The Advisors' Blog

– Fred Cook, Frederic W. Cook & Co.

We’re now in the equity grant season for calendar year companies. Most clients are on dollar-based LTI grant guidelines, which means that, if prices are up, new shares granted decline, and vice versa.

Commonly, compensation professionals argue that, if it’s fair to cut shares when prices increase, then it’s likewise fair to increase shares when prices decline, to preserve LTI grant values. For the most part, Compensation Committee members agree with this “fairness” argument.

But, what few seem to recognize is that there is an asymmetrical relationship between share increases when prices decrease and share decreases when price increases. Thus, as shown in this first graph (see this PDF for the first graph), if the price declines, e.g., 50%, the number of shares do not go up 50% – they double. But if price increases 50%, the shares only decrease by a third.

Note that, as the grant price approaches zero, the shares needed to maintain constant value approach infinity. The second graph illustrates the math even better (see this PDF for the second graph).

With average year-over-year stock price declines of 40-50%, advisors and compensation committees need to be aware of this math in approving new grant recommendations. If the price has declined significantly, consideration needs to be given to either (1) using a price higher than current market price to convert dollars to shares, (2) applying a discount to intended grant values, particularly if it is stock options that are being granted, or (3) applying a run-rate cap or cap on value transfer to the total shares granted. Otherwise, the share dilution just becomes too great and executives benefit excessively just for getting stock prices back to last year’s levels.