Is it Time to Change the Equity Compensation Paradigm?

Even with the explosion in performance-based equity, most equity compensation plans look very much like they did almost twenty years ago. Stock options, restricted stock unit and employee stock purchase plans would be familiar to a time-traveler from 1995. The biggest differences are in the size of the payouts and that many participants receive equity as an addition to base and bonus pay, instead of as a replacement for some of it. The similarities now and then are almost too numerous to list.

For the sake of a theme let’s talk about private companies.

Recently, many investors, executives and employees at privately owned companies have started thoughtfully questioning the reasons behind plan design and features, process and communication. These questions are less focused on traditional public company issues of skyrocketing CEO pay and governance issue and more aimed at how to create programs that fit the needs and patterns of the current economy as they relate to smaller companies.

Let’s start with vesting. Why does almost every plan offer 3 years vesting on full-value awards (restricted stock RSUs, Phantom Stock) and 4-5 years for appreciation-only awards (stock options, SARs, etc.)? There are two basic answers to this question.

1)     Legacy. When stock options plans were first solidified in the 1990s it was common for an exit event to occur in 4-5 years. Everyone followed the leader and an innovative idea became a dictum.
Restricted regained popularity after the Dotcom bust. The first few of these newer plans to make the headlines had three year vesting (AT&T, Microsoft). Once again an idea that had been focused on the needs of a moment became a kind of commandment.

2)     Practicality. Most companies find it hard to see more than three years into the future. Most compensation professionals see three years as being the minimum for “long-term” incentives. Conveniently these mesh well.

You’ll notice that I didn’t mention any scientific evidence behind typical vesting schedules. In most almost two decades working on these plans, I have not seen any convincing research that explained how nearly every company would benefit from nearly identical vesting norms.

More important than the initial questions about vesting tradition is the unspoken question: Why won’t longer or shorter vesting periods work? Vesting should exist to help the company meet specific goals and objectives. Awards with shorter, and much longer, timeframes do work for some companies. Why wouldn’t an eight-year schedule work if it matched the expected period for fruition of the company’s goals?  Why not two years for employees with shorter-term goals? The issues with vesting schedules are that most advisors are stuck in a rut, and most executives have been led to understand that equity is bound by legacy design considerations.

What about the type of instrument? Stock options have been the “go to” resource since the late 1980s. Unfortunately, they can be a bit like heroin. The initial grants are small and have an amazing impact. In order to repeat that feeling grants must get bigger and more expensive. Participants become more dependent on them and companies lose sight of some of the critical reasons they started using them in the first place. Once addicted, it becomes difficult to wean people off of stock options.

We have also heard a lot about the growth in restricted stock shares and units, but these vehicles are seldom used beyond founders in most start-ups. After the first few people, they tend get put on the back burner until the stock is publicly traded and the price is subject to the whims of the public market (consider them a form of methadone). Stock Purchase plans are difficult to do in private companies, but there are still valid reasons to consider them. We seldom hear much about the other forms of equity compensation, or the alternatives to traditional equity.

Even if we stick with the traditional big three, why haven’t these programs evolved with the changes in the markets, types of investors, company lifecycles and more? In 1990, when most of the current program designs were locked-down phones were still attached to a wall and there was no such thing as email. We live in a smart-phone world while using tools from a time when the Internet or calling someone from your car was still a concept bordering on science fiction. We can do better and I hope to spur a discussion here at the Compensation Café on what we can change to move these plans forward.

 What do you think needs to be fixed about equity compensation?

This article is the start of a discussion I hope will expand through this year and beyond. Look for future articles on this topic as we explore the possibilities of evolving compensation to meet the needs of the 21^st century.

Dan Walter is the President and CEO of Performensation an independent compensation consultant focused on the needs of small and mid-sized public and private companies. Dan’s unique perspective and expertise includes equity compensation, executive compensation, performance-based pay and talent management issues. Dan is a co-author of “The Decision Makers Guide to Equity Compensation” and “Beyond Stock Options.” Dan is on the board of the National Center for Employee Ownership, a partner in the ShareComp virtual conferences and the founder of Equity Compensation Experts a free networking group. Dan is frequently requested as a dynamic and humorous speaker covering compensation and motivation topics. Connect with him on LinkedIn or follow him on Twitter at @Performensation and @SayOnPay

Comments

[E. James (Jim) Brennan]

The homogeneity of exec comp plans follows the same lemmingitis CYA followship pattern of most conventional compensation practices. Although you can't lead well from the back, it's a lot safer in the middle of the pack. Compensation types are not known for their innovative instincts and enthusiasm for taking chances; in fact, they are characteristically remarkably risk-averse.

More on that later....

[Jacque Vilet]

Well the reason why we can't be able to change this? Money pure and simple. Executives are too used to getting big bucks with stock ---- and there is very little or nil pay-for-performance for them. So why would they be willing to change?

