Major Trends In Equity Compensation During The 21st Century: A Celebration Of Our 15th Anniversary
Happy birthday to us! In June 2015, we at myStockOptions.com celebrated the 15th anniversary of the website's launch. We have seen a lot of changes in equity compensation since myStockOptions.com went live in June 2000. As part of our 15th-anniversary celebrations, this article reviews, in rough chronological order, some of the major issues and developments in equity compensation that we have witnessed and covered since the end of the 20th century. Let's take a break, look back, and have some fun.
From The 1990s Through 2000: The Democratization Of Stock Options In The Dotcom Boom
For most of their quiet history, stock options were an elite form of equity compensation, largely for senior executives and directors. As everybody knows, this changed during the 1990s. Technology startups and other fast-growing companies found that stock options perfectly suited their need to attract and retain bright talent on a low cash flow. The popularity of options brought them prominently into the public eye. (In 1997, stock options were even featured in an episode of the TV sitcom Seinfeld.) The lure of stock option wealth after a successful IPO helped many of today's top technology companies expand and flourish into the giants they are today.
By 1999–2000, when myStockOptions.com was developed and launched, there was a frenzy over stock options in the tech industry. Our files of news articles from that time reveal vibrant references to ambitious employees who "crave" or "lust for" stock options. The wealth-building leverage of options was expressed as "the stock option dream." In Silicon Valley, the biggest market for tech options, newspapers such as the San Francisco Chronicle and the San Jose Mercury News assigned reporters expressly to cover the stock option beat. In their pages, articles on option financial planning became as normal as tips on home-buying or personal banking.
This business trend democratized stock options, bringing them down from the lofty heights of Mt. Executive into the workaday foothills of middle-class people who in an earlier era might never have heard of them. And it wasn't just the technorati who derived the benefits. Many "stock option millionaires" included people not on the front lines of technological innovation. For example, one of Google's in-house masseuses became a millionaire from stock options granted to her in 1999.
myStockOptions.com was born into a world where options, and other forms of stock compensation, had the potential to change anybody's life. You no longer needed elite family or business connections: just the right equity incentives and a lot of honest, hard work. Equity comp had become a wealth-builder for the masses, both in the United States and elsewhere in the world.
2001–2006: Underwater Options, Mandatory Option Expensing, And The Rise Of Restricted Stock And RSUs
Long before the financial crisis and recession of 2008–2009, the phrase underwater stock options had become painfully known to many people and their companies. The stock-market downturn of 2000–2002 revealed one of the weak points of options: they were, at least temporarily, worthless if the company's stock price fell below the exercise price of the options. However, after the options-fueled growth of the 1990s, much of corporate America had come to depend on robust equity incentives to draw and keep the brainpower they needed.
As a result, talk turned to alternatives for stock options. The expected change in accounting rules that finally came with FAS 123(R) (now called ASC Topic 718) also encouraged this discussion, as soon all grants would need to be expensed on the company's income statement instead of merely appearing a footnote. Now that stock options were losing their favored accounting treatment, companies had an additional financial incentive to consider other types of grant that could fit their approach to compensation.
Many types of equity award were bruited about, but one in particular was taken up widely. From the ashes of the downturn, restricted stock and restricted stock units rose up and started to gain widespread favor. Like stock options, restricted stock had previously been an obscure form of senior executive compensation—not a pay practice for lower-level executives or regular employees. However, it emerged into the corporate limelight in 2002 as the best broad-based alternative to stock options because, as a "full value" award, it was downturn-proof: a grant of restricted stock is always worth something (unless the stock price falls to zero). In fact, many observers foretold that restricted stock would become the new stock options.
They were half right. As events have unfolded, it is the unidentical twin of restricted stock—restricted stock units, or RSUs—that has become the most popular alternative to stock options at many companies. You are now more likely to receive RSUs than restricted stock. The use of restricted stock and RSUs at companies has continued to grow. While not granted as broadly to employees as stock options were during their heyday, they have joined stock options among the top forms of equity compensation. Many executives now have portfolios of various types of equity awards, including stock options and restricted stock/RSUs.
We at myStockOptions.com spotted this trend as it became evident during the downturn of 2000–2002. Our coverage of restricted stock and RSUs may, in fact, now rival or even exceed our coverage of stock options. While myStockOptions.com has become our trusted brand name, we could just as well be called myRestrictedStock.com (in fact, we own the URL!). This is no exaggeration: our varied content on restricted stock/RSUs includes articles, FAQs, podcasts, calculators, quizzes, and even self-study courses for continuing education credits. myStockOptions.com also has special tools dedicated to financial planning with restricted stock and RSUs.
