Equity effectiveness: creating alignment and value with your equity compensation plans
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The document discusses the importance of achieving equity effectiveness in compensation plans, emphasizing the balance between costs and motivational value. It highlights the changing landscape of equity compensation post-2008, along with generational differences and cultural factors influencing employee perceptions. The authors advocate for aligning equity programs with organizational culture and behavior to drive performance and value.
Equity effectiveness: creating alignment and value with your equity compensation plans
- 1. Compensation practice Equity effectiveness: creating alignment and value with your equity compensation plans Jim Sillery and Sandra Sussman October 25, 2012
- 2. Compensation practice Seeking equilibrium Equity effectiveness is the point of equilibrium in share utilization: • Effectiveness refers to both: – Grant efficiency (tax/accounting/dilution) – Motivational value • Optimum utilization occurs when the return (motivational effect) outweighs the cost (dilution, expense and administration) • Equilibrium point is where strongest correlation between share utilization and total shareholder return occurs 2
- 3. Compensation practice Achieving equity effectiveness During the 1990s, achieving equilibrium was easy, with little or no concerns about: • Run rates • Overhang • Expense • Allocation • Motivation 3
- 4. Compensation practice Achieving equity effectiveness In the years following the 2001-2002 recession, optimization was more difficult: • Economic pressure drove increased diversification in the use of equity plans • Changes felt across many participation levels and geographies • For a long time, the solutions were simple… 4
- 5. Compensation practice But no one expected… The 2008-2009 recession was unprecedented in: • The depth of its decline • The duration of its decline • Its global economic impact …And had a profound impact on equity compensation programs 5
- 6. Compensation practice Why was this a surprise? Are the foundations of global equity programs built on an anomaly? $1,000,000 Growth of $10 invested in the Total S&P500 Index starting in 1900 $100,000 Real S&P 500 Index Long-Term "Equilibrium" $10,000 Total Return Index: 9.30%/Yr The “birth” of global equity $1,000 Total Price Index (Dividends Reinvested) $100 $10 $1 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020 Year 6
- 7. Compensation practice Potential disconnects of today’s reality with conventional wisdom Accountants vs. Option in March 2009 with strike of $4.00 < entrepreneurs option in March 2012 with strike of $20.00 Data vs. Surveys are reliable source of information for facts compensation comparison and planning Reciprocity vs. Equity grants are powerful motivators, incentive especially when based on performance Timing is “Stocks for the Long Run” everything 7
- 8. Compensation practice Current state 8
- 9. Compensation practice Understanding the disconnect: right-brain vs. left-brain In design and delivery of equity programs: Left is dominant: • Tax • Accounting • Compliance Right is dormant: • Perceptions • Behaviors • Culture 9
- 10. Compensation practice Left-brain: determines what an equity grant is worth • We use complex models to calculate stock option value • But restricted stock is the face value at grant • Performance shares are the possible delivered value • What about long-term cash? So, what is the total value delivered at grant? 10
- 11. Compensation practice So at the date of grant, what is the perceived value? Value of Stock Options vs. Restricted Stock $8,000 $7,000 $6,000 $5,000 $4,000 $3,000 $2,000 $1,000 $0 Grant 1 2 3 4 5 6 7 8 9 10 Stock Options Restricted Stock Assumes ratio of 3 stock options for exery 1 restricted share Value of Stock Options vs. Restricted Stock $120,000 $100,000 The answer is $80,000 simple… it $60,000 $40,000 depends… $20,000 $0 Grant 1 2 3 4 5 6 7 8 9 10 Stock Options Restricted Stock Assumes ratio of 3 stock options for exery 1 restricted share 11
- 12. Compensation practice But what does perceived value depend on? • Work culture • Personal biases and experiences • Generational differences • Global cultures 12
- 13. Compensation practice Work culture Alignment of equity compensation practices with both business strategies and work culture… … is critical for successful change and work force commitment to the change. 13
- 14. Compensation practice Perceptions and behavioral economics The three main themes in behavioral economics are: • People often make decisions based on “rules of thumb”, not rational analysis • The way a problem is presented will affect the decision a person makes on how to act • There are behavioral explanations for observed market outcomes that are contrary to rational expectations and market efficiency 14
- 15. Compensation practice Behavior and behavioral economics Behavioral economics provides us with insight into employee perceptions: • Mental accounting -- “What is this grant worth now?” • Loss aversion -- “What if it goes underwater?” • Hyperbolic Discounting -- “But, when do they become mine?” • Decision paralysis -- “What if I don’t know how to decide?” • Regret aversion -- “What if I make the wrong decision?” • Overconfidence -- “This should be easy!!!!” • Following the herd -- “But it’s a best practice” 15
- 16. Compensation practice Behavior and generational differences • Generational differences manifest themselves in several ways, including how individuals view their compensation • There is variation in the nature of intrinsic rewards each generation considers • The generations also relate to their organizations differently 16
- 17. Compensation practice Implications on perceived equity values Baby Boomer: • Optimistic + Involved + High Risk/High Rewards = Preference for highly leveraged grants like stock options Generation X: • Cautious + Conservative + Distrustful = Preference for low leverage grants like service-based restricted stock Generation Y: • Realistic + Confident + Career Focused = Preference for moderate leverage grants like performance shares 17
