Changing The Face Of Long-Term Incentives
By: Brent Longnecker & Nathan White
The best of intentions can often go astray, as many companies using stock options as a long-term incentive have discovered. Brent Longnecker and Nathan White, of Resources Consulting Group, discuss some alternatives to align the best interests of a company with the compensation desires of senior executives.
As politicians, auditors, and examiners circle the smoking ruins of many a recent corporation crash, it’s become apparent to all involved that in the rapidly changing world of corporate accounting practices and longterm incentives for executives, there are certainly better options than options.
Don’t be mistaken, long-term incentives continue to be an integral component of any and all executive and key employee compensation packages. And they should be. After all, long-term incentives, done right, keep executives, companies, and shareholders pointed in the same direction.
And in order to ensure that executives don’t make short-term decisions at the expense of the company’s long-term objectives, long-term incentives should exceed the award opportunity provided through short-term incentive plans.
Analysis of various companies has, unfortunately, demonstrated that this is not always the case.
The forms that these incentives take varies from company to company and will continue to evolve as tax and accounting laws are amended.
Due to their favourable accounting treatment, stock options have come to be the most widely-used vehicle for long-term incentives.
Motivate Key Employees
Like other long-term incentives, stock options are intended to serve to motivate key employees, align their goals with those of shareholders, and promote the long-term vision of the company.
That’s the intention, anyway. Like anything else in life, the potential for abuse is constantly lurking around the corner.
In recent weeks and months, we’ve seen countless examples of how stock options have served instead as (wrong-headed) ‘motivation’ to drive up stock price through misstated earnings and inflated balance sheets.
Now, whether or not one should expense options is for a different debate and a different article, but it is important to realize the results of a change in option favourableness.
An open-ended charge to earnings wouldn’t be a positive financial move for any company – especially one in the early stages of the business cycle. And should stock options become in any way, shape, or form an expense to the P&L, you can bet that innovative new trends will quickly develop in long-term incentive practices.
So after a short period of sleepless nights for CFOs, there would begin to be mounting pressure on human resource directors to develop newer, better alternatives with fixed-cost expenses that can be easily budgeted – in other words, a better option than options.
One such option is the restricted stock award, a long-term incentive vehicle that is rapidly growing in attractiveness.
Restricted stock awards possess several unique characteristics that make them attractive as an incentive program in the eyes of shareholders, board members, executives, the human resource department, and financial officers alike.
Shareholders like it because although restricted stock awards require immediate dilution of EPS, the dilution is set at the grant date and does not vary as restrictions lapse.
Board members appreciate the fact that the long-term nature of these restricted stock awards serves to align the goals of the executive with the long-term vision of the company.
Attractive To Executives
Restricted stock awards have an automatic value at grant with restrictions on their sale or transfer until the restrictions lapse over time. Therefore, the executive immediately owns the stock, has voting rights with the stock, and is eligible to receive dividends – all attractive to executives.
Human resource departments find that restricted stock awards have a high retention value due to forfeiture of the stock following an early departure.
And finally, with a fixed charge to earnings at the time of grant for restricted stock awards, the open-ended variable accounting nightmares are behind financial executives.
This is not to say that restricted stock awards are without their detractors.
Opponents of restricted stock awards will point to a disconnect from pay-for-performance because the restrictions lapse simply as time passes, with no motivation to surpass performance goals.
However, there are customized techniques for restricted stock awards that allow flexibility within the programs to remedy this situation.
Some of the alternatives include accelerated vesting to award key employees for exceptional performance, as well as an election – IRC Section 83(b) – which allows the recipient to choose to be taxed at the value of the shares at award rather than when the restrictions lift.
As pressure mounts from both Capital Hill and Wall Street for re-vamping stock option accounting treatment, look for restricted stock awards to grow in prevalence among common compensation practices.
Brent Longnecker is the president of Resources Consulting Group, a provider of compensation solutions. Nathan White is a consultant for RCG.
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