Articles

The future role of equity awards in executive compensation.

As we embark on another proxy season, disclosed total compensation numbers for named executive officers are creating headlines, and pundits are questioning whether we are back to where we were in 2007. As recently as mid-March, an article in the Wall Street Journal indicated that a growing number of U.S. companies were looking to replace annual bonus structure with semi-annual bonuses, based on shorter performance periods. While just now gaining momentum in the high-tech and retail sectors, there were some indications that this practice could become more widespread. As a result, we are seeing renewed attention to the problems associated with equity compensation, and how to fairly remunerate executives who are able to create meaningful, long-term value for a company's stakeholders.

Note the key points embodied above -- Stakeholders include not only the debt and equity investors of a company, but also the customers, employees, suppliers and the communities where a company operates. Long-term value creation suggests building for sustainable, profitable growth over a long period and with returns exceeding the risk-adjusted cost of capital. Riskier enterprises should conceptually have a higher cost of capital, and equity capital will have a higher cost (and hopefully return) than debt capital.

The challenges for a company’s executive team are balancing the above interests, supporting and encouraging innovation and controlling costs. The challenges for the company’s directors are defining and measuring the accomplishment of the key objectives, and then ensuring that the reward structure in place incents the appropriate behaviors.

It is in this context that the ongoing debate over equity compensation takes place and this is why there has been a fundamental dispute between advocates of leveraged equity awards (options and stock appreciation rights) and non-leveraged awards (restricted stock or restricted units). The debate extends to the basis on which the awards are earned (i.e. with the passage of time or the occurrence of specified non-time conditions after which the awards vest). Added features of awards include stipulations on whether shares acquired through vesting or exercise of an award may be sold, as well as conditions on whether those shares may later be forfeited or clawed back by the company. Further complicating this debate are the tax (both for the company and for the award recipient) and accounting implications of various forms of awards and the legal and regulatory limits of particular forms of awards in certain countries.

The parties to the negotiation over equity compensation are the executive recipients and the shareholders, as represented by the board of directors, and their agents in the form of compensation consultants and shareholder advisory services. Unfortunately, the interests of many of these parties may best be served by simple, plain vanilla types of awards, which are readily understood and easily communicated, although arguably not the best suited for promoting the desired long-term outcomes. That is why we so often see options granted at the stock’s fair market value at the time of grant, with a four-year vesting period, expiring after ten years or on leaving the company, and outlining certain conditions which potentially accelerate the vesting of the award or the period during which an option may be exercised. Shareholder advisory services then subject an equity plan granting these types of awards to a formulaic analysis and determine whether it is in the best interests of the shareholders. The objective, of course, is to have a plan which passes muster with the advisory service, so that large institutional shareholders can vote in favor of the plan.

Obvious challenges in the adoption of performance-based plans and awards are the following:

• Establishing meaningful, measurable and clear multi-year goals is very time consuming and difficult (and an area where reasonable minds can easily disagree)
• The linkage to stakeholder value creation may be tenuous, change over time or have a lagged effect
• The complexity of performance-based awards makes them difficult to convert to an award document
• Because they are complicated, they are costly to administer, track and account for (and present in the CD&A section of the proxy)
• If the recipient does not understand the cause-effect embodied in the award, it will likely not have its intended impact on executive behavior

In its recent Long-term Incentive Plan Survey, Towers Watson found that in the period between 1999 to 2009, the percentage of companies using stock options had declined from 89% to 63%, while restricted stock awards were used by 62% of companies in 2009, up from only 14% ten years earlier. Performance plans showed a less dramatic increase — 48% in 1999 to 69% ten years later. In terms of responding companies that did use performance-based awards, 82% of them used one or two measures and the most commonly reported (in descending order of frequency) were: Growth in EPS, growth in total shareholder return, growth in revenues, growth in income and return on invested capital. It was unclear if these targets were absolute or relative to an index or peer group of companies.

