You Get 2 Shares and You Get 4 Shares and So on and So on…

Geometric progression of pay from one pay grade or level to the next sounds pretty crazy. But, while doing research for a recent presentation on equity compensation, I found more than one source that stated that doubling the equity from one level to the next was a standard rule of thumb. When we look at the expansion of executive pay versus broad-based pay, we tend to focus on the volatility of stock market as a driver of the spreads between the top and the bottom. Market volatility certainly has an impact, but it is our legacy approach to equity that is likely the biggest contributor to the inequity of equity.

Like any compensation element there are inherently positives and negatives to equity compensation. This makes equity great for some uses and poor for others. Stock options, restricted stock units and employee stock purchase plans are often demonized by shareholders, politicians and the media. Compensation professionals often misunderstand them. Their impact has been distorted due to an oddly, non-compensation approach to their use.

Let’s transfer the practices for equity into cash. Entry level 1 employee is paid $30,000, Level 2 is paid $60,000, Level 3 $120,000, manager $240,000, VP, $480,000, SVP, $960,000, EVP, $1,920,000 and CEO $3,840,000.  I have seen a lot of pay structures, but none that look like this! However, this is how many companies use equity compensation.

And, equity has an additional potential multiplier built in which is the stock price. If the value of each unit, share or option increases during the vesting period, this unsupportable progression is amplified. It isn't unheard of for values of each share to increase ten-fold or even hundred-fold during the life of an equity grant. In a volatile market (up and down movement), this is even more likely than during periods where prices are only going up.

How did we get to this place? Twenty years ago equity, mostly in the form of stock options, had “no value” at grant. Nearly every equity plan was managed outside of the compensation area. In fact, the majority of these plans are still managed or controlled by legal or finance departments. Add in the general lack of understanding by compensation professionals and an effort to “keep things simple” and you have a recipe for explosive differentiation.

Since the decision makers at the top are benefiting nicely from this structure and no one is spending much time and effort educating them on a better approach it is unlikely this will change. The graphic below shows the volatility of the stock market from 1913-2013 aligned with CEO pay ratios from 1960-2012 overlaid. Given the information above it should be no surprise that pay spreads have mimicked the volatility of the stock market. While I have seen no specific data to support it, I would hazard a guess that the spread between each level below CEO and the average employee is unequal in halving proportions.  This is due simply to our approach to using equity compensation.

Golden decade ceo pay ratio

Perhaps the real future revolution in equity compensation isn't better performance metrics and linkage, but a better approach to determining grants sizes. Maybe we can call this new, more balanced, approach the “rule of the opposable thumb.” Does your company have a great way to determine equity compensation amounts for each level of staff? 

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