As the economy moves through various stages of recovery, striking a balance between providing incentives to executives while navigating unprecedented business challenges is no simple task. Although the market has shown resilience from March lows, many companies continue to weigh their cash flow and goals against an evolving outlook.
What are companies doing to solve their equity compensation dilemmas, and how will conversations around equity compensation develop moving forward?
While many companies have maintained a “wait-and-see” stance, a significant minority are adjusting their programs because of the pandemic’s economic fallout—making structural changes, delaying grants, splitting annual bonuses or long-term incentive plans (LTIPs), or adapting compensation models.
With sustained pressure on performance expectations, available share pools and management expenses associated with their equity compensation plans, as of May 16, 19% of Russell 3000 and 25% of S&P 500 companies had announced decisions to cut base salaries and annual bonuses for C-suite executives, as well as board cash retainers.1, 2
There is a direct correlation between companies announcing executive-level pay cuts and the company’s stock performance: The more a company’s stock fell at some point in 2020 relative to the wider index or sector, the deeper the announced cuts.2
Notably, Semler Brossy research also highlighted:
Whether companies have made cuts, not made cuts or are reversing cuts they made earlier in the year, how do such changes play out in terms of equity compensation?
When a stock price drops, a company may need to issue more shares to meet employee purchase agreements. This puts pressure on managing share pools against the threat of unwanted dilution—as well as balance sheets and wider strategies for recovery.
In anticipation of this bind, some companies choose to pause or cancel their employee stock purchase plans (ESPPs), but this move requires serious foresight. Due to the length of most ESPPs, the decision to halt a program is significant: Because these offering periods are so long, it can take another six months to a year to reset plans.
For more immediate actions, some companies may instead leverage reset provisions, reprice stock options, adjust performance goals or tweak plan provisions—perhaps adjusting the company-level restricted stock tax elections from netting shares to sell-to-cover, where cash for taxes is generated from the sale of the company stock. Other companies have responded by shifting short-term equity grants for certain employees, perhaps issuing cash equity rather than straight cash—mitigating market risk and controlling expenses with vesting or restricted periods rather than with less-predictable performance-based or restricted awards.
These tactics are clearly intended to help preserve cash flow, providing ballast by rationing the balance sheet and stock pools against current unpredictability and possible future hiccups on the road to recovery—which may be why some leaders have gone so far as to volunteer for pay cuts.4, 5
However, the devil is in the details, and changes to executive compensation can have unintended consequences.
Modifying equity awards can require repricing stock options, changing performance metrics, or updating financial expense reporting for any modifications to stock options, performance grants or plan structures. It’s critical that companies confirm they have the bandwidth to handle these and any other special accounting projects that may be needed. They also need to sensitively balance executive, employee and shareholder goals, especially when modifying goals downward or adding a “performance kicker” to change how stock is awarded.
Companies must also walk a legal tightrope to comply both with existing legislation and new measures enacted in response to the coronavirus pandemic, including the Coronavirus Aid, Relief and Economic Security (CARES) Act and its Paycheck Protection Program (PPP). Companies may not qualify for PPP loan forgiveness if they implement salary reductions or layoffs for employees who make under $100,000—which may influence any decisions to cut the salaries of higher-paid executives.6
Then there are goals to consider—not only for the company, but for leaders. According to the National Law Review, most growth and performance targets for equity awards that were set before the coronavirus pandemic are probably no longer viable—which is why it may be worthwhile to consider relative performance goals.7 The Harvard Law School Forum on Corporate Governance has noted related performance goals can also open up room to sync with revised company goals and reward leaders for outperforming their peers—but it may be key to tie executive rewards to company performance.5
While the companies making changes to executive pay remain a minority, many more may consider taking action.
Another big caveat is the challenge of supporting changing goals while incentivizing individual executives to remain in their roles, delivering stability and valuable leadership in difficult times. Cutting compensation can trigger “good reason” provisions in employment agreements that allow executives to jump ship—taking a big severance package with them and potentially disrupting high-level company strategy. Employment and severance agreements should be carefully reviewed before making changes.4, 5
Solutions such as stock options that vest according to long-term performance goals can help provide incentive and promote retention, especially since stock options granted when stock prices are low have a greater potential for upside gain and long-term value. On the other hand, any stock options granted before a stock price declines may now be underwater, significantly altering their anticipated value.5 Public companies must balance the long-term implications of any underwater options, both in terms of motivating and retaining their leaders and in managing the number of shares they have available for current awards. Repricing or replacing underwater options can raise complex legal and tax implications, and generally requires shareholder approval.5
Bear in mind that any reduction to equity compensation can affect taxes both for the company and the executive, whether from the timing of deferred compensation or in triggering additional tax consequences for “golden parachute” arrangements.5 For example, any change that breaches complex regulations around equity compensation, such as Section 409A of the tax code, might also kickstart additional or accelerated tax, interest and penalties for the executive, as well as consequences for the employer in terms of tax withholding and reporting. It is essential to structure any adjustments in compensation to account for tax implications to avoid further complications—and seek legal counsel.4
A record-setting market rally is not an economic recovery. While we don’t yet know the long-term outcome, companies may continue to revise their executive compensation plans as they rebound—either by setting new parameters meant to optimize recovery or reverting to the old structure.
While the companies making changes to executive pay remain a minority, many more may consider taking action. Providers must also continue to deliver the customer services and support that companies and executives require as they navigate tectonic plan changes. Intuitive, self-serviced digital systems will be especially in demand in this age of remote work and rapid change.
As executive compensation committees and companies adapt to the many ramifications of the evolving coronavirus pandemic, equity compensation—and changes to how executives are incentivized to lead through the crisis—will continue to require careful deliberation, planning and disclosure.
Craig Rubino is Head of Education and Technical Sales at E*TRADE Corporate Services.