The Advisors' Blog

– Doug Stewart, Intel

The headlines are coming. “CEO pay rises while stock prices decline sharply.” Investors will be outraged, the compensation committees will be targeted, and critics will ask “where’s the pay for performance?”

The short answer is that for equity awards, and options in particular, the SEC requires disclosure of the cost of equity to the company rather than the benefit of the award to the employee. Of course, the value of what the employee would actually receive from the award fluctuates with the stock price, and this is the missing performance link rarely discussed in news articles.

For many executives, equity compensation makes up the majority of total compensation as reported in the Summary Compensation Table, and the value of equity compensation that is reported is the FAS 123R accounting charge. The Associated Press formulation substitutes the grant date fair value of equity awards granted during the year, but this too is an accounting charge. For most time-based options, the accounting charge is set when the option is awarded and does not fluctuate with changes in the company’s stock price. This is where the performance link breaks down, because the SEC and the media rely on accounting estimates (cost) that are not influenced by performance.

Let’s look at an example that, unfortunately, will be fairly common this proxy season. At the beginning of 2007, ABC Co.’s Compensation Committee determines their CEO’s compensation as follows: salary of $1 million, a cash bonus target of $3 million, and stock options with a FAS 123R value of $6 million for a target total compensation of $10 million. At the beginning of 2008, the Compensation Committee reviews ABC Co.’s results: revenue and net income both increased 10%, the stock price rose 20% and the CEO earned 100% of his targeted bonus amount, so the Summary Compensation Table shows the CEO received $10 million in total compensation for 2007.

Because of the solid performance for 2007, the Compensation Committee elects to increase the CEO’s target 2008 compensation by 10% to $11 million as follows: $1.1 million salary, $3.3 million cash bonus target, stock options with a FAS 123R value of $6.6 million. At the beginning of 2009, the Compensation Committee reviews the grim 2008 results. Revenue and net income are flat, the stock price is down 25% (which is slightly better than its peer group). Based on the cash bonus formula, the CEO receives only 75% of his targeted bonus ($2.5 million). In the proxy statement, the CEO’s total compensation for 2008 is $10.2 million, an increase of 2%. How can this be?

Because the accounting charges that are reported in the Summary Compensation Table are static. For stock options with time-based vesting, the values reported in the option award column will not reflect the impact of stock or financial performance. To see pay for performance in action, you need to look at the intrinsic value of the CEO’s option award. Let’s assume that at the beginning of 2008, the CEO’s $6.6 million FAS 123R cost consists of one option for 1 million shares with a strike price of $10.

If the stock price declines by 25% over the course of 2008, and now trades at $7.50, the intrinsic value of those options is now zero. In fact, the stock price would have to rise 33%, back up to at least $10.01, for the option award to have any intrinsic value at all, let alone $6.6 million of value. If you look at the impact to the CEO’s pocketbook, the total compensation is closer to $3.6 million (salary of $1.1 million, bonus of $2.5 million, options with an intrinsic value of zero) rather than the reported $10.2 million. Here is where the impact of performance becomes vividly clear; the CEO will only receive value from his option award to the extent the stock price increases.

Recent History of Reporting Equity Award Values

In 2006, the reporting of equity awards was addressed by the SEC on multiple occasions. In January, the proposing release would have included the grant date fair value of awards granted during the year in the Summary Compensation Table and included the original grant date fair value of equity awards in the Option Exercises and Stock Vested Table so stockholders could see how the initial estimate differed from the ultimate outcome. In August, the requirement to report the grant date fair value in the Option Exercises Table was removed due to concerns that it would be confusing and could lead to double counting.

Then in December, the SEC replaced the grant date fair value of equity awards granted during the year with the FAS 123R compensation expense for all outstanding equity awards incurred during the year. The original grant date fair value was included as an additional column in the Grants of Plan-Based Awards table, so both accounting measures are readily available to stockholders and the media.

How to Demonstrate the Pay for Performance Link

Unfortunately, there is no consensus on the best way to show the impact of stock price on the value of the named executive officers’ outstanding equity awards. Measuring the year over year stock price change is the easy part; the difficult part is what do you multiply it by? All outstanding equity awards? What about grants made during the year? Or exercises? And what about previously vested awards that are reported in the beneficial ownership table? Should those count? For Intel’s 2008 proxy, we attempted to capture realized and unrealized gains/losses on outstanding equity awards in the CD&A. We also showed the market value of options and restricted stock units in the “Outstanding Equity Awards Table” for directors and officers.

While I believe these measures are helpful, I would like to see more discussion and debate on this topic, with the goal of establishing an accepted methodology that crisply shows the pay for performance link for equity awards, focusing on the benefit of equity awards to the employee rather than the cost to the company.

At this point, I am not arguing that the equity costs included in the Summary Compensation table should be replaced with a benefit value based on the intrinsic value based on the current stock price, but rather, how do we come up with a benefit value to serve as a companion to the accounting charges? How do we report a number (or numbers) that shows how stock price performance influences what the employee may ultimately receive? By developing a benefit-based measure of equity awards, we can demonstrate the pay for performance link that exists.