Share purchase plans, restricted shares may address emerging concerns
Stock options, once the crown jewels of a total compensation package, have lost some of their lustre in the face of economic turbulence and market uncertainty.
The seemingly endless chorus for more options, so prevalent during the market boom, has evolved into a different tune as executives and other key talent realize that underwater options aren’t nearly as exciting as those on a steep growth curve.
In ideal circumstances, stock options play three important roles.
•They contribute to the competitiveness of a total compensation package, particularly at the executive level.
•They align the interests of employees with those of shareholders.
•They help organizations retain key talent since vesting provisions mean individuals holding options will leave something on the table if they choose to depart.
The challenge for many organizations today, however, lies in extracting optimal value from stock options that don’t seem to offer the same promise of wealth creation they once did. During the market boom, some organizations started distributing stock options more broadly, as a mechanism for rewarding and retaining top talent at all levels, rather than just senior management.
In fact, some organizations saw stock options as almost a magic bullet for addressing employee retention concerns in a cost-effective manner.
But with the fall of stock markets over the last 12 to 18 months, have stock options lost their shine? And what about the companies that pushed the boundaries on stock options?
Some are no longer in business, while others have had to re-price their stock options. Some have had to provide additional retention bonuses payable in cash, and others have had to redesign compensation programs to provide greater emphasis on the cash component. Still others are struggling with what to do.
So do stock options have the same appeal they once did? For employees? For organizations? For shareholders? Do they ensure sustainable performance or guarantee employee ownership? Do they have retention value when they are underwater or out of the money? Do they provide enough line of sight to really motivate employees? Are stock options really an effective compensation vehicle for all employees? What should be top of mind for organizations in these turbulent times — and what are some of the alternatives?
What happened?
So what went wrong? In reality, nothing. Stock options are meant to be a form of variable compensation, and like incentive plans, perform better or worse depending on market conditions. But in recent years, option holders began to expect that the markets would rise continuously and that each year’s grant of stock options would result in another gain. In some cases, an entitlement mentality took shape — fuelled by the misguided belief the party would never end.
In response, organizations started to rely more heavily on stock options to provide competitive compensation to employees. Some even provided options to offset a lower salary or bonus. Some also provided large one-time grants upon hire or on an ad hoc basis as opposed to annually. And so the seeds for disappointment were planted.
While market volatility should be expected and accepted by recipients given the long-term nature of stock options, poor planning and communication have contributed to a lack of appreciation for fluctuations and uncertainty in the stock market — but these oversights can be avoided.
There is a need for an increased understanding of stock options — by both the employees who receive them and the organizations that grant them. First, however, a fundamental question must be addressed: Are stock options an appropriate compensation vehicle for all employees or only a select few?
Objectives of stock options
Generally, organizations grant stock options for the following three reasons.
•To provide competitive compensation: Stock options represent an integral part of the compensation arrangement for most senior managers and executives. Moreover, from a cultural perspective, they can be a critical element of compensation for all employees in some high-tech or start-up environments.
•To foster a longer-term perspective: Stock options provide an element of compensation that focuses employees on results beyond the current year. The typical option term varies between seven and 10 years.
•To align employee and shareholder interests: It is commonly argued that stock options align the interests of employees and shareholders since both parties win when the share price increases.
However, it can also be argued that stock options don’t fully achieve this goal since option holders only share in the upside potential (unlike shareholders who also have downside risk) and don’t receive dividends (if applicable).
Challenges with stock options
There are five major challenges associated with stock options.
•Limited facilitation of employee ownership: There is no guarantee that option holders will hold the company shares for long when they exercise their options. In fact, it is quite common for virtually all of the shares acquired through option exercise to be sold immediately.
Many companies facilitate this process through brokers and/or stock appreciation rights. In some cases, employees just don’t have the financial ability to pay the taxes associated with exercising options without selling the shares. Some companies have instituted shareholder guidelines requiring executives to hold a prescribed value of the company’s shares. A few have even taken punitive measures and cancelled the remaining options of employees who do not hold a certain amount of shares upon exercise.
•Low employee understanding: Many employees exercise their options as soon as they vest (so long as they are in the money). The benefit to organizations in these circumstances may not be enough to offset the impact of dilution.
•Little retention value in a down market: Option holders quickly lose sight of the long-term nature of stock options when they fall out of the money. This can be exasperated by grants at a particularly high price, especially when combined with an ad hoc granting policy. Some companies recently re-priced their stock options to ensure they still had retention value to employees.
