The Advisors' Blog

– Frank Glassner, Veritas

Companies have continued to tune down their use of stock options, driven by the need to minimize the often significant financial impact of option expensing and equity dilution. There is also the very real need to better align executive compensation with sustained growth in shareholder value. Here are the charts that go along with this blog.

The most common approach to the options issue is reduction of option grants, elimination of broad-based plans, amendment or elimination of employee stock purchase plans, and/or adjustment of the vesting period or other terms of existing plans. While stock options should, and will remain a key element of executive compensation, the multi-million dollar “mega-grants” that fueled the biggest executive pay packages in recent history will continue to dwindle.

In place of stock options, companies are tuning up the use of performance-based restricted stock and restricted stock units (RSUs), as well as cash-based performance shares and performance units. With pure time-vested awards widely criticized by shareholders and governance watchdogs as “equity giveaways”, well designed long-term incentive (LTI) plans are based on meeting tangible, clearly defined, and measurable financial and/or operational goals that are ultimately linked to boosting overall corporate performance – rather than just share price alone.

The new accounting rules support this new trend, permitting companies considerable creativity and flexibility and in combining the use of different LTI vehicles, including cash-based alternatives such as stock appreciation rights (SARs) that pay out the difference between the strike price and the fair market value of the underlying shares. Even better, the optics of these performance-based plans look great to the very public eyes of shareholders and the media. We still have to be thoughtful though, and need to take into account the reduced risk of full-value plans such as restricted stock, as compared to stock options or other LTI vehicles, and need to carefully consider the standards and methodologies used by different institutional shareholder and governance ratings services when assessing new LTI plans.

Some companies, particularly start-ups, pre-IPO, and other high-growth companies, continue to conclude that the usefulness of stock options in attracting, retaining and motivating essential talent is worth swallowing the charge to earnings. Other companies use the advent of option expensing as the rationale for continuing to curtail or eliminate stock option participation, particularly among lower level employees. Either way, companies should ensure that, in analyzing the impact of accounting considerations and investor pressures, business and human resource considerations do not take a back seat.

As companies focus LTI plans on nuts-and-bolts business fundamentals that drive sustained growth rather than just market performance, short-term (annual) incentive (STI) plans are assuming a much more prominent role. Revised STI metrics reward executives for meeting specific tactical (quarter-by-quarter) targets, such as business unit or departmental performance goals that represent milestones that are key to the achievement of multi-year strategic goals.

For example, a performance-based long-term incentive plan pegged to three-year return on invested capital might be supported by an annual plan with related goals such as increasing revenue, lowering expenses, restructuring debt or developing new business opportunities.

Opportunities and leverage in both STI and LTI plans are also being customized to an organization’s business strategy and financial situation. For instance, rather than adopting the traditional “80/120” leverage design, payout thresholds might be lowered when budgets are “stretched” and difficult, or raised when performance is more certain. Likewise, some companies have chosen to increase upside opportunities to make rewards for incremental performance more meaningful.