I recently did a webinar
with Comp Café colleagues, Ann Bares and Margaret O’Hanlon. During the
Q&A after the presentation, one of the attendees mentioned she works
for a small company that’s owned by a global business that doesn’t
offer stock options. She asked what Long-Term Incentive (LTI)
instruments existed that would allow her company to compete against
those who offer stock options. Employee Stock Options can be powerful
tools, but I am also keenly aware of the many situations where stock
options cannot, or should not, be used. The following is my detailed
answer to her question.
Long-Term Incentives (LTIs) are a broad category of compensation that
generally includes any form of payment that stretches out two or more
years. While stock options are the LTI that make the news most often,
they are not the most common LTI delivery mechanism. Long-term cash
incentives, in the form of both performance-based programs and various
deferred compensation programs, are far more common than stock options.
Long-term cash programs have the upside of being based in “real”
money. People love and understand cash. Using cash as both the
measurement and delivery mechanism can simplify some aspects of
communication. If the goal is to provide the same upside potential as
stock options, cash programs must incorporate significant variability
that can increase compensation expense. There is also the issue of
making sure you actually have the cash when the payout comes due. If a
company wants to deliver cash compensation in form of a percentage of
the value of the company and stock options are not an option (no pun
intended), synthetic equity programs may fit the bill.
It is possible to create programs based on units or rights. These
programs can have a value based on underlying stock or some other
fraction of enterprise value. It’s common for these programs to payout
only in cash with no actual ownership being delivered. With each type of
program there are significant legal, tax and accounting considerations
that must also be weighed along with compensation issues.
Most stock options provide only the appreciation in stock price over
the period from grant date to exercise date. Stock Appreciation Rights
(or “Unit Appreciation Rights” for those without access to stock)
provide virtually the same return. Like stock options, SAR’s
compensation expense is based on a valuation at the time of grant. This
value incorporates the potential risks inherent in both the time and
corporate value increase required to deliver income to the participant.
SARs also have similar vesting, termination and change-in-control
provisions to stock options. Unlike stock options, cash-settled SARs
must be revalued on a regular basis like other forms of cash
compensation. This can make them more expensive to the company. In the
end, the participant voluntarily exercises and cash equal to the spread
at exercise, less required tax withholding, is delivered.
Compensation can also be based on the full value of an underlying
share or unit (Phantom Stock and Restricted Stock Units/RSUs). Full
value unit programs are excellent vehicles for combining performance
criteria to determine award eligibility, size, vesting dates and/or
final value delivered. Since these instruments have the full value of
the underlying shares or units at the time of award, they have a higher
compensation expense per unit than SARs. Due to this fewer units are
issued, providing potentially less upside, but also a more protective
downside. These programs become taxable income at the time they vest.
Given the recent unpredictability of the stock market full value
programs (usually under the generic heading “restricted stock awards”)
have become more popular than at anytime in the past couple of decades.
In addition to the programs listed above, there are several other
tools that may allow your company to level the playing field against
companies with stock options. You can see that this is too extensive a
topic to fully cover here at the Café. I will cover other long-term
compensation tools such as profit sharing, employee stock ownership
programs (ESOPs) and deferred compensation in upcoming posts.
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”, “If I’d Only Know That”, “GEOnomics 2011” and “Equity Alternatives.” 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