2004–2008: The Backdating Scandals
In the early 2000s, the Securities and Exchange Commission (SEC) seemed to be focusing on the "springloading" of stock grants, i.e. the timing of grants to occur just before the release of good news that pumped up the company stock price. Then, in 2004, its focus changed. Suddenly, the SEC and prosecutors shifted their glare to the corporate backdating of stock options: the action, whether intentional or accidental, of granting stock options with a lower exercise price than the fair market value of the company's stock on the date of grant.
The investigations and prosecutions that followed shook the world of stock options from top to bottom. After enjoying praise in the news media as everyman wealth-makers during the sunshine years of the 1990s, stock options became a media dartboard on which everybody could pin the blame for executive greed and finagling. The first big backdating case, in 2005, involved only an admission of backdating grants at a major company and the resignation of its CEO and two other executives. However, in July 2006, things got more serious: SEC and the US Attorney for Northern California brought the first criminal backdating case. Others followed. By the end of 2007, the SEC had charged seven companies and 26 former executives associated with 15 firms, and it had made at least 10 criminal filings.
While our coverage of the backdating scandal was limited to its impact on corporate practices and individual taxation, myStockOptions.com avidly watched the backdating soap opera for several years. It was amazing for us to see, for better or worse, stock options in front-page headlines of major newspapers. Although the backdating saga tarnished the reputation of stock options, it did at least improve the administrative process for granting them at many companies.
2005–2015: The Rise Of Pay For Performance
Right from the start of broad-based grants of restricted stock and RSUs, one of the recurring groans about these grants was that vesting was based entirely on time: receiving the shares was usually contingent on nothing more than continuing to work as an employee of the company. This gripe is most famously encapsulated in the phrase "pay for pulse," which has become a plaintive refrain among shareholders dissatisfied with time-based vesting.
The answer to "pay for pulse" has become "pay for performance." Over the past few years, myStockOptions.com and other observers in the equity compensation arena have charted the rise of performance shares or units among long-term equity incentives. These grants typically resemble grants of restricted stock or RSUs but require more than just continued employment before they vest: the company must meet stipulated performance goals during a stated period after the grant. In addition, some companies have added performance requirements even to grants of stock options.
While stock options and restricted stock remain important for corporate recruitment, retention, and motivation, performance shares both make investors happy and create a stronger link between pay and performance. In fact, for senior executives they have become almost mandatory as a sign that the company is trying to improve the alignment of pay, performance, and long-term shareholder value. Now companies are starting to grant performances shares beyond a narrow group of key executives who steer a company's long-term success. Outside the US (e.g. in the United Kingdom), these grants have fairly common for a while.
The "pay for performance" trend has been one of the most interesting developments in stock-based compensation during the past decade. We continue to cover its evolving aspects in a special section on performance shares.
2006–2015: The Surprising Resilience Of Employee Stock Purchase Plans
We have always been big fans of employee stock purchase plans (ESPPs). Depending on the type of ESPP and its features, ESPP participants may be able to purchase shares of their company at a discount of up to 15% off the company's stock price. ESPPs also let participants take advantage of something called dollar-cost averaging. In this concept, you invest the same amount of money to buy stock regularly through payroll deductions, regardless of the stock price, so you end up buying more shares when the price is down and fewer when the price is up. While dollar-cost averaging does not ensure a profit or shield you from a loss, people who use dollar-cost averaging generally tend to pay less per share over time than those who purchase shares all at once. Lastly, a company's ESPP is generally available to all of its employees, while the population that receives stock options and restricted stock/RSUs is often much smaller.
The accounting change that introduced the mandatory expensing of stock options in 2006 also required expensing for tax-qualified Section 423 ESPPs. Some observers believed that mandatory expensing would have a deleterious effect on ESPPs, as expensing essentially penalizes companies for providing the discount of up to 15% that is permissible in Section 423 ESPPs.
Fortunately, the predicted decline of the ESPP did not happen. In fact, tax-qualified ESPPs with meaningful discounts and lookbacks have shown remarkable resilience in spite of the corporate accounting expense that they incur. A survey by Fidelity Investments, for example, revealed that over half of the surveyed companies (51%) plan to modify their ESPPs in the next few years, and that 31% will make their plans more attractive for participants with such measures as increasing the purchase-price discount or adding a lookback provision. Other highlights of the survey:
- 50% of the surveyed companies consider an ESPP to be part of the company's benefits package, as opposed to a form of compensation.
