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.