the
option/SAR term is 7-10 years
(2)
Assuming 50% all-in tax rate
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