When it comes to equity compensation, there’s the good, the bad and the ugly

Jul 18, 2013

by Max Fawcett

http://albertaventure.com/2013/07/the-options-play/

Edward Sampson isn’t exactly a popular man with investors these days. Shares in his natural gas exploration company, Niko Resources, have plummeted – no, skydived – from more than $100 at the end of 2010 to just over $5 this past March. And while that underperformance is surely frustrating to even the most patient investor, what really tends to draw people’s ire is the fact that, despite this performance, Sampson has pulled in one of the largest compensation packages in the country. In 2010, he made a shade over $15 million, and in 2011, he took home just a tick under $11 million. Sampson took a more substantial pay cut in 2012, but still earned $4.8 million.

Outrageous, right? Not necessarily. Sampson has consistently received the vast majority of his pay in stock options, and that’s a decision that doesn’t look particularly good right now. Take his attention-grabbing 2010 pay package: of the $15 million and change that he took home on paper, he collected just US$648,600 in salary and US$662,400 in non-equity incentive plan pay. The rest – a whopping $13,845,041 – came in the form of the 425,000 options he was granted at strike prices (the price at which he has the right, or the option, to purchase it) ranging between $93.15 and $104.10 with expiry dates of between December 2, 2011, and June 28, 2015. As the company stands today, all of those options – all of them – are worthless. Some have already expired. And unless something changes dramatically, so will the rest of them.

That’s Edward Sampson’s dilemma.

But there are a lot of lesser Edward Sampsons out there in Alberta, sitting on worthless options of their own. Marc Lattoni, a principal with Calgary’s Total Rewards Professionals, recently produced an analysis on the subject for a medium-sized energy services company. “We went through and looked at the value of all the long-term incentives that have been granted over the last three years for 10 companies,” he says. “Most of them are in the hundreds of dollars.” That’s obviously a problem for those employees, who had counted on – and perhaps made spending decisions based on – them being worth much more than that. But it’s a problem for the companies that employ them too, Lattoni says. “The problem is twofold. One, it disengages people – they think, ‘Gee, I’ve been sweating my guts off for years here, and this is all I get?’ And two, it makes it relatively easy for companies to poach talent, because the people have nothing left on the table – they’ll just walk away.”

Part of the problem is that the model most companies use to determine the correct price and value of stock options, one called the Black-Scholes model of option pricing, isn’t built to account for the kind of turmoil that most major markets have experienced over the last decade. “It’s gone askew,” Lattoni says. “Stocks have become more volatile, and they’ve become more volatile downward, not upward, when you measure them over the last three years. The valuation methodology that companies are using is unreliable now.” The result, he says, is confusion on both sides of the conference table. “If they’re giving out options, they don’t know what they’re giving – are they worth way too much money or nothing? And the people who are getting them don’t understand how they’re working either.”

That’s why companies are increasingly using Restricted Share Units (RSUs) and Performance Share Units (PSUs) in place of traditional stock options to compensate senior executives. Unlike options, employees who are granted RSUs and PSUs aren’t at risk of ending up with nothing if those shares tank. Yes, they’ll be worth less, depending on how far they fall, but they’ll never be worth zero. “They’re not as highly leveraged,” Lattoni says. “In a normal world, options are potentially worth a lot more money because they’re way more leveraged. But in uncertain times like this, it’s better to use RSUs and PSUs because they have more certainty of value.”

But there are those who think companies should get rid of options altogether – to “cut the Gordian knot,” as professor Yvan Allaire said in a 2012 paper for the Institute for Governance of Public and Private Organizations, “of a compensation system largely based on stock options, a system that prevails only since the 1990s and has wreaked havoc on many companies.” Why havoc? As professor Allaire writes, it has distorted the incentives of senior managers, turning them away from the task of building their business for the long haul and towards the short-term goals that the stock market prefers to fixate on. Stock-based compensation schemes, Allaire writes, “incite management to take undue risks as they share in the upsides but not in the downsides. They tend to reward ‘luck’ as much as performance; a booming stock market lifts all boats.”

