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As we approach the end of the first quarter of 2008, the HR and compensation professionals at many public companies are asking themselves a question they have not had to worry about in quite some time: "Do we have enough shares reserved for our long-term incentive (LTI) awards?" This is a reasonable query given that through the end of February the Standard & Poor's (S&P) 500 and the Dow Jones Industrial Average (DJIA) were down 7.5 and 9.4 percent, respectively, for the year to date, and many economists are forecasting further declines. The reason for concern is simple: most public companies grant their executives and managers LTI on a value basis (e.g., $50,000 of stock options1 or full-value shares), and the lower the stock price, the more shares it takes to reward LTI participants at levels similar to previous years.
The fact that some companies are being caught off-guard with a shortage of shares is a fascinating blend of "glass half-full" optimism, recency theory2 and insufficient foresight. From 2002 through December 2007, all the major U.S. equity indices enjoyed a run of double-digit growth.3 Companies that reaped high returns also saw their pool of stock authorizations for LTI last longer (i.e., fewer shares provided greater value). The prospect of share price decline or worse, a broad economic correction, were lost amidst the revelry over growing market caps. All that, of course, has changed. Today, many companies are caught short and are faced with asking shareholders for a new stock authorization, reducing their LTI program or awarding cash that could better be used for other purposes.
There are, however, a number of strategies that companies can use to stretch the pool of stock available for LTI. These techniques can be implemented in ways that not only ensure a company has enough shares to support its LTI program today, but can also hedge against further stock price declines.
Share Price Impact on Authorizations
Publicly traded companies that grant their employees equity (see "Employee Stock Grants") must ask shareholders to authorize shares for use in compensation programs and recruiting and retention efforts. Requests for authorization typically happen every three to five years, although recent trends show companies asking for fewer shares more frequently.
As discussed, above, the value of a company's stock has a significant impact on how long the authorization will last. If the stock is appreciating, the pool may last one to three grant cycles4 longer than planned. On the other hand, a declining market may shorten the grant cycle by the same amount of time. (See the graph below.) In this example, a company whose share price declines 10 percent a year will be nearly 1.2 million shares (or two cycles) short of meeting its five-year equity requirements. It is exactly this scenario that many companies are now facing.
The Importance of Stretching a Stock Authorization
Institutional investors and perceptive retail shareholders are asking public companies to become more diligent in their equity granting practices and to manage stock authorizations more carefully. Moreover, the rise of proxy adviser organizations, which evaluate and advise shareholders on such requests, has added yet another hurdle to the process. Couple the above with the recent decline in shareholder returns and a questionable outlook for the future and it is clear that the environment has changed.
The bottom line is that many companies are now reluctant to ask their shareholders for more stock, preferring instead to stretch the existing authorization as long as they can. For companies choosing this conservative route, here are four strategies they can pursue, either separately or in tandem.
Strategy One: Reduce Equity LTI Participation and/or Award Levels
Under this tactic, either some employees are cut out of the LTI program altogether (most often from the bottom up) or all or a portion of participants' awards are reduced, typically by some percentage that allows the company to back into its share limitations. Although this is the most common of the four strategies and perhaps the easiest to execute, it is not necessarily the best option because when any component of remuneration is decreased, it tends to diminish employee goodwill and could lead to increased turnover.
There are, however, ways to manage this strategy to mitigate harm. Instead of treating such a move as a problem, Sibson has found companies can recast it as a reprioritization of their talent investments. To do this, they:
- Develop specific eligibility criteria and apply it consistently. Before any decisions are made, companies identify which key roles and individual employees have the greatest impact on business results. The following criteria are often helpful when deciding who remains in the plan and who does not: (1) The strategic nature of the role — how important is it in executing business strategy? (2) Performance — who are the high-performing employees? (3) Talent scarcity — what roles are particularly difficult to recruit and retain? (4) Market opportunities — how competitive are the pay opportunities with and without LTI?
- Plan for the future. One of the main reasons companies may be in this situation to begin with is that they failed to plan adequately. The moral of this story is clear: Do not make the same mistake twice. In determining how much to cut, companies can model several scenarios to understand the potential results under each and decide whether the reductions are a one-time "haircut" or permanent. It pays to be conservative; the last thing companies want to do is to make LTI cuts this year, only to further reduce awards in subsequent years.
- Manage the message. Companies need to communicate with employees in a way that is honest and supported by facts. They need to stay on message: Do not let those who deliver the news say or imply "Look what management is making us do."
This does not, however, mean that the message must be universally downbeat. If some employees will not be negatively affected, companies can use this as an opportunity to reinforce their value to the organization. If 50 percent of the LTI population is "taking a haircut," then 50 percent can receive a positive message to the tune of "while the company has reduced grants for many, you are a key player and your award is the same."
Applying the above criteria across the organization will tie the selection process directly to key business needs, leading to more uniform and effective results.