•Limited line of sight: Very few employees are able to influence the price of a company’s stock. As a result, it can be argued that stock options do not provide line of sight for most option holders. Option holders can gain from a windfall or lose an in-the-money position as a result of a variety of factors outside of their control. From the company’s perspective, there may be more motivational value in an incentive plan with performance measures employees can understand and influence.
•Understated cost: Up to now, the cost of stock options has typically been borne by shareholders through dilution. When an option is exercised, a new share is created, thus reducing the share of the total pie owned by each shareholder. Currently, companies seem to be more concerned with a comparable bonus expense than dilution. The Canadian Institute of Chartered Accountants has recommended companies disclose option expenses in financial statements. (See page 1, “Pressure mounts to reform stock option accounting.”) Going forward, this expense will likely have to be recognized in the company’s profitability. This would put pressure on options, particularly broad-based plans.
Alternative to stock options #1: Share purchase plans
For organizations seeking to foster a stronger sense of employee ownership, share purchase plans may be an appropriate mechanism. Such programs are relatively simple to understand and can generate increased awareness of the company’s stock and how it is performing.
Under a typical program design, an employee contributes a regular amount (often up to six per cent of salary) on each pay date to buy company shares. Most employees find it easy to set aside a small portion of their pay to invest in the company’s share purchase plan. The company provides a match — usually one share for every two or three shares that the employee purchases. Plans with a high match, for example, often have in excess of 75 per cent participation.
Recent trends in share purchase plan design include allowing employees to direct their portion into a number of mutual funds, allowing them to achieve diversification of their investment portfolio — with the company match staying in company shares.
Given their comparative simplicity — as well as their ability to engage a broad employee population — share purchase plans can facilitate broad-scale ownership better than stock options. They can also serve as a vehicle for helping employees to build wealth. The company match provides an element of retention in that employees need to remain with the company for a prescribed period (usually one or two years) to take ownership of the company match. The only weakness of a share purchase plan is that it does not provide a strong line of sight.
Alternative #2: Restricted shares
Restricted shares/units can also serve as an alternative to stock options. They have been growing in popularity in Canada. They are also relatively simple to understand.
Employees receive a grant of real shares or phantom share units (tied to the price of the share). Access to these shares, however, is restricted until certain time and/or performance requirements are met. For example, the restricted shares might vest over a period of time (usually up to three years) or only after the share price doubles.
Unlike options, restricted shares always have a value — unless, of course, the company goes bankrupt. Therefore, even if the price declines, restricted shares can still help the organization retain employees.
Restricted shares/units don’t provide the same leverage as options — typically only one full value share is granted in the place of every two or three options. Restricted share grants result in a greater likelihood of employee ownership. The main advantage of restricted shares is that they can incorporate vesting based on performance measures other than share price, which can provide greater line of sight for employees. For example, restricted shares in a large organization with many business units can be designed to vest based on the performance (such as profit or return) of each business unit.
But this isn’t to say that a company should forego its option grants outright. Rather, the effectiveness of the long-term component of its compensation program could potentially be improved if a portion of options were replaced by restricted shares/units.
Strategies
Regardless of whether a company decides to keep granting stock options or redesign its compensation program, it is critical that companies and employees increase their understanding of how “ownership-oriented” programs operate — including issues around risk and volatility.
The communication challenges facing companies can be great, particularly if stock options are to be broad based. To this end, companies really need to think about the kinds of pay elements they include in their total compensation mix — and how this mix may vary by role or organizational level.
A key question emerging from the latest economic downturn is around how broadly stock options should be distributed, and whether other vehicles may be better able to help deliver desired outcomes, such as increased employee ownership of company shares.
For example, share purchase plans may be a better vehicle for building ownership across all organizational levels. Restricted shares/units may provide better retention value than stock options. Annual incentive plans may provide better line of sight. And if ownership is the goal, companies can even consider paying a portion of the annual incentive in shares.
As with any other aspect of compensation planning, it is important to consider the role of longer-term compensation elements in driving desired behaviours, as well as the related costs. It is also critical that organizations develop multi-faceted strategies for retaining top talent, so no single element of a total offering is over-emphasized.
Edward Elliott is an executive compensation consultant in Towers Perrin’s Toronto office. He can be reached at (416) 960-2841. Claudine Kapel is a rewards and performance management consultant in Towers Perrin’s Toronto office. She can be reached at (416) 960-7515.
