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 21st century.