- 18. Compensation practice Behavior and global culture Hofstede • Culture is the underlying value Cultural Dimensions framework that guides an Small Power Distance Big Power Distance individual’s behavior • Culture reflects perceptions, Individualism Collectivism social interactions and business interactions Masculinity Femininity • Culture guides the selection of appropriate responses in Strong Uncertainty Avoidance Comfort with Uncertainty social and business situations Long-Term Orientation Short-Term Orientation 18
- 19. Compensation practice One company, one plan? European Countries 70 60 World Average 50 40 70 30 20 60 10 50 0 PDI IDV MAS UAI 40 30 Latin American Countries 20 10 80 0 70 PDI IDV MAS UAI LTO 60 50 40 United States 30 20 10 0 100 PDI IDV M AS UAI 90 80 70 Asian Countries 60 50 90 40 80 30 70 20 60 10 50 0 PDI IDV MAS UAI LTO 40 30 20 10 Source: Geert Hofstede™ Cultural Dimensions 0 PDI IDV MAS UAI LTO 19
- 20. Compensation practice Achieving equity effectiveness • If this is what an understanding of employee behavior tells us, then how should we act today? • By left-brain: – Accounting – Tax – Compliance • And right-brain: – Perceptions – Behaviors – Culture 20
- 21. Compensation practice Looking ahead at equity effectiveness 21
- 22. Compensation practice But, how do we make this work? First, ask five simple questions: • What does our participant group look like? • Is our plan aligned with our work culture? • How should/does the plan work? • What behaviors and outcomes do we want to drive? • Are we meeting the needs of all constituencies? 22
- 23. Compensation practice But, how do we make this work? Pay for Creating Line of Performance Sight… Workforce 300% Analysis Wealth 250% % of Target Payment Received 200% Creating 150% ROI TSR Alignment… 100% Analysis 50% 0% 70% 80% 90% 100% 110% 120% 130% Work Culture % of Goal Achieved Retention Diagnostic Design Outcome Creating Value… Analysis 23
- 24. Compensation practice Workforce analysis An analysis of workforce demographics can provide insights into who your employees are, how their perceptions are formed and how you can manage those perceptions 24
- 25. Compensation practice Work culture diagnostic • A company’s work culture defines − How it is organized − How roles are defined − Who succeeds − How performance is managed − How people are rewarded • Using a series of diagnostic tools to assess the current, and desired, work culture to ensure that equity grants are creating alignment with those attributes that have the greatest impact on performance 25
- 26. Compensation practice Pay for performance analysis • There is a range of metrics associated with value creation. • Some like Free Cash Flow are “drivers” of future value while others like TSR measure the value created 26
- 27. Compensation practice Pay for performance analysis • A pay for performance analysis looks for the cause and effect relationship between the plan design and desired/final performance outcomes • This analysis ensure that there is a direct correlation between key financial, economic and behavioral factors and desired/realized outcomes 27
- 28. Compensation practice Design outcome analysis TSR Distribution 0.5% • Performance-based 0.4% Simulation Theoretical incentives can and often 0.4% do have unintended 0.3% consequences • The design outcome 0.3% analysis allows a 0.2% company to look at the 0.2% “inner working” of a plan 0.1% before it is implemented 0.1% 0.0% -200% -100% 0% 100% 200% 300% 400% 28
- 29. Compensation practice Design outcome analysis • By running multiple scenarios of potential outcomes, this analysis can quickly pinpoint if and where plan design may deviate from plan intent so that it can be recalibrated Rank Distribution Vol 50% 16.0% 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% 0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 80.00% 90.00% 100.00% Rank 29
- 30. Compensation practice ROI analysis • The ROI Analysis looks at the end-of-plan return to all stakeholders: - Shareholders - Company - Participants • This provides a key look at the effectiveness of the equity plan — was there equilibrium between the return to shareholder and the company (left brain) and the return to the participants (right-brain) • It also provides valuable feedback to enhancing future plan effectiveness 30
- 31. Compensation practice ROI analysis • The success factors considered in this analysis can and will vary across organizations and their constituencies - Companies may define success in terms of a combination of cost, retention, recruitment, commitment, market position and/or other factors - Shareholders may define success in in terms of increased share price relative to dilution, dividends and/or other factors - Participants may define success based on delivered value compared to date of grant value, stock ownership, long-term capital accumulation, financial security and/or other factors • These success factors should be identified at the onset, checked on an ongoing basis to confirm their continued relevance and then measured at the end of the period 31
- 32. Compensation practice Parting thoughts • Technical aspects of equity are important, but not enough • To understand perceived value, a better understanding of the global workforce is needed • Value is perceived, not calculated • Classical rational decision-making is not the model for actual employee decision-making • Triangulate to get answers rather than focusing on the single best base of information • Design simplicity should be an imperative • More intuition, less conventional wisdom 32
- 33. Compensation practice Questions Jim Sillery Principal 612.215.6940 James.sillery@buckconsultants.com Sandra Sussman Director 415.617.3935 sandra.sussman@buckconsultants.com 33