How have the stock-market volatility and economic fluctuations of recent years changed stock grant practices?
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 Great Recession
A big turning point in equity compensation was the market crash and economic downturn of 2008 and 2009. It shifted the focus in stock compensation from the mere adjustment of grant practices for mandatory expensing to a re-examination of equity-award use in general. 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.
Meanwhile, an article from the firm 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. "Wait and see" is the most common approach for the large majority of companies with calendar fiscal year-ends.
Some companies, such as Boeing, are replacing 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 US include Section 409A on nonqualified deferred compensation if the employer intends to repay the reduced compensation at a later date.
Valuation And Grant Size
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.
Equity Awards 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 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.