According to a F.W. Cook & Company presentation to the NASPP on March 25, there is a trend toward the use of alternative awards underway. An example cited was market-linked RSUs (or Market Stock Units – MSUs). Simply stated, these awards grant a specified number of units subject to a vesting or earning period. At the end of the vesting period, the price of the stock relative to its price at grant (the formula can use an average price over a specified number of days or spot prices for both beginning and ending prices) determines the multiplier to compute the actual number of shares the executive earns. Plans which use this form of award set a maximum percentage of the base number of RSUs which can be earned, regardless of stock price performance. The floor percentage can be as low as 0%. Companies that had adopted these forms of awards in the past two years were Biogen IDEC, CarMax and Xerox. For the awards reviewed, the change in stock price over the vesting period was expressed in absolute terms, not in comparison to a market index or an average of share prices of peer group companies.

These awards represent a hybrid between stock options and restricted stock or RSUs. They can be difficult to value but they are characterized by fixed compensation expense, i.e. determined at grant. Also, because of the novelty and complexity of the awards, they may be difficult to communicate. And because the awards share some of the same disconnects between standard stock options and restricted stock/RSU grants and risk-adjusted valuation creation, they may not incent the desired behaviors.

Radford has identified an increasing use of relative total shareholder return-based (TSR) awards in the past five years. (TSR awards include in the calculation any cash or stock dividends paid by the subject company and the comparator group during the vesting period.) According to the Radford database of announced plans or awards, these plans have increased in prevalence among Fortune 1000 companies from five announced plans in 2005 to 120 by 2009. This form of award, which has been in use for some time in the U.K., uses a similar concept to the MSU and can apply the multiplier to either a grant of options or restricted stock/RSUs. The principle difference between relative TSR awards and MSU awards is the use of an index or peer group, which complicates the calculation. TSRs have to be computed (and audited) for the subject company as well as the comparator group, although if a standard index (such as the S&P 500) is used, this helps facilitate the calculation.

When a peer group of companies is selected for the TSR comparison, the company must be careful to select a large enough group to avoid distortions caused by a limited sample. Ideally, these peers should be as similar as possible, in terms of company size and characteristics (financial and operating leverage). Once the peer group is selected, the company needs to be concerned with changes such as acquisitions, divestitures, mergers, bankruptcy, etc., as well as extraordinary events impacting one or more companies in the group. These complications lead many companies to opt for the S&P index as a simpler but less ideal comparator.

A novel idea for redesign of equity compensation was put forth by Roger Martin, Dean of the Rotman School of Management at the University of Toronto. In a March 22blog article to the Harvard Business Review, he argued that the current structure of a standard executive stock option promotes the taking of “excess” risk to drive the short-to-medium-term stock price, as follows: An option in a leveraged company is somewhat equivalent to a sliver of levered equity, where the payoff occurs after the debt is retired and dollar earnings accrue to the equity owners. However, there is no downside risk to the executive option holder, since s/he has no stake in the company. Mr. Martin argues that especially for the debt holders, the downside risk to their investment is large.

Mr. Martin also proposes that aligning the interests of executives with the providers of capital can better be achieved by selling executives a sliver of the firm's senior and junior debt in proportion to the actual mix, with that debt instrument being permanently stapled to a sliver of its equity in proportion to the actual debt and equity proportions. The company could finance the executive’s purchase of the stapled debt instrument, but only with a recourse loan. This combined equity-debt instrument would have the upside payoff of a deferred or restricted unit of stock, with the benefit of focusing the executive on the cash discipline required to make principal and interest payments on the debt. This should reduce the tendency to “swing for the fences” in an effort to generate a short-term boost to company stock price.

UHY Advisors, a public accounting and valuation firm, has created a model which purports to disaggregate the change in a company’s share price over a period of time. The firm calculates the portions of the price change which are due to changes in operating performance (presumably within management’s control) versus other factors, either outside of management control (i.e. changes in the overall financial markets) or within management control but which have risk implications (i.e. changes to the company’s financial or operating leverage). If or when this approach -- or similar approaches in use at other public accounting or valuation firms -- gains traction, it could easily be substituted for the multipliers used for MSU or relative TSR awards. This type of model would likely be more applicable in the case of restricted stock/RSUs than options, however, since it doesn’t mitigate the risk of a strong down-market putting the stock options underwater -- regardless of how good management’s operating performance was.