I really do not want HR to be involved in developing exec comp programs. It needs to come for a real, non-biased 3rd party. I'm afraid that it would be career-threatening for HR to be the ones to make recommendations.

BOD's now want HR to take a more visible in advising them --- once more they push their responsibility off on someone else ---- 1st outside consultants who know which side their bread is buttered on and now poor old HR. BOD's need to "suck it up" and do some reseach with the help of the 3rd party. God knows they get paid enough. They ought to work for it.

[Jacque Vilet]

Thanks for posting Dan. I would like this topic to remain alive too. I promise to keep quiet and learn something. Why don't we start with a fresh slate? Quit "bandaiding" stock and start completely over again. Stock out ---- now what?

Exec jobs have changed SO much since the 1970s since stock rewards started. There's got to be a better way to reward them.

What do you think?

[Dan Walter]

@Jim,
I think there is something to be said about the ease of following the herd. Those that do that in the would spend thousands of year building up real instinct. Those without instinct are often doomed to perish if their leader choose poorly.

[Dan Walter]

@Jacque

Money is certainly an aspect at public companies. I believe it is less so at private companies. The unknowns are greater and the data thinner.There is little to defend the current paradigm for most private companies (not even loads of cash.

I think HR also tries to take the easy way out too often. Rather than understand their companies business and make cogent arguments, some HR pros simply point to the external consultant and say "Ask them!" In order for HR people not to feel threatened they need to get a seat at the table. That requires learning things, and making the type of accountable decisions that many HR people are not willing to do. (Perhaps there is a good basis for a Compensation Fear Factor article)

The consultants are a mixed group (like the population at large). Some support big pay, others support big performance. A smaller number promote bucking the system, a plan that is usually followed only when a company has been in trouble. And, some exec comp consultants make more money than an attorney for OJ Simpson, but a great number of them make very reasonable (and not huge) sums.

[Bruce Brumberg]

What do you mean by Paradigm? Do you mean more what needs to be fixed or changed?

I have seen very big changes in the stock compensation practices since the 1995 date you give above, including the big shift from stock options to restricted stock, the narrowing of who gets equity grants, and the growth of performance share plans beyond the very top executives. These were caused by many factors and do represent a paradigm shift to me.

Are you looking for a whole new way of thinking in a big picture way or more related to very specific provisions, such as vesting you discuss or grant guidelines? You mention private companies. Their grants have gone through many changes in structure, including early-exercise stock options that turn into restricted stock, and most recently two-level vesting provisions that have both time vesting and a liquidity event required.

Bruce Brumberg, Editor http://www.myStockOptions.com

[Dan Walter]

Hi Bruce,

Good question. By paradigm, I mean the entire structure and use of equity as we currently know it, and as it has been for a very long time.

Vesting: Stock Options 4-5 years

Term of Grant: 10 years

RSU vesting: 3 yrs

Private companies: no dividends, time frames of 3-5 years even when it take much longer for the average company to see any liquidity to equity holders

Distribution curve: So heavily weighted to the first 5-15 employees, that it often becomes impossible to afford hiring a competent employee #20 or #50, especially if it is a tech heavy start-up.

Some of changes you mention are a good start, like the two tier vesting that I have used in several plan design for my clients. Even with those changes, someone who went into a coma in 1999 would be able to catch up with our current world in a very short time, with only a few new rules, not strategies, to learn.

While the equity strategies used by public companies have changed more in recent years, those in start-ups have remained closely reminiscent of past decades.

It is time to reevaluate and figure out if there are better/new ways to use the tools in our toolbox. We should also determine if there are tools that exist, but are not in our tools box. Many other countries have a much wider range of instruments that are used more often.

Dan Walter, Performensation http://www.performensation.com

[Yaniv Shiryon]

Thanks for posting Dan. Would love to share this with my clients including the on going discussion. Lets think how.

[Dan Walter]

On Feb 15, 2012 Inc posted this article (http://www.inc.com/noam-wasserman/four-myths-about-startup-pay.html

by Noam Wasserman and Furqan Nazeeri. Interesting how many people are starting to talk about this. I will be including some of their research in an upcoming post.

Dr. Noam Wasserman is a professor at Harvard Business School. His book, The Founder’s Dilemmas: Anticipating and Avoiding the Pitfalls That Can Sink a Startup, will be published in March. Furqan Nazeeri is a Partner at ExtensionEngine, LLC with more than 15 years experience building and managing high growth software companies. @noamwass @altgate

[John Olagues]

Linked below is a slideshare presentation of a new type of employee stock option, which I call Dynamic Employee Stock Options.

http://www.slideshare.net/OLAslideshare/desos-presentation-jan-03-2012

It substantially improves almost every aspect of traditional ESOs and is better for the grantee, the company and even better for the wealth manager. It even eliminates the need for hedging. Yingping Yuang did the cost calculations and found that the extra cost over traditional ESOs is only 3.5%.
Please tell me what you think.

John Olagues