How have the stock-market volatility and economic fluctuations of recent years changed stock grant practices?
Changes in executive compensation and equity pay practices stemming from the downturn of 2008 and 2009 were far more extensive and vigorous than those caused by the 2000–2002 market drop. More companies were affected by the market crash in 2008–2009, which was accompanied by a steep rise in unemployment. Moreover, stricter rules on disclosure and shareholder approval of stock plans and executive compensation were already in place by 2008. While it is too early to know exactly how stock grant practices may change because of impacts from the Covid-19 pandemic in 2020, there are some lessons from what happened in past big market drops.
In general, after 2008 the focus in stock compensation shifted from adjusting grant practices for mandatory expensing to re-examining the uses of equity awards, particularly performance-based grants. Companies continue to decrease their use of stock options in favor of restricted stock/RSUs and performance share grants. The advantages offered by ESPPs have made them also appealing for broad-based use by companies.
Adjustments In Grant Sizes
Some companies have reconsidered the valuation approach they use to determine the size of new stock grants. Many companies base grant sizes on either a target amount of compensation or a target number of shares (see related FAQs on these grant guidelines for stock options and restricted stock). In down markets, one problem for many companies is whether to adjust the target dollar value of stock grants (converted into a specified number of shares/options/units) or to adjust grants that are usually a fixed target number of shares. Under the target value method, lower stock prices means companies need to grant many more options or shares to reach a target value. This, in turn, uses up shares much faster (i.e. increases the burn rate), raises dilution concerns, and creates too large a gain for executives if the price rises quickly. However, the target size approach, without an adjustment in the size, results in a grant with a much lower value.
Amid the big market declines and volatility caused by the Covid-19 pandemic, a commentary from the law firm Winston & Strawn suggests companies should consider changing their valuation approach accordingly, such as using a volume-weighted average closing price over a period of trading days (e.g. 30 to 90 days) prior to the grant date. An article from Pay Governance discusses the challenge companies face in calibrating stock grants during a period of depressed and volatile stock markets. It explains the considerations involved and numerous alternative approaches.
Potential Stock Grant Changes In Downturns
What may happen to stock grants in a downturn? What actions can companies take? That is the focus of a 2019 commentary from the law firm Morgan Lewis: Executive Compensation Planning For An Economic Downturn. For example, according to the authors, companies could cap payouts from performance-based plans to avoid unintended consequences. Shareholders may object to a payout that is significantly above the target during a financial downturn. That could raise questions, for example, when one metric exceeds the maximum while another fails to hit the threshold. Companies may also move to denominate grants in dollars and not shares, as with the latter the value of the award would be smaller should the stock price drop.
In Turn Up Your Exec Comp Plan, the consulting firm Semler Brossy presents potential plan designs and actions that companies may take to prepare for the next downturn. The authors look at some of the approaches companies took during the Great Recession of 2008–2009. In their view, some boards "overreacted" to the downturn, resulting in mixed outcomes and unintended consequences. For example, some boards decided to use more stock options to avoid the challenges in setting performance goals in the uncertain economy and increased the upside opportunity for executives. With the strong market upturn that eventually arrived, the options grants became very lucrative.
The Semler Brossy consultants caution that action to adjust stock plans in a downturn should "probably not mirror those of the past." The performance goals and maximum potential payouts must be acceptable to shareholders in a declining business environment yet still engage executives. When companies have the discretion to adjust award sizes after the fact, executives should understand in advance what rules will be applied and the possible scenarios.
Will Stock Options Make A Comeback?
For an interesting take on why stock options deserve a revival, see a white paper from the consulting firm Semler Brossy. The authors argue that granting options is especially sensible during periods of economic growth, when companies are investing for the long term and encouraging innovation with extended compensation payback periods. Their reasons:
- Options can be a highly effective tool for the right business and circumstance.
- Data suggests that companies using options outperform peers.
- The governance and regulatory environment has changed considerably since 2000 to control abuses of employee stock options.
- Alternatives to options, such as performance plans, have their own drawbacks.
Survey Data On Grant Trends
A related FAQ features survey data about the effects that expensing, stock-market trends (before Covid-19), and other developments have had on equity compensation.