The seemingly endless chorus for more options, so prevalent during the market boom, has evolved into a different tune as executives and other key talent realize that underwater options aren’t nearly as exciting as those on a steep growth curve.
In ideal circumstances, stock options play three important roles.
•They contribute to the competitiveness of a total compensation package, particularly at the executive level.
•They align the interests of employees with those of shareholders.
•They help organizations retain key talent since vesting provisions mean individuals holding options will leave something on the table if they choose to depart.
The challenge for many organizations today, however, lies in extracting optimal value from stock options that don’t seem to offer the same promise of wealth creation they once did. During the market boom, some organizations started distributing stock options more broadly, as a mechanism for rewarding and retaining top talent at all levels, rather than just senior management.
In fact, some organizations saw stock options as almost a magic bullet for addressing employee retention concerns in a cost-effective manner.
But with the fall of stock markets over the last 12 to 18 months, have stock options lost their shine? And what about the companies that pushed the boundaries on stock options?
Some are no longer in business, while others have had to re-price their stock options. Some have had to provide additional retention bonuses payable in cash, and others have had to redesign compensation programs to provide greater emphasis on the cash component. Still others are struggling with what to do.
So do stock options have the same appeal they once did? For employees? For organizations? For shareholders? Do they ensure sustainable performance or guarantee employee ownership? Do they have retention value when they are underwater or out of the money? Do they provide enough line of sight to really motivate employees? Are stock options really an effective compensation vehicle for all employees? What should be top of mind for organizations in these turbulent times — and what are some of the alternatives?
What happened?
So what went wrong? In reality, nothing. Stock options are meant to be a form of variable compensation, and like incentive plans, perform better or worse depending on market conditions. But in recent years, option holders began to expect that the markets would rise continuously and that each year’s grant of stock options would result in another gain. In some cases, an entitlement mentality took shape — fuelled by the misguided belief the party would never end.
In response, organizations started to rely more heavily on stock options to provide competitive compensation to employees. Some even provided options to offset a lower salary or bonus. Some also provided large one-time grants upon hire or on an ad hoc basis as opposed to annually. And so the seeds for disappointment were planted.
While market volatility should be expected and accepted by recipients given the long-term nature of stock options, poor planning and communication have contributed to a lack of appreciation for fluctuations and uncertainty in the stock market — but these oversights can be avoided.
There is a need for an increased understanding of stock options — by both the employees who receive them and the organizations that grant them. First, however, a fundamental question must be addressed: Are stock options an appropriate compensation vehicle for all employees or only a select few?
Objectives of stock options
Generally, organizations grant stock options for the following three reasons.
•To provide competitive compensation: Stock options represent an integral part of the compensation arrangement for most senior managers and executives. Moreover, from a cultural perspective, they can be a critical element of compensation for all employees in some high-tech or start-up environments.
•To foster a longer-term perspective: Stock options provide an element of compensation that focuses employees on results beyond the current year. The typical option term varies between seven and 10 years.
•To align employee and shareholder interests: It is commonly argued that stock options align the interests of employees and shareholders since both parties win when the share price increases.
However, it can also be argued that stock options don’t fully achieve this goal since option holders only share in the upside potential (unlike shareholders who also have downside risk) and don’t receive dividends (if applicable).
Challenges with stock options
There are five major challenges associated with stock options.
•Limited facilitation of employee ownership: There is no guarantee that option holders will hold the company shares for long when they exercise their options. In fact, it is quite common for virtually all of the shares acquired through option exercise to be sold immediately.
Many companies facilitate this process through brokers and/or stock appreciation rights. In some cases, employees just don’t have the financial ability to pay the taxes associated with exercising options without selling the shares. Some companies have instituted shareholder guidelines requiring executives to hold a prescribed value of the company’s shares. A few have even taken punitive measures and cancelled the remaining options of employees who do not hold a certain amount of shares upon exercise.
•Low employee understanding: Many employees exercise their options as soon as they vest (so long as they are in the money). The benefit to organizations in these circumstances may not be enough to offset the impact of dilution.
•Little retention value in a down market: Option holders quickly lose sight of the long-term nature of stock options when they fall out of the money. This can be exasperated by grants at a particularly high price, especially when combined with an ad hoc granting policy. Some companies recently re-priced their stock options to ensure they still had retention value to employees.
