Dan Walter's Latest Article: "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