Considerations for long-term incentive compensation plans

Many boards of directors with calendar fiscal years are currently preparing their 2024 long-term incentive (LTI) compensation plans. The challenges of increased interest rates, volatile capital markets and uncertain macroeconomic forecasts have prompted companies to review the success of their compensation plans to ensure they are aligned with the business’s strategy. Boards would be well-served to take a renewed look at their company’s long-term incentives to monitor how share dilution, accounting values and executive retention have been impacted by the aforementioned changes in the broader business environment.

The following frameworks provide an appropriate baseline to follow for determining upcoming awards:

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Cap table and economic dilution

Boards at both public and private companies have long set equity-based LTI awards by computing their accounting value, through grant date fair value (GDFV), relative to peer groups or other established data sources. While the focus on GDFV remains an appropriate approach, particularly for mature firms in stable sectors, it can ignore the impact of the number of shares being granted relative to a company’s cap table. Sectors that have experienced recent share price volatility, such as life sciences, may find that the same GDFV of awards from prior years now represent significantly more shares in company stock.

As an example, let’s assume that two years ago an executive received an award of 5,000 restricted stock units (RSUs) at a $20 share price, equivalent to a GDFV of $100,000. If the share price is $5 today, the company would need to award four times as many shares (20,000) to deliver the same GDFV as the prior award. This GDFV focused approach can ignore the dilutive impact to shareholders and quickly drain a company’s equity plan.

Many boards find that considering the GDFV and cap table impact allows them to have a more robust understanding of their LTI plan and its impact on shareholders. The same sets of analyses also remain appropriate at closely held private companies, where LTI may be delivered in cash instead of equity, with award values being expressed as a percentage of revenue and/or earnings instead of shares in the company.

Accounting value of other equity awards

The accounting methodology for RSU awards, as shown in the example above, is relatively straightforward: the number of shares awarded is multiplied by the stock price on the date of grant. Stock options and performance-based equity, however, require more complicated accounting that is sensitive to changes in the broader economic environment. It is important to understand how changes in the calculation inputs may impact award values, particularly because of the complexity of accurately valuing equity types.

The valuation of stock options, which is often calculated using a Black-Scholes model, considers six variables: volatility, dividend yield, company share price at the time of grant, strike price of the option (usually the same as the grant price), estimated time of the option expiration, and the risk-free interest rate.

Stock option award values have been particularly impacted by higher interest rates over the last few years. Holding the other five variables constant, an increase in risk free interest rates from 2% (a rough approximation for values used by companies in calculating 2022 grants) to 5% could increase the accounting value of awards by 5% to 15%. Volatility, another variable within the Black-Scholes calculation, can also significantly increase accounting values for companies that have had greater share price fluctuation.

Performance-based equity with “market conditions,” such as relative total shareholder return (TSR), is typically accounted for using a Monte-Carlo simulation, a separate methodology from Black-Scholes. The accounting for relative TSR awards is similarly impacted by increased interest rates and volatility, where a theoretical company awarding a relative TSR award with the same number of shares and share price as prior years may find that their accounting cost will increase by 5% to 20%.

Directors should not be concerned with the minutiae of accounting value calculations, but rather be aware of the impact internal and external variables will have on the cost of their equity awards in financial statements, proxy tables, and evaluations by third parties (such as proxy advisors or business publications).

Retentive hold of outstanding awards

Lastly, boards should use the 2024 award cycle to review the retentive hold of their executives’ vested and unvested LTI levels. Companies in industries that have depressed equity values, such as biotechnology and regional banks, may find that historical stock option awards and performance-based equity cycles are now underwater, leading existing pay plans to have minimal retentive value. Boards can conduct executive ownership analyses expressed as a percentage of common shares outstanding and total intrinsic value in order to help identify risk areas where individual ownership is minimal, or where multiple rounds of previous LTI awards may now have little economic value.

Boards in strong performing industries, such as software and semiconductors, may find their problem reversed if peer companies have increased their compensation levels and have now created a gap in the market. Increased annual equity awards (or even one-time/off-cycle grants) can address below-market pay and help position key roles with higher compensation to fend off competitive offers.