Competitive Equity Compensation: The New Rules Will not Help

December 2009

The SEC recently finalized new disclosure rules affecting a number of governance and executive pay issues as of February 2010. Among other requirements, the new rules attempt to provide more meaningful disclosure about equity awards granted to Named Executive Officers by requiring the value of equity awards at the date of grant to be included in the Summary Compensation Table; currently, the Summary Compensation Table shows the accounting expense under FAS 123(R).

With a sense of resignation we can, with some certainty, make three predictions about the new requirements. They will (1) require modest incremental administrative work on the part of companies and their advisors; (2) do nothing to reduce the controversy among shareholders, institutional investors and shareholder watchdog groups on the size of executive compensation; and (3) lead to requests for expanded and/or different disclosure around executive pay starting almost immediately.

In addition to being observers of the evolution of the corporate proxy statement, we can safely make these predictions because developing appropriate and competitive equity compensation is inherently problematic for at least two reasons and those reasons will not be fixed by different or additional disclosure. Identifying competitive equity compensation requires the consideration of a variety of competitive groups, valuation methodologies and time periods.

The true value of an equity grant is uncertain and is apparent only when and if it is converted to cash. The calculation of a present or current value must, by necessity, be based on a number of assumptions as to future stock price movements, timing of any option exercise and prevailing interest rates. Companies often place restrictions on the conversion of stock to cash, such as continued employment for a period of years or the achievement of company performance goals. This requires additional assumptions as to future length of employment and company performance. For private companies, the calculation is further muddied by the lack of a transparent, liquid market for the equity.

Competitive data is often skewed by the irregularity of the timing and size of equity grants. Some companies grant large amounts of equity periodically and other grant smaller amounts each year. There is typically no delineation of what a "target" award is, as is the case with annual bonuses. Equity awards often vary significantly from year to year without regard to individual or company performance based on the prevailing stock price, value of prior grants, and shareholder dilution concerns.

Because of the problems with arriving at competitive benchmarks for equity compensation, boards are often presented with conflicting and ever changing data around the appropriate average grant to offer.

Consider as examples, three widely used measures of equity compensation: 1) Present Value at Grant, 2) FAS 123(R) expense value and 3) percentage of ownership. To get a sense of how these measures look in practice, we analyzed 15 Fortune 500 companies with approximately the same revenue ($4.5 billion).

The following chart shows the median equity compensation for the CEO using Grant and Expense Value and percentage of shares transferred (after converting options to full-share equivalents).

Value at FAS 123(R) Ownership
Grant ($k) Value ($k) Transferred

Current Year 2,671 3,082 0.11%

Year – 1 5,849 2,415 0.10%

Year – 2 2,544 1,268 0.70%

Notice that none of the measures provide any sense of consistency. A board looking at these numbers will have a hard time trying to make sense of what the appropriate “target” annual award for their CEO should be. The percentage of ownership transferred appears to show the least volatility but, in fact, the median value hides a lot of variation as companies with smaller market capitalizations are transferring a greater percentage than companies with larger capitalizations. That is, the trend is to deliver a somewhat competitive annual pay rather than a share of ownership.

All three values have their strengths and weaknesses. The grant value is a good indicator of current practice but does not reflect that companies often vary their grants significantly from year to year or make one large grant with a vesting requirement and no grants for several years thereafter. The accounting value is a smoothed value of prior grant practices but does not necessarily reflect current practice. Ownership transferred is independent of stock price and provides a good measure of the cost to shareholders of executive pay in terms of dilution but provides no indication of the value received by an executive.

So, where does that leave us? First, accounting expense will no longer be reported. We felt it was a good measure of target equity grants when the competitive community was 10 or fewer, as it already smoothed over the volatility in historic grant practices. For private companies or smaller-cap public companies, we find the percentage of ownership transferred to be a particularly important and meaningful measure of executive pay as there is either no liquid and transparent share value and/or the share value is subject to wide fluctuations. Also, these companies are the most likely to grant awards at non-periodic intervals. For other companies a three-year average of Value at Grant provides a reasonably consistent and robust target equity award.

Because of the vagaries of grant practices and valuation methodologies inherent with equity compensation, boards and shareholders will never have a straightforward and always-consistent method for determining a competitive pay value - no matter what the SEC requires as disclosure.