Market downturns or volatility tend to drive changes in approaches to equity compensation. These can be observed in past downturns and in the current volatile market environment of the Covid-19 pandemic era. The stock-market volatility and downturn that began in 2022, along with the ongoing challenge to hire and retain talented employees, has led to replacement and refresher equity grants, along with changes in vesting schedules and other plan futures. (See an article elsewhere on this website: How Amazon, Apple, Google Adapted Their RSU Grants To Help Retain Top Talent.)
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.
Return to topWhat 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. Amid the 2022 stock-market downturn, a commentary from Meridian Compensation Partners notes similar issues with PSU grant payouts for "less negative" stock-price performance relative to peers, along with other impacts on equity pay (see Equity Incentive Pay Issues In A Down Market).
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.
Ideas that companies considered amid the impact of the Covid-19 pandemic are presented in articles from the law firm Mintz and the consulting/accounting firms Deloitte and KPMG.
"Wait and see" was the most common approach for the large majority of companies with calendar fiscal year-ends. A 2021 article from Equilar (Compensation Conundrum, pages 20-23) noted with data that it was not common during Covid-19 for companies to change metrics or reduce or adjust pre-set goals used to measure long-term performance compensation.
Among companies that had earlier fiscal year-ends in 2020, some of the approaches they took are explained in commentaries from Meridian Compensation Partners, FW Cook, and Pay Governance.
Some companies, such as Boeing, replaced annual merit salary increases with stock grants. Other companies looking to do the same will want to review a commentary on this topic from the law firm White & Case. Issues the firm discusses include whether employee consent and notice are needed (likely outside the United States) and other unintended legal and tax consequences. The authors recommend that before swapping stock for salary, companies should review state and federal requirements on minimum wage and overtime (for nonexempt employees) to assure they continue to be met even after the pay reduction. Tax traps in the United States include Section 409A on nonqualified deferred compensation if the employer intends to repay the reduced compensation at a later date.
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 to control abuses of employee stock options.
- Alternatives to options, such as performance plans, have their own drawbacks.
At the NACD Summit 2020 for board members, a number of compensation committee members revealed that their companies have started to award stock options or increase the percentage they grant, according to a commentary from Michael Melbinger of the law firm Winston & Strawn. He explains three reasons for the renewed use of stock options mentioned by committee members: simplicity; reward for performance over time; and pure alignment with stockholders' interests. He also noted that no compensation committee member said they were granting options because the stock price was at a low because of the Covid-19 pandemic. Instead, they said the focus was on stockholders' interests.
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.