And while forms of shareholder activism like the growing “say-on-pay” movement might seem like a step in the right direction, Allaire thinks they’re actually exacerbating the problem by reinforcing the linkage between compensation and short-term performance. “The quest for a direct and quantitative link between compensation and performance has already spawned complex forms of compensation and esoteric performance measures,” he writes. “The threat of a negative vote by shareholders if this linkage is not sufficiently persuasive may well shift the ways boards set compensation. Boards and management may well focus on short and medium terms financial ratios while neglecting longer term challenges and less tangible aspects of running a company, which are critical to its success and survival.”

The Canadian Securities Administrators, the association of provincial and territorial securities regulators, took a step towards addressing that when it decided in July 2011 to require public companies to disclose whether their board of directors “adequately considered the implications of the risks associated with the company’s compensation policies.” But as Lattoni points out, having incentives that aren’t perfectly aligned is probably still better than having none at all. “I think the
concern is engaging executives. You don’t want people coming in with long faces every day, saying, ‘I did all this, and what do I have to show for it?’”

Trigger Happy

Last year, when Glencore International bought the Alberta-based grain handling business Viterra for more than $6 billion, Viterra CEO Mayo Schmidt came out of the deal with a tidy severance package: $37.5 million. Much of that was a product of the stock options that Schmidt held (and the considerable premium they received as a result of the takeout bid price), but some (upwards of $6 million, by various estimates) was the result of the company’s generous change of control policy, which dictates what happens in the event that the company is purchased.

There was nothing untoward or illegal about the payout that Schmidt received, but Gary Clarke, a partner in Calgary with Stikeman Elliot LLP, says those sorts of generous severance packages (and the backlash they can provoke) are leading many companies, public and private, to tighten up their change of control provisions. One of the most popular changes is the introduction of a so-called “double-trigger” – a provision that requires both a change of control in the ownership of the company and a termination of the employee in question. “Single triggers have become kind of off-limits in a way,” Clarke says. It’s not hard to see why, either. “What used to happen is that they’d cash out and the acquirer sometimes would want to keep them on, so they’d get a huge payout and they’d still have a great job.”

Show Them the Money

One of the more interesting parts of the Dodd-Frank law (passed by U.S. President Barack Obama in 2010 to reform the financial regulatory environment in that country) was the provision that required companies to disclose their CEO-to-worker pay ratio. Even more interesting is the fact that, as of earlier this year, most of them still hadn’t done it. And no wonder: As Bloomberg News reported in early May, the average American CEO earns 204 times as much as their average rank-and-file employee, a figure that’s increased 20 per cent since 2009.

Things are scarcely any better in Canada. While there’s no law on the books – yet – requiring that kind of disclosure, according to Yvan Allaire’s paper, the ratio of median CEO compensation to average pay in the private sector has increased from 60 in 1998 to over 140 in 2010. The increase hasn’t been nearly as significant for other people in the C-Suites, though, as the two next highest paid executives saw their ratio
go up from 31.5 to 57.

Private Company, Public Plan

There may be problems associated with using equity options to incent managers and leaders at publicly-traded companies, but they’re problems that many private companies wish they had to deal with. “Private companies have difficulties trying to come up with good compensation plans because, in part, they don’t have that aspect,” says Clarke, with Stikeman Elliot. “Because of that, in the private sector you often see much greater base compensation and less equity compensation.”

That doesn’t mean they’re not trying, though. Many private companies are developing so-called “phantom plans” that approximate a publicly-traded stock, while others use internal performance metrics to determine how much senior managers deserve. “We have clients in the land-development business that use a kind of economic value-added. Over three years, has the net benefit to the shareholder been positive or negative? There are ways of doing that using economic value models,” Clarke says. Still, because of the difficulty associated with setting up such an arrangement, many private companies prefer to stick to salary as the primary form of compensation.

What matters most, according to Lattoni, is transparency. “[Saying] ‘we know best’ doesn’t work,” he says. “As opposed to saying, ‘We’ll look after you,’ now the guys know that they can look at EBIDTA.” In a way, he says, it’s a better way to compensate people than the option-based arrangements that still tend to prevail at publicly-traded companies. “I think they want to reward people for actually doing stuff, and they have to look a little higher up the profit and loss statement to be able to measure that. Measuring it at the net profit or share price level isn’t the most appropriate way to recognize people for annual performance.”