Strategy Two: Remix the LTI Portfolio
For several years now, companies have been moving towards a portfolio approach to LTI. This shift was primarily fueled by the passage of Financial Accounting Standard 123 Revised, which took effect in 2005 and said that stock options must be recognized as an expense on financial statements when granted.
Adopting a portfolio approach can also help lower shareholder dilution5 because a company can use less-dilutive LTI vehicles to provide value. By increasing the use of cash LTIs and/or performance or time vested full-value shares, a company can significantly reduce its share usage without reducing the value of the LTI package. (See Figure 1 below.)
When considering how to best shift LTI value into the various buckets, companies should consider that the ideal remix will:
- Moderate shareholder dilution,
- Improve performance by linking the LTI portfolio mix to business strategy execution and value creation and
- Mitigate the impact of overall market changes on the amounts of LTI value delivered (macro-economic swings will affect only a portion of the value).
The goal is to handle the remix so that it solves the company's LTI problems for both the near and the long term, to make sure that the stock pool lasts through a variety of circumstances and uncertainties.
Strategy Three: Stretch the Timing of Grant Cycles
Instead of making LTI grants every year, a company can lengthen the grant cycle to, say, 18 months. This is a subtle yet effective way to reduce share usage. Stretching the grant cycle by 50 percent could decrease share usage by 33 percent. (See Figure 2 below.)
It is interesting to note that employees do not seem to mind this tactic, at least compared to more drastic measures like cutting overall grant levels or eligibility. "What's another six months?" is often the attitude. The switch to a longer cycle is usually temporary, lasting two or perhaps three cycles. It allows the company to buy extra time before it must ask shareholders to authorize more stock or revamp the entire LTI program, as outlined in Strategy Two.
Strategy Four: Move to a Fixed Share Grant Methodology
Although fixed share grant practices were prevalent 10 to 15 years ago, they have since fallen out of favor. A fixed grant approach rewards employees with a static number of shares year after year, regardless of the value being transferred (i.e., in multiple years, a company grants a specific employee X number of options and Y number of restricted shares).
The lack of consistent value transfer often results in above- or below-market competitive LTI awards and is a primary reason companies no longer grant equity in this fashion. Fixed share grants also create volatility in the income statement, which raises the ire of CFOs who almost universally prefer cost certainty. As the stock price fluctuates, a fixed share methodology increases or decreases charges to earnings commensurate with the variability in LTI award values. This volatility affects companies' ability to meet earnings targets as well as guidance to "the Street," which in turn has ramifications on both incentive plan payouts and ultimately, stock price.
For the reasons identified above, fixed share grants are not a recommended long-term practice,6 yet they do offer a short-term stop-gap for companies facing share constraints in down markets. Many a CEO and board member has wondered aloud, "Why are we granting more equity to employees when the stock price is falling?" With a fixed-share approach, equity grants remain constant year after year, insulating grants from the falling stock price.
Although this essentially amounts to a reduction in LTI, it can be couched more favorably by communicating that share grants are similar to past years in number, if not in value. However, as alluded to earlier, companies need to monitor the situation to make certain lower total direct compensation levels do not lead to excessive unwanted turnover or other adverse business outcomes.
Alternatively, Mix It Up
While none of these four strategies is a panacea for share utilization constraints, they can be used in combination. For a longer-term solution only Strategy Two, a remixing of the LTI portfolio, is sustainable.
Companies must choose the tactics that best fit the needs of the organization and its employees and then adapt them to dovetail with its circumstances and culture. There is no such thing as an "off-the-shelf" solution that will suit every organization, but with some planning and redesign, companies can buy themselves time before they must go back to the shareholders for a new authorization.
1As determined through either a binomial or the Black-Scholes option valuation model. Black-Scholes is a mathematical model used to determine the value of options contracts.
2Simply stated, recency theory is the concept that people tend to best remember and base their decisions on things that happened in the immediate past - in this case, a booming stock market.
3Between January 2002 and December 2007, the compound annual growth rate was 12 percent for the S&P 500, 11 percent for the DJIA and 16 percent for the NASDAQ.
4A grant cycle is the amount of time between stock grants to employees.
5Shareholder dilution occurs when an increase in a company's number of shares shifts the fundamental positions of the stock, including ownership percentages, earnings per share and voting rights.
6A company that chooses to adopt a sustainable fixed share grant approach needs to test and potentially adjust grant values every few years to ensure it is providing the proper value to retain participants and attract key talent.
About the authors:
Jason Adwin is a senior consultant in the New York office of Sibson Consulting. He offers specialized expertise in compensation strategy, design and performance management, creating programs targeted to all levels of an organization. He can be reached at 212.251.5196 or at jadwin@sibson.com.
Richard V. Smith is a senior vice president and executive compensation consultant in the New York office of Sibson Consulting. He has extensive experience designing and implementing reward strategies that define the proper mix of annual and long-term incentives as appropriate to the organization and its culture. He can be reached at 212.251.5444 or at rsmith@sibson.com.