As companies’ share prices continue to recover from the severe market correction of 2007-2008, they (and their boards) are increasingly challenged to attract, retain and remunerate executives who can be difference-makers in terms of shareholder value created (or more appropriately, stakeholder value created). We can expect boards to increasingly focus on designing equity-compensation plans which achieve this objective in a cost-effective and efficient manner.

—James McBride, Managing Principal, Solium Equity Consulting

Part 2 of 2 —Determination of Outsourcing Options

In Part 1 of this article on evaluating your stock plan administrative solution (found in the last issue of KnowledgeWorks), we looked at how you should go about conducting an internal assessment – a report card, if you will. In this, the second installment, we’ll outline which steps to take once you’ve determined that outsourcing all, or a portion of your equity plan administration, is the best solution for your company.

The initial task for your project team, which is ideally the same team for the assessment phase, is determining what can and should be outsourced. Does outsourcing apply to all plans, or might it exclude ESPPs? The team will also want to focus on specific advantages and disadvantages of outsourcing with single, versus multiple providers.

The ten key areas to consider are:

1. Organizational Roles and Responsibilities
2. System Integration
3. Performance Record
4. Software Platform
5. Vendor Processes and Procedures
6. Brokerage Services
7. Participant Services
8. Implementation, Migration or Transition
9. Contract and Budget
10. References

1. Organizational Roles and Responsibilities

As is the case with a decision to continue outsourcing, the team will need to resolve roles and responsibilities in the post-outsourcing environment. Start with the initial process diagrams completed during the assessment and revise those to redefine processes which now include your company’s outsourcer(s). Here too, the objective is to eliminate existing functional overlaps while addressing presently unmet needs. In redefining your processes, ensure that you are taking advantage of the competencies the outsourcer brings to the table, while retaining elements of your program that are strategically important. With any good outsourcing relationship, you should begin thinking of your provider as a partner, or a member of your team, whose key responsibility is to deliver an excellent equity plan administrative program.

2. System Integration

With an outsourced solution, consider specifically how well the outsourcer interfaces to your other systems, especially payroll, tax and accounting. Evaluate automation opportunities as you migrate from your present environment. For example, are there offline analyses being done in Excel or Access which can be integrated into your new solution? These represent opportunities to increase efficiency as you transition to a new environment. This information, in addition to the redefined roles above, will allow your team to develop a cost-benefit analysis of your recommended solution, i.e. internal cost savings measured against outsourcing costs and/or program enhancements or reduced risks (and associated value).

3. Performance Record

With any outsourced solution, assess the outsourcing candidate’s track record in keeping their system current with changing tax (consider tax requirements in all countries where your plans are operating) and regulatory and accounting requirements. One of the advantages of outsourcing is shifting this burden from your internal areas. Be sure that your auditors accept the calculations used in the software reports. Related to this item, review your prospective outsourcer’s software reporting flexibility and your ability to customize and run your own reports as desired.

4. Software Platform

In your evaluation, consider who is responsible for updates to the software. Do prospective outsourcers maintain the software themselves? Or is the software installed on your company’s servers, leaving your group and your IT area responsible for version changes? In the latter case, is support from the vendor during the upgrade process available, and is there a charge for this support?