•Limited line of sight: Very few employees are able to influence the price of a company’s stock. As a result, it can be argued that stock options do not provide line of sight for most option holders. Option holders can gain from a windfall or lose an in-the-money position as a result of a variety of factors outside of their control. From the company’s perspective, there may be more motivational value in an incentive plan with performance measures employees can understand and influence.
•Understated cost: Up to now, the cost of stock options has typically been borne by shareholders through dilution. When an option is exercised, a new share is created, thus reducing the share of the total pie owned by each shareholder. Currently, companies seem to be more concerned with a comparable bonus expense than dilution. The Canadian Institute of Chartered Accountants has recommended companies disclose option expenses in financial statements. (See page 1, “Pressure mounts to reform stock option accounting.”) Going forward, this expense will likely have to be recognized in the company’s profitability. This would put pressure on options, particularly broad-based plans.
Alternative to stock options #1: Share purchase plans
For organizations seeking to foster a stronger sense of employee ownership, share purchase plans may be an appropriate mechanism. Such programs are relatively simple to understand and can generate increased awareness of the company’s stock and how it is performing.
Under a typical program design, an employee contributes a regular amount (often up to six per cent of salary) on each pay date to buy company shares. Most employees find it easy to set aside a small portion of their pay to invest in the company’s share purchase plan. The company provides a match — usually one share for every two or three shares that the employee purchases. Plans with a high match, for example, often have in excess of 75 per cent participation.
Recent trends in share purchase plan design include allowing employees to direct their portion into a number of mutual funds, allowing them to achieve diversification of their investment portfolio — with the company match staying in company shares.
Given their comparative simplicity — as well as their ability to engage a broad employee population — share purchase plans can facilitate broad-scale ownership better than stock options. They can also serve as a vehicle for helping employees to build wealth. The company match provides an element of retention in that employees need to remain with the company for a prescribed period (usually one or two years) to take ownership of the company match. The only weakness of a share purchase plan is that it does not provide a strong line of sight.
Alternative #2: Restricted shares
Restricted shares/units can also serve as an alternative to stock options. They have been growing in popularity in Canada. They are also relatively simple to understand.
Employees receive a grant of real shares or phantom share units (tied to the price of the share). Access to these shares, however, is restricted until certain time and/or performance requirements are met. For example, the restricted shares might vest over a period of time (usually up to three years) or only after the share price doubles.
Unlike options, restricted shares always have a value — unless, of course, the company goes bankrupt. Therefore, even if the price declines, restricted shares can still help the organization retain employees.
Restricted shares/units don’t provide the same leverage as options — typically only one full value share is granted in the place of every two or three options. Restricted share grants result in a greater likelihood of employee ownership. The main advantage of restricted shares is that they can incorporate vesting based on performance measures other than share price, which can provide greater line of sight for employees. For example, restricted shares in a large organization with many business units can be designed to vest based on the performance (such as profit or return) of each business unit.
But this isn’t to say that a company should forego its option grants outright. Rather, the effectiveness of the long-term component of its compensation program could potentially be improved if a portion of options were replaced by restricted shares/units.
Strategies
Regardless of whether a company decides to keep granting stock options or redesign its compensation program, it is critical that companies and employees increase their understanding of how “ownership-oriented” programs operate — including issues around risk and volatility.
The communication challenges facing companies can be great, particularly if stock options are to be broad based. To this end, companies really need to think about the kinds of pay elements they include in their total compensation mix — and how this mix may vary by role or organizational level.
A key question emerging from the latest economic downturn is around how broadly stock options should be distributed, and whether other vehicles may be better able to help deliver desired outcomes, such as increased employee ownership of company shares.
For example, share purchase plans may be a better vehicle for building ownership across all organizational levels. Restricted shares/units may provide better retention value than stock options. Annual incentive plans may provide better line of sight. And if ownership is the goal, companies can even consider paying a portion of the annual incentive in shares.
As with any other aspect of compensation planning, it is important to consider the role of longer-term compensation elements in driving desired behaviours, as well as the related costs. It is also critical that organizations develop multi-faceted strategies for retaining top talent, so no single element of a total offering is over-emphasized.
Edward Elliott is an executive compensation consultant in Towers Perrin’s Toronto office. He can be reached at (416) 960-2841. Claudine Kapel is a rewards and performance management consultant in Towers Perrin’s Toronto office. She can be reached at (416) 960-7515.
