As firms consider ways to adjust employee pay due to the COVID-19 pandemic and resulting economic slowdown, the decision points around addressing outstanding equity awards are especially complex. Here are factors to consider by type of equity vehicle.
The COVID-19 pandemic, along with the economic slowdown created in its path, is a having a severe impact on company performance to-date in 2020. Most companies — though not all — are currently underperforming against their financial forecasts for the year, many businesses have shut down significant portions of their operations, and some firms have even filed for bankruptcy. Adding to the challenge is the fact that we don’t know when this crisis will end, making it very difficult to develop reliable business plans for the remainder of the year.
Yet, despite these challenges, companies must continue to look forward. Employees must be paid, retained and motivated, and the mission of seeking new clients and revenue must go on to ensure long-term business success. As more firms move from reacting and responding to the immediate crisis, to recovery and stabilization, and ultimately to reshaping themselves for the future, a rare opportunity to rethink and reevaluate total rewards strategies exists.
We believe companies should take a holistic approach to this opportunity, which is especially true for equity compensation. Equity awards pose unique complexities that cash compensation does not — from accounting and regulatory rules to managing the impact of market volatility.
To help compensation and HR professionals rethink their equity compensation plans in this new environment, we address considerations to outstanding grants in this article. In follow-up articles, we will examine considerations for upcoming grants and developing a communications strategy around your equity plans.
What to Consider Before Addressing Outstanding Awards
The decisions companies make around their outstanding awards should incorporate the impact of COVID-19 on the individual organization and industry, as well as the type of equity vehicles that are outstanding. Given the long-term nature of equity incentives, most investors and proxy advisory firms are not expecting changes to outstanding awards. Therefore, clear disclosure on the rationale for making adjustments must be included if any changes are made.
The decision to change outstanding equity awards should also take the following into consideration:
- The measurable impact of lost value of equity awards on the engagement and retention of key talent and critical roles,
- The size of the gap between realizable values, grant values of this year’s grant and any other unvested grants,
- The mix of equity vehicles, especially the percentage of restricted stock granted (this influences how quickly changes in share price impact this gap),
- The overall impact on run rate and dilution of any decisions weighed against the value in terms of retention on employee engagement, and
- Shareholder and other governance concerns.
Addressing Stock Options and Stock Appreciation Rights
Many companies are seeing the majority, if not all, of their outstanding stock options significantly underwater in today’s environment. There are two choices to recoup the value if deemed necessary: One is additional grants of options or restricted shares; the second approach is a repricing or exchange of the out-of-the-money options for new replacement awards (typically structured as at-the-money options or restricted stock).
A repricing or an exchange is more complex than additional grants, but it may be an attractive program to return value to employees and address retention concerns. We recommend a balanced approach to any stock option exchange by looking at the impact to dilution, potentially putting shares back in the pool (if allowed by your plan and shareholders), and not creating significant incremental expense. In order to balance these priorities, companies should consider exchange ratios above 1-for-1, which offsets some incremental expense and helps to address dilution.
For most companies, repricings or exchanges require shareholder approval, which poses significant obstacles to the design and implementation of the program. If taking this action does not require shareholder approval, it is still important to understand the institutional shareholder perspective, to have a business justification for your actions and to be prepared to respond to the shareholder criticism that will come — which may include negative say-on-pay votes and/or votes against the election of board members.
If you are considering addressing your underwater options, we encourage you to do your due diligence. This includes the need to:
If a company determines a repricing or exchange is not viable, supplemental grants can be used to offset some of the lost value. However, we recommend first considering the impact of doing so on increased stock dilution, especially given the lower stock prices potentially used to determine grant sizes.
- Understand Proxy Advisor Policies – Both Institutional Shareholder Services (ISS) and Glass Lewis have policies on these programs with ISS’ policies being more restrictive. Understanding their perspective is helpful, even if you do not comply with all policies, to ensure the design is as attractive to shareholders as possible and disclosure is robust and compelling.
- Know Your Investor Base – Most programs do not comply with ISS’ policies and therefore receive an “against” recommendation by the firm. This may not cause the repricing or exchange to fail if you launch a thorough investor outreach campaign to illustrate why supporting the program is needed. To increase your chances of success, know your investors’ policies and voting history on these programs and engage in direct outreach to gain broader support.
- Clearly Articulate the Situation – The rationale for program amendments should be clearly made and focus on the company’s unique circumstances; this is a critical element of creating a successful program. Citing macroeconomic events, such as the environment we are in today, is usually not enough to convince shareholders to support the program.
Time-Based Restricted Stock
Following the financial crisis of 2008-09, many companies and sectors swapped stock options for full-value shares or restricted stock. In doing so, they eliminated the negative impact of underwater options and enhanced the retention value of their equity plans. That’s because full-value awards maintain value (albeit less) in a down market. Given the current economic slowdown, we expect to see even more companies shift at least some portions of stock options to full-value awards.
Still, companies already using full-value awards may feel that the decreased value of their awards lack retention value, especially if the company’s stock price remains suppressed. If a company is in this situation, they may want to add supplemental grants — just be sure to be cognizant of how your grant sizing methodology may impact the awards.
In this section, we are focusing on long-term performance awards typically with performance periods that are three years in length. Companies may have more flexibility in modifying goals in short-term incentive plans.
Performance-based equity has grown in popularity over the last decade. However, many of the goals set for the awards outstanding were made during very different economic environments than we are in right now. For companies using operating metrics, you may have set your revenue or earnings per share goals, for example, based on different financial assumptions. Many firms now face a lack of business visibility on these goals, putting the viability of the incentive plans into question. As a result, companies may consider modifying performance goals to enhance the retention value of the plan and ensure goals are reasonable in the current economic environment.