5. Vendor Processes and Procedures

Ensure outsourcing candidates have detailed, actionable procedures in place for each facet of stock plan administration. Consider in detail how they support each transaction under review, including the following (as applicable):


• Processing new grants and grant acceptance, if required
• Processing expiring or cancelled grants and notification to holder
• Processing option exercises (restricted stock/RSU vestings) with or without simultaneous sales
• In case of share sales, are limit orders allowed and if so how are they managed?
• Processing tax withholding and tenders
• Converting currency for international participants
• Processing terminations and managing exceptions to standard termination conditions
• Managing ESPP enrollments, withdrawals, purchases, share transfers, share sales, tax withholding, etc.
6. Brokerage Services

Based on the specific needs and past operation of your company’s program, evaluate the advantages and disadvantages of using a captive broker versus multiple brokers. Consider the commission structure, simplicity and automation features available when dealing with a single broker versus the flexibility afforded with multiple brokers.

7. Participant Services

Does your prospective provider maintain a customer service centre and give you the option to connect with a live person? What are the hours of the service centre? What are the wait-time and abandoned-call statistics and how are issues escalated?

8. Implementation, Migration or Transition

Ensure you fully understand your prospective provider’s process for the implementation of your company plan. An efficient implementation requires them to have a complete understanding of your company’s existing internal processes, any current software workarounds and special support or reporting requirements. Your selected outsourcer and your company should each designate one person responsible for the implementation to ensure clear communication and lines of authority. Ensure as well that the selected provider has a communications protocol with website addresses and contact phone numbers which clearly and concisely notify your plan participants of the program changes and how they are specifically affected by those changes.

9. Contract and Budget

In selecting an outsourcer, don’t neglect the contract terms. Thoroughly review and consider:


• All fees assessed, including exception fees and when they are applied;
• Whether fees are paid by the company or the participant
• The contract’s duration and ability for each party to renew
• Contract cancellation clauses
• Rights and responsibilities of each party
• Price escalators; and performance guarantees, and
• Financial consequences if the provider fails to meet these conditions
• That the contract outlines the responsibilities of the outsourcer, if any, to assist in a subsequent conversion to another outsourcer
10. References

Since you are making a large and long-lasting decision, schedule a site visit to the short-listed provider(s) to allow your team to personally observe and assess their performance, especially against your selection criteria. Also, although it likely goes without saying, check references thoroughly. References should include companies similar to your own, and be comprised of both satisfied clients and former clients, particularly if the client left for specific causes. Make sure you thoroughly question the references to determine the provider’s strengths as well as deficiencies (and whether those were subsequently corrected). As with the site visit, focus on the performance attributes most pertinent to your program.

Similar to your internal assessment, spending time and money in selecting the right outsourcing solution for your company will pay long-term dividends and result in a well-run program and satisfied participants.

If you would like assistance in evaluating and selecting a third party provider, Solium Equity Consultants can give you valuable direction. Please contact:

Jim McBride
Managing Principal
248.882.5724

jim.mcbride@soliumconsulting.com

The Separation of Gen Y from their Stock Plans

According to a 2009 study by KRC Research, 67% of Generation Y (also called ‘Generation Next’ or ‘Millenials’ and refers to those born from the mid 70s to 1999) respondents said it’s unlikely they would invest in the stock market, while half of them also said it’s unlikely they would fund a 401(k).

Although some respondents may have been a little extreme in their answers (22% said they’ll never even open a bank account), this survey does show a prevalent trend amongst Gen Yers – they’re apprehensive about investing. Many of them have been offered stock and share plans before, and don’t understand exactly how they work.

If you are a stock and share plan administrator, this trend reflects one of your major challenges: educating your younger staff members about the advantages of having stock and share plans, and how they can best use them to their advantage. Because they’re young, Gen Y stands to make some profitable long-term investments now – which means long-term employee engagement and retention within your company.

Approaches to the problem
A Cisco study released in February showed more than one third of its Gen Y respondents believe they need help managing their financial affairs. The same study also showed that, although they value financial advice from their family and friends, they would prefer the use of electronic mediums to access financial advice in the future.

As a stock plan administrator, you may want to reach out to your younger employees with this in mind. Try giving them basic information on the advantages of their stock and share plan incentives in an easy-to-follow tone and format. Making information available on a searchable company intranet, in a location that is easy to find and access is a great way to present the information to Gen Y in a format they are accustomed to using (i.e. internet searches). Also consider including a list of FAQs that deal with questions that are specific to your plan and your company (see callout for examples of commonly asked questions).

