The Psychology of Equity Awards - A Compensation Consultant's View
(The following post originally appeared on ONSecurities, a top Minnesota legal blog founded by Martin Rosenbaum to address securities, governance and compensation issues facing public companies.)
February 23, 2012
This time of year, many public companies are drafting the Compensation Discussion and Analysis section of their proxy statement, including a description of how the company’s executive compensation program aligns the interests of executives with those of shareholders. But do the elements of compensation always have the desired effect? Not according to one compensation consultant.
Jim Sillery of Buck Consultants today gave an entertaining presentation to the Twin Cities Chapter of the National Association of Stock Plan Professionals entitled “Achieving Equity Effectiveness: A New Understanding.” Sillery gave several examples of studies showing that equity awards often do not provide the intended motivation for employees, including executives. Among his points:
- Stock options became popular in the 1990s, at a time when there was unprecedented appreciation in stock price. Stock options had great motivational value (after all, the stock always went up), with no “cost” from an accounting point of view. Now, following two recessions in the past 12 years, stock options are underwater in many cases and don’t have the same motivating effect. At the same time, after changes in accounting rules, increasing shareholder activism and the imposition of mandatory shareholder votes on executive pay, options involve significant downsides.
- Sillery discussed the concept of “equity effectiveness” – finding the point where the motivational value of compensation awards outweighs the costs, administrative effort and other negatives of a compensation program. In other words, balance the “right brain” factors that cause employees to perceive value with the “left brain” factors that cause headaches for the company – tax treatment, accounting treatment, compliance issues, etc.
- Sillery discussed the characteristics of stock options vs. time-vested restricted stock vs. performance shares. As he shows in his presentation (PDF) (slide 17), the different types of awards have differing advantages in terms of potential appreciation, stability, etc. A lot of the value in each awards is in how they are communicated to employees. He describes a “kitchen table” test – would the participant be able to describe to a spouse the basic features of the award and how it will benefit them?
- In an interesting sequence, he described generational and cultural differences that affect which type of award might provide the proper motivation. Baby boomers, Gen X’ers and Gen Y’ers have differing characteristics that may make different types of awards more attractive. Also, for global companies, employees from different countries have radically different perceptions that affect their perceptions of value, long-term vs. short-term view, etc.
- Sillery said he often recommends that companies consider increasing in the performance shares component of equity compensation to provide flexibility. For example, the company can vary the terms of awards in terms of leverage/risk, performance metrics, payout, etc., to adjust for cultural differences in different countries and regions or for different categories of employees, while keeping the basic structure of the awards constant.
Public companies will always struggle to find the right compensation mix to properly motivate executives while minimizing costs and headaches. Maybe the best approach is to get a degree in psychology.