Modifying performance-based equity is often a reasonable approach in a period of sustained economic uncertainty, but given the long-term focus of these awards, we do not expect to see many modifications until later in the year. If your firm believes it’s time to modify performance goals, we recommend paying attention to two things:
Modifying these awards can be a good use of shares and expense since you are repurposing existing shares and expense through the change, but a modification may be impractical to execute depending on your situation. For instance, the practicality of a modification may change based on the timing of the proposed modification compared to the performance period end. Modifications of recent grants may appeal less to shareholders than modifications of grants made over two years ago, because a significant amount of time remains for these goals to potentially be met. Additionally, shareholders may not support modifications for performance awards that are based on market conditions since generally total shareholder return is declining.
- Shareholder and Proxy Advisor Reactions – These groups historically don’t like modifications to outstanding awards; however, adequate disclosure of a compelling rationale may win them over.
- Accounting Implications – These types of changes are considered “modifications” under the accounting rules and require a remeasurement of the fair value at the time of the modification. If goals are being materially lowered, this could introduce significant incremental expense to the company. However, it should be noted that if your outstanding awards are based on internal operating metrics, there is potential that the original grant date fair value can be permanently reversed, meaning the ultimate expense recognized is simply the fair value of the award after modification.
As an alternative to modifying outstanding performance awards, you may consider supplemental grants if the share usage allows for it. Generally, shareholders support supplemental grants that are performance based if the goals are set reasonably and the metrics align with shareholder interests. Again, clear rationale is vital with this approach.
Employee Stock Purchase Plans
According to our research, approximately half of public companies maintain an Employee Stock Purchase Plan (ESPP). These plans tend to be very effective programs at providing shares of the organization broadly without incurring significant expense. However, the current economic slowdown may have companies limiting, modifying or eliminating these plans to cut costs. Still, we think companies should consider the value of an ESPP in motivating employees for relatively small cost compared to other types of equity compensation. ESPPs also can create cash flow for the company as employees purchase shares at the end of the offering period.
Given all the variations of ESPPs that exist, the list of considerations associated with these programs is exhaustive. However, one significant consideration is how a lower starting stock price for employees joining the program may allow them to purchase significantly more shares in the upcoming offering than expected. In that situation, a share cap may be appropriate.
Supplemental Equity Grants
As discussed earlier, one of the responses to outstanding equity that has diminished in value is to consider supplemental grants. These can be very attractive as a company does not need to approach shareholders for approval if you have enough shares remaining in the pool. We don’t expect many supplemental grants to occur until later in the year with the level of business and financial market uncertainty that exists today. However, for some companies, supplemental grants may be needed now so it’s important to understand the specific situation of your organization.
When considering supplement grants, we recommend thinking through these three issues:
Share Usage and Dilution – Unlike a modification or exchange — which can repurpose outstanding shares or even lower dilution — supplemental grants will add to it. It’s important to be cognizant of the existing share pool and how awards like this may force the firm to request more shares from investors sooner than anticipated. This approach may also increase the organization’s burn rate to levels that do not align with institutional investors and proxy advisors. This will have consequences for future say-on-pay votes and/or share requests. With these considerations in mind, business leaders will want to evaluate the most effective vehicle for additional grants — whether that is stock options, which can go underwater given market uncertainty, or full-value awards, which will provide a level of supporting value even in this uncertain time.
Investor Perspectives – If the supplemental grants increase the compensation of your executives above industry and sector standards, this has the potential to trigger more scrutiny from proxy advisors and institutional investors. You will need to have a clear rationale for the supplemental grant and why it was necessary at this time. As a result, companies may want to consider a performance vesting condition to align any supplemental award with the long-term goals of the organization. Taking this action requires visibility into the business and macro environment, which is why a wait-and-see approach may be best, with grants coming later in the year when companies have more line-of-sight into future conditions. Still, many companies will struggle with setting new long-term goals in this environment, so awards based on market conditions may be the easiest to implement. We expect to see many companies consider supplemental grants based on premium-priced options, ensuring a return to shareholders, or performance awards based on relative total shareholder return, ensuring outperformance against peers in any economic environment.
Accounting Costs – Modifications can be effective tools at addressing underwater equity because some of the cost of the replacement award can be offset by the original cost of the underwater award. With supplemental grants, there is no such offset and the company must be prepared to absorb the full cost of the new award in addition to the cost of the original underwater programs. Still, for some industries, this expense may not be significant. There are also many design provisions that can be considered to help mitigate cost without drastically impacting the perceived value of the awards, including post-vest holding periods and total value caps.
Addressing equity awards with diminished value will be specific to each organization, but generally speaking, we recommend evaluating your outstanding equity programs in the following manner:
- Assess the retentive value of your current programs and the likelihood of recovering value through those awards.
- Understand how the current economic environment impacts your industry and company to assess the need to shift the focus of goals and employee retention. Some industries may need to make very serious changes to maintain employees over this volatile time while others can to survive with minimal changes.
- Determine the viability of supplemental grants within your organization. Can the share pool handle the increased grants? How will this change the way investors view your organization’s compensation programs? Does the additional expense impact your organization’s success?
- If supplemental grants are insufficient, consider the modifications outlined above to reset value and employees’ expectations. The rationale for taking this step should be clear and impactful to shareholders.
For questions about any of the issues discussed in this article, please reach out to one of the authors or write to email@example.com.
To read more articles on how rewards professionals can respond to the COVID-19 pandemic, please click here.
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