- 72% consider ESPPs to be as valuable as pensions and dental benefits, and more valuable than company-provided life insurance.
- 28% believe their employees value their ESPP more than other company benefits.
Even mainstream journalism has become interested in the benefits of ESPPs. See, for example, articles in the San Francisco Chronicle and in Forbes.
One further intriguing aspect of ESPPs came to our attention recently. While doing research for an academic paper, Do Non-Executive Employees Have Information? Evidence From Employee Stock Purchase Plans, Ilona Babenko (Arizona State University) and Rik Sen (Hong Kong University of Science and Technology) stumbled upon evidence suggesting that ESPP participation can predict the future direction of a company's stock price. While most academic research on stock trades focuses on what senior executives are doing, Ms. Babenko and Mr. Sen analyzed stock-trading by rank-and-file employees. The authors found that stock prices of companies in the top half of aggregate ESPP purchases outperform those in the bottom half by up to 8% during the year after purchases. "Since ESPP purchases reflect the decisions of thousands of employees...they can provide a reliable signal of future performance," the researchers claim. They also found that an increase in participation by lower-level employees can be associated with a higher probability of good news ahead for the company, such as a takeover, while a decrease in participation may signal hard times ahead, such as an earnings restatement.
The ESPP section at myStockOptions.com has an extensive body of articles, FAQs, and videos on all ESPP topics, including survey data showing the latest trends among employee stock purchase plans.
2003–2012: The Politics Of The Alternative Minimum Tax
The alternative minimum tax (AMT) is a topic of importance to employees with incentive stock options (ISOs), as the spread at the exercise of ISOs is part of the AMT income calculation. Now notorious, the AMT was enacted in 1969 to stop extremely wealthy people from dodging their tax liabilities. However, for various reasons, the reach of the AMT has expanded over time to hit middle-income people it was never intended to tax, including people who exercise and hold ISOs.
To limit this unfair expansion of the AMT, Congress began enacting temporary tax relief in the early 2000s. The tactic was to raise the AMT income exemption amounts each year in accordance with inflation. Without these annual "patches" to control the spread of the AMT, the AMT exemption amounts would have returned to the low levels of 2000, unleashing the AMT on 30 million middle-income taxpayers it was never intended to tax. However, the issue of paying for the resulting reduction of tax revenue without adding to the national deficit became a political wrestling match between Democrats and Republicans. By 2007, the annual legislative fight over AMT relief had become predictable. Whenever Congress considered an annual AMT patch, Democrats proposed to pay for the resulting revenue shortfall, and thus meet budget spending, by raising taxes elsewhere. However, Republicans rejected the idea of tax hikes because they felt these might damage economic growth. Democrats retorted that raising tax rates for big business and the wealthy would be better than worsening the federal deficit. Back and forth it went.
A long-term fix finally came in the American Taxpayer Relief Act of 2012. This law introduced three provisions on the AMT that are important for high-income taxpayers, particularly those who exercise incentive stock options. One of these was the permanent indexing of AMT income exemption amounts for inflation in future years. This was a huge development. By essentially automating the annual AMT patch, the indexing of the exemptions for inflation obviated the former annual need for Congressional action and eliminated the related yearly uncertainty. Nevertheless, for anybody with ISOs the AMT continues to require extensive tax planning to minimize its painful impact.
Dodd-Frank Act Of 2010: Ongoing Equity Comp Impacts For Senior Executives
In enforcement actions, the SEC has often targeted option or stock profits gained by senior executives at share prices that were unfairly inflated by financial fraud. In addition to demanding the disgorgement of any compensation that resulted from inaccurate financial statements, the SEC has ordered the relinquishing of any remaining stock options and other grants. Enacted by Congress in 2010, the historic Dodd-Frank Wall Street Reform and Consumer Protection Act has increased the likelihood for this type of SEC enforcement action.
Enacted partly to enhance protections for investors in the wake of the financial crash of 2008, Dodd-Frank directed the SEC to issue rules that make clawback provisions mandatory for any corporate accounting restatement caused by the company's failure to comply with SEC reporting rules. Companies must recover gains received by any implicated current or former executive officer that stem from incentive-based compensation (including stock options, restricted stock, and performance shares) and were paid during the three-year period preceding the date by which the company is required to prepare the accounting restatement. The law requires clawbacks for a restatement even without any misconduct by executives.
