Equity Compensation is a Game of H.O.R.S.E.

As kids, many of us played H.O.R.S.E. Heck most adults who touch a basketball still play the game. For those of you not in the know, H.O.R.S.E. is a competition where you call a shot and if you make it your competitor needs to make the exact same shot. If they miss, they get a letter in the word horse. If they make your shot, they get to return the process and you have to copy their next shot. This goes on until someone loses by spelling out the word H.O.R.S.E. The goal is to take difficult shots that you can make and your opponent probably can’t.

There are some entertaining videos out there if you would like to skip some of your work time today.

Equity compensation is a game that the majority of companies play like unimaginative or unskilled people play H.O.R.S.E. Rolling out a basic stock option plan to everyone at your company (you know that one with the four year annual vesting schedule, no performance conditions and boiler plate language for every plan feature) is the equivalent to playing your whole game of horse shooting from the free-throw line. You may make your shots, but your competitor can not only make those shots, but can easily defeat you by making more interesting shots of their own.

The companies people like to imitate are now turning to performance-based equity and interesting plan features. This makes their plan difficult to duplicate and more aligned with their unique strategy and culture. In the world of incentive plans the concept of effective but hard to replicate, gives you a competitive advantage. We are seeing companies blending multiple types of equity instead of simply using stock option or restricted stock units. We are seeing companies with multiple vesting schedules sometime on a single award! We are seeing companies create programs that fit the needs they have carefully diagnosed rather than those that came straight out of the boilerplate consultant presentation or lawyer’s plan document.

Sometimes they succeed. Sometimes they fail. But, to some extent, that is the core nature of ANY equity compensation plan. There are not, and shouldn’t be, many guarantees when it comes to equity compensation. The risk-reward equation is not the same as base pay or even shorter-term cash incentives. A key purpose of these plans is to get a company and employees to stretch a bit to obtain success that is otherwise unreachable. Making a few inspired trick shots and leaving your competition behind is all part of the game.

Survey data doesn’t show much about this game and we all love the comfort of survey data. Using survey data to explain equity plans is like describing every trick shot in a game of H.O.R.S.E. as, “the player shot the ball from 30 feet away and the ball went through the hoop.” In the actual game, the player jumped over his friend and landed into a somersault. He then shot the ball off the left wall of the gym and it bounced off a light and into the net (from 30 feet away.)

There are some potential caveats. Accounting for these more interesting plans is more difficult. Generally not more expensive, but the work is more difficult. Communications require more effort. But, we already know that communications of even the most basic plans require more money and effort than most of us invest. These are not reasons not to play. The plans may fail. Equity plans fail all the time. Sometimes it’s because of poor design, sometimes because of poor performance. More often it fails because of poor communication, management and perception by the participants. These are not legitimate reasons to avoid creating a plan that may allow you to win.

Dan Walter is the President and CEO of Performensation a firm committed to aligning pay with company strategy and culture. Do you want to know more about Performance-Base Equity Compensation? Dan’s new comprehensive issue brief is now in print. Dan has also contributed to “Everything You Do in COMPENSATION IS COMMUNICATION”, with Comp Café writers, Ann Bares and Margaret O’Hanlon. And if you’re still not sick of Dan, he has co-authored “The Decision Makers Guide to Equity Compensation”and “Equity Alternatives.” Connect with Dan on LinkedIn. Or, follow him on Twitter at @Performensation and @SayOnPay.

Comments

[E. James (Jim) Brennan]

Nice analogy, Dan. Imitating another is playing for a tie. Winners act first and define what is best. Leaders don't wait for others to guide them.

[Jacque Vilet]

Dan ---- some positive news about changes in executive compensation. Two questions:

1) Do you know of actual companies that have these new plans in place? Can you share the names?
2) What is the size of companies using these plans? Any particular industry?

Thanks.

[Dan Walter]

Jacque,

I do know of actual companies doing this. Most have very little motivation to share their secret's to success. Most tend to be either very large or very small.

There are a few "poster children" for different approaches to equity compensation. Netflix is one. Google is another. Both were incredibly innovative when they created their programs. Both programs seem more normal now as others have done similar things.

[Tony Bergmann-Porter]

I'm very dubious about anything that requires more than 3 sentences of 8th grade level reading comprehension to explain.

[Jacque Vilet]

Dan --- could you give an example of a plan design. It's difficult for me to understand without examples. Thxs

[Dan Walter]

Jacque,

Great question. I can give you tons of examples, but they only make sense in context to each company's specific philosophy, goals and approach to equity compensation.

The major areas are:
Vesting: When and why does something vest? 4 years is the base line, but anything from 1 year to 10 years may be in play. Pure time was the gold standard for years, but a mix a time and performance is not becoming normal for executives and more progressive companies are pushing this concept deeper into their organizations.

Type of Equity: Stock options were the only tool used by a majority of companies not so long ago. Now option use has been declining as some companies have moved solely to RSUs (often not a great idea) and others have started using a blend of tools. The blend is where the differentiation occurs and it is hard to corral and "common" tendencies.

Performance conditions: When companies moved to performance-based equity just 4-5 years ago almost everyone focused solely on TSR (Total Shareholder Return) as the performance metric. Many companies have seen a misalignment between pay and actual performance due to this metric and companies are now looking to create metrics that are more representative of shareholder expectations and company strategy. BUT>>> The SECs new pay for performance rules focus their eye on TSR, so we may see companies continue using the metric alone even as that practice is being proven to be critically flawed.

I can go on, but the variations are almost endless. Vesting 50% at 2 years and 50% at 4. Immediate vesting. Expiration in 4 years or 7 year, instead of 10. the list goes on.

[Jacque Vilet]

Thanks Dan.