Experiment with ways to engage employees in educational activities. For example, hold a contest about the company’s stock plan program where they need to find the answers in the intranet FAQs.

Communicate the Benefits of a Stock Plan
Equity Incentive plans yield benefits for both the employer and the employee but many Gen Yers don’t understand or realize the benefits that participating in a share purchase plan would have for them. In previous years, corporate stock-based incentives were typically granted only to high-end executives who, on the whole, are well-informed of the intricacies of stock-based compensation. More and more, companies are using them for employees of every level. According to money.cnn.com, there were only about one million workers covered by a few hundred stock option plans in 1990. Today there are nearly ten times that many participants in approximately 3,000 plans. The issue that has surfaced is that as the availability of such awards has spread to a wider, less financially savvy employee base, those newly added staff may not fully understand or appreciate the benefits the plan offers.

Any type of profit sharing program offered by a company is a reflection of the value the company sees in the employee, and this needs to be communicated to Gen Y. Inform them that the employer created the plan as a means of engaging, attracting and retaining valuable employees by allowing them to “buy into” the company. Properly informed employees are more likely to enroll in share purchase plans and gain a deeper investment in the work they do and the company they work for.

Here are a few common questions about stock and share plans you should be prepared to answer:

1. What is ‘vesting’?
2. What does exercise mean?
3. What do the different exercise types mean?
   1. What is an exercise and hold?
   2. What is a cashless exercise?
   3. What does sell to cover mean?
4. How am I taxed on my stock options and/or share purchase plan?
5. What’s the difference between Non-Qualified Stock Options (NQSOs) and Incentive Stock Options (ISOs)?
6. What is the schedule for the employer contributions to be received? What is a vesting schedule?
7. What should my short- and long-term strategies be?
8. How often can I exercise or withdraw?
9. Should I exercise immediately at the time of vesting?

Building effective and properly voiced employee communications specifically for Gen Y can ensure that the intended value of the plan is fully realized by the recipients. Communications should anticipate and answer common questions as well as topics specific to your plan and any unique circumstance or considerations surrounding it. This critical information is often missing in many existing corporate plans, limiting the plan’s success. After all, the central reason for the plan is to give added incentive to these employees so that they are encouraged to perform well in their role. But how can they be more motivated if they don’t fully understand the benefits that are being offered to them?

If you require assistance with developing informative communications specific to your plan or developing a comprehensive communication strategy, please contact Solium’s Communication Specialists. For complete consulting services contact Solium Equity Consulting.

Regular Sections

Tools to help navigate IFRS

The SEC has not made a final decision on the adoption of IFRS yet, but there are already tools in place to help the industry comply with the standards, and learn about how they compare to current regulations.

In January, the American Institute of Certified Public Accounts (AICPA) launched an online resource on its IFRS Resource website (IFRS.com) that provides a look at the International Accounting Standards Board’s International Financial Reporting Standard for Small- and Medium-Sized Entities (IFRS for SMEs) - a simplified version of IFRS which aims to help private companies understand the system and how it compares to U.S. GAAP.

Click here to access the tool.

The post is set up in a comprehensive and user-friendly way, divided into relevant sections, each featuring a columned comparison of relevant IFRS information vs. U.S. GAAP information, as well as the AICPA staff’s views on how corresponding requirements compare.

And because it’s a Wiki, anyone with an interest in and knowledge of IFRS for SMEs and U.S GAAP is invited to read and contribute to the site. Wiki posts are collaborative products of online participants.

For customers using Solium’s Shareworks® software, they have access to an IFRS conversion tool, which allows for easy compliance with the new regulations, while maintaining the accuracy, reliability and speed that participants are accustomed to with Shareworks. The IFRS Transition Tool compares the results under both GAAP and IFRS using cloned data from previously GAAP entries, and even takes into account various scenarios and interpretations of IFRS 2.