In a study of clawbacks at Fortune 100 companies, the research firm Equilar found that most of the companies had adopted clawback policies voluntarily even before Dodd-Frank ordered the SEC to make them mandatory. Some of Equilar's findings:
- While in 2006 only 17.6% of the surveyed companies had a clawback policy, 84.2% of the companies had adopted clawbacks by 2011.
- Of the companies that adopted or amended their clawback policies after 2006, 46.9% did so in 2010 or 2011.
- In 2011, 81.3% of the clawback policies covered both cash and equity incentive compensation, up from 70.65% in 2010.
Over the past several years, Congress and the SEC have been focusing increasingly on issues involving excessive executive compensation. Further developments like those stemming from Dodd-Frank are sure to emerge in the coming years, especially if another market crisis occurs. Meanwhile, other Dodd-Frank provisions have introduced new regulatory requirements for hedging and for the disclosure of pay ratios and pay-for-performance measures by companies.
2011 To The Present: New IRS Tax-Return Forms And Cost-Basis Reporting
While IRS paperwork is not a subject likely to quicken the pulse, some major recent changes in basic IRS tax-return reporting and forms have had a historic impact on equity compensation, the related tax reporting, and the need for improved stock plan education. (Hear us out.)
Let's begin at the beginning. The cost basis is an all-important number you must subtract from your stock-sale proceeds to determine the gain or loss that you report on your federal tax return. At least for covered securities, the cost basis is reported by brokers to people who have sold shares. This reporting occurs either on IRS Form 1099-B or on the broker's equivalent substitute statement. Before 2011, only the gross sales proceeds had to be reported on Form 1099-B after stock was sold. After IRS changes that took effect in 2011 and 2014, Form 1099-B reporting now includes not only the gross proceeds from stock sales but also the cost basis of the shares, the date when the shares were acquired, and whether gains (or losses) were short-term or long-term.
For regular stock that you buy on the open market, the cost basis is the purchase price. With stock compensation, however, figuring out the basis can be tricky, as the compensation element that appears on Form W-2 is part of the basis under this formula:
cost to acquire securities +
the compensation recognized by acquiring it
This is where it gets tricky. For various reasons, the W-2 income might not be included as part of the basis on the Form 1099-B that the IRS receives. In addition, restricted stock and RSUs are considered noncovered securities, so no cost basis for them is reported on Form 1099-B. The resulting possibility that you may need to make a special adjustment in the gain/loss you report your tax return creates the potential for tax-return mistakes and for overpaying taxes. An incorrectly reported basis would probably be too low.
The elevation of complexity did not stop there. When the IRS revised Form 1099-B to expand cost-basis reporting, we wondered where and how all that additional information on the cost basis of stock sales was going to be reported on the Form 1040 tax return. Could the extra data on the cost basis be somehow squeezed into the traditional Schedule D for stock sales, or would another form be needed? Perhaps predictably, in 2013 the IRS answered that question by introducing us to yet another form for tax-return reporting: Form 8949. At the same time, the IRS also revised Schedule D. Form 8949 is where you now list the details of each stock sale, while Schedule D aggregates the column totals from this form to report your total long-term and short-term capital gains and losses.
The additional cost-basis information on Form 1099-B may be helpful for filling out those forms. However, it may also be incomplete if you sold shares acquired from stock grants or an employee stock purchase plan. In short, cost-basis reporting, both for your broker on Form 1099-B and for you on your tax return, is now more complex, confusing, and vulnerable to errors. These small changes in tax-reporting details and paperwork have had a surprisingly big impact on the world of equity compensation. They led us to devote a special part of our Tax Center to reporting company stock sales. It has FAQs with annotated diagrams of Form 8949 and Schedule D to help you complete your IRS tax return without making costly mistakes.
From 2015 Into The Future: What's Next?
What is the future of equity compensation? Performance features in long-term incentives are not just here to stay but continuing to gain prominence. We think vesting will increasingly be linked to individual or company performance for some equity award participants. Tax-return reporting has become more complex than ever, and the frequent confusion over the cost basis of stock compensation on tax returns seems likely to continue. Stock plans also continue to become more global, and equity compensation is becoming more and more available to employees throughout the world.
Other developments, perhaps less foreseeable, are sure to emerge in the coming years. During that time, myStockOptions.com will remain your best resource for staying on top of developments affecting the financial planning, taxes, and wealth-building potential of stock compensation, whether stock options, restricted stock, performance shares, or employee stock purchase plans.
Matt Simon is the Editor & Content-Manager at myStockOptions.com.