Equity Compensation - The Good and Bad of Broccoli and Chocolate
Broccoli is good. It can be a useful side dish for any of the three major daily meals. It can even be a useful side dish for all three meals on any given day. But broccoli every meal, every day would be a bit much. In the end, it will result in some unfortunate consequences for you and those around you.
Chocolate is good. It can be a useful addition to any of the three major daily meals. It can even be a useful side dish for all three meals on any given day. But chocolate every meal, every day would be a bit much. My four-year-old son will tell you that chocolate every meal is great. My much older self will tell you that there are some unfortunate consequences.
Companies love equity compensation. We often use it without understanding its cost. We also use it without understanding its tangential impact. As it turns out, there has been a ton of research over the past 20 years, much of it invisible to most compensation professionals. The types of equity, terms and conditions of awards, and communications supporting these programs all have greater weight than most people realize.
CFO.com published an article comparing restricted stock awards and stock options and their impact on income smoothing. The article was based on an academic research paper “Managerial Equity Holdings and Income-Smoothing Behavior,” by Sydney Qing Shu of San Diego State University and Wayne B. Thomas of the University of Oklahoma. They looked into executive stock and stock options on decisions affecting company earnings.
Restricted stock is mainly used as a retention tool. It is low risk with limited reward. Stock options are mainly used as an incentive tool. Options are high risk with the potential for extraordinary rewards. The research shows that the characteristics of these two vehicles seep into decision making that drives company earnings in profound ways.
Shareholders generally appreciate predictability when it comes to projecting future company performance. The research shows “the results are consistent with stock holdings aligning the interests of managers and shareholders, and managers using discretionary accruals to smooth past earnings to reveal information to investors about future performance.” In other words, restricted stock makes it easier for investors to know what they are investing in.
On the other hand, stock options were linked with excessive risk-taking and the use of awards “to mask the volatility of less predictable future earnings.” In other words, stock options may turn investors into gamblers. This is where too much of a good thing can be a bad thing.
When a company leans too heavily on either equity tool they miss out on the potential for better success. All restricted stock may result in a boring company that cannot keep up with its peers. All stock options may result in a company where the risks simply do not justify the rewards or the attention of future investors. Whether its broccoli or chocolate, the key to success is in balance.
Dan Walter is a CECP and CEP and works as Managing Consultant for FutureSense. He is passionately committed to aligning pay with company strategy and culture. Dan is also a leading expert on equity compensation issues and has written several industry resources including the one-of-a-kind Performance-Based Equity Compensation. He has co-authored ”Everything You Do In Compensation is Communication”, , “Equity Alternatives” and other books. Connect with Dan on LinkedIn. Or, follow him on Twitter at @DanFutureSense.
Posted by DanFutureSense on 04/23/2019 at 12:13 PM in Executive Compensation, Stock/Equity Compensation | Permalink | Comments (0)