Click here for more information on Solium and its Shareworks application.

US Adoption of IFRS Delayed
The SEC will keep the target date of 2011 to vote on adoption but delays the final conversion date until 2015.

The SEC announced in February it would still make a final decision on the U.S.’s plan to adopt and implement IFRS regulations in 2011 but delay the earliest possible required adoption date for U.S. public companies. The original intent with favorable vote for adoption would have put the standard into effect as early as 2014. The delay means the earliest U.S. companies would begin using the rules is now 2015. The SEC will focus time in the coming year to further look into the impact the new standards would have, and to determine whether switching over would be in the best interest of companies and investors.

The last time the Commission formally met to discuss possible IFRS implementation was November 2008, when they set out a roadmap outlining several milestones that, if achieved, would lead to the adoption of the standards by 2014. However, since then, the process has been overshadowed by economic factors, delayed and put on the backburner for more pressing issues. Last fall the SEC announced they would devote more time to the implementation of IFRS and that the financial crisis’ impact globally had reinforced the need for international financial standards. At that time, SEC Chief Accountant Jim Kroeker also said that of the more than 200 letters they had received, there was definitely a sense of widespread support for global standards – but with diverse opinions on how to get there.

Globally, there are already more than 100 countries that currently allow, or enforce, the use of IFRS. The European Union adopted it in 2005.

Reactions to IFRS adoption:
Following the SEC’s announcement, a KPMG survey found that, of 2,500 U.S. executives, 58% of them were opposed to, or undecided about if they supported adoption of the IFRS. Another 49% of respondents said they would like to be able to adopt the standards before 2015.
Click here to read more

Another study by California-based Accountants International, which polled 3,500 accounting, finance and HR executives across the U.S., indicated that more than half of respondents (55%) had no opinion about IFRS implementation, while one third (36%) were in favor of adopting the new standards. The same survey also found that only 15% of respondents said they would consider bringing in an outside consultant to help with IFRS implementation, while 41% said they would not and 44% said they were unsure.
Click here to read more

Many U.S. companies have expressed concerns about complications and costs associated with a conversion, as well as the lack of a definitive implementation date. Some have criticized the move, saying it will only benefit large-scale, international companies, but another KPMG study found that 65% of investment executives and analysts surveyed thought an IFRS adoption would drive more foreign investment into the U.S. market. The move towards IFRS would also mean publicly traded companies would be more transparent to potential investors, as they would be required to provide more disclosure.

What are your thoughts on the SEC’s delay in making a decision and the U.S.’s adoption of IFRS? Give us your feedback here. A summary of responses will be posted in the next issue of KnowledgeWorks.

To read previous Solium news about IFRS, visit:
IFRS Off the Backburner
SEC releases IFRS roadmap
SEC status briefing on Transitioning GAAP to IFRS
Canadian Issuers Checklist for IFRS2 Share Based Payments
Download the white paper GAAPing or IFRSing: The Fundamental Question

The SEC Hit List

Stability over career advancement
Post-recession employees looking for long-term stability over career advancement

In a sharp contrast to pre-recession mentality, a recent study of employee attitudes and workplace trends by Towers Watson found that U.S. employees are looking for security and long-term stability over other career objectives these days.

While earlier trends indicated employees were more interested in advancement opportunities and retirement expectations, the reality of the recession is fresh in people’s minds as they reconsider what they value in a career, said Laura Sejen, a leader of Towers Watson’s talent and rewards business.

“The recession has clearly prompted many employees to rethink their priorities and focus on a longer-term commitment to their employer in return for some semblance of job security” Sejen stated.

The shift in mentality is good news for employers, who can realize higher rewards and better returns from long-term benefit programs -- such as RSUs, Stock Options and Employee Share Purchase Plans -- to give employees the stability they’re craving, while also building long-term working relationships and loyalty.

Click here for more information on setting up stock and share plans in your workplace.

Top 10 Reasons for Restating