The Equity Market Roller Coaster

We wrote a recent article in these pages about a definitive playbook on how to address current short-term incentive cycles. However, with long-term incentives or equity plans, we cannot be as definitive as there are many more moving parts such as their multi-year nature, the long-term performance goals, the vagaries of the stock market and the dramatic volatility of many companies’ stock prices. Companies understand this as well, with only 18% of companies considering changes to long-term incentives compared to 41% of companies considering the same for short term incentives, according to a recent Korn Ferry survey. But, despite this, there are lessons CEOs can bring to their Compensation Committees to help navigate these unprecedented times.

Clearly, outstanding performance-based long-term incentive cycles require the same examination as short-term incentive plans in terms of the likely impact of the financial downturn on the achievement of performance objectives. There is a range of possible outcomes for which CEOs should prepare Committees: from doing nothing (especially applicable if new performance cycles start each year when new grants are made), to modifying target goals for outstanding performance cycles, to changing the objectives or time period against which performance will be measured and awards calculated (which could include shifting from an absolute measure of performance to one measured relative to peers). Before acting, CEOs should keep in mind that these plans are long-term in nature. Company performance could bounce back significantly post-COVID-19 and during the remainder of the performance cycle.

We believe, in general, that any existing performance cycles should proceed as is, with the Compensation Committee retaining discretion to determine awards at the end of the performance period. However, if performance metrics are no longer aligned with the current business priorities, consider truncating the current outstanding cycles and create new “stub plans” for the remaining years of each outstanding grant.

The final consideration is any stock-based long-term incentives that have not yet been granted in 2020 or will be granted in early 2021. Things get a little (or a lot) trickier here. Some companies need to make decisions now with respect to sizing these new grants, and it is more complicated now with stock prices all over the map. Even with companies whose stock price has recovered, there is no guarantee that it will hold based upon factors such as the current unemployment rate, continued uncertainty surrounding COVID-19, heightened civil engagement, and the upcoming presidential election.

There is an array of complex issues to consider when determining your approach to making equity grants—too many to cover in detail in this article (e.g., burn rates, type of equity program(s), extent of stock price decline and/or recovery, overall magnitude of “normal” equity grants, portion of total compensation normally delivered through equity grants, etc.). But it is important to remember that the main driver of increases in executive pay during the long 11-year bull market was equity-based long-term incentives. These programs (e.g., stock options, restricted stock, performance shares, etc.) often make up the greatest portion of CEO and senior executive pay and, in turn, attract the greatest scrutiny. When put in context with the recent salary reductions implemented at many organizations, a 50% reduction in a CEO’s base pay will look like nothing if the company significantly increases the number of shares granted in the equity program to adjust for the drop in share value. This could potentially increase award values by millions of dollars. Conversely, pegging the grant size to recent recovered but precarious market values also runs the risk of not granting enough equity.

To thread the needle, we suggest instead granting the same number of shares as the prior year or using a stock price equal to an average of the price at the start of the calendar year and the price at the grant date to calculate the number of shares to grant (or some similar period to determine a “fair” grant price that removes the “noise”). Regardless of specific direction, we suggest companies adopt a carefully measured if not conservative approach in adjusting the size of equity grants due to the stock price dip, recovery and continued uncertainty.

There is no question that equity/long-term incentives are the primary program for shareholder alignment, retention and wealth creation for CEOs and other senior executives. But CEOs need to provide strong guidance to their Compensation Committees in order to not over or under shoot a reasonable compensation level.

The world of executive pay, and equity incentives along with it, was open for a new direction, and the current crises have only accelerated this change. More than ever, the design and quantum of executive pay will send messages about a company’s role in broader economic and social recovery. As we have said before, this gives CEOs and their companies the ability to convey the right signals to a world that is hungry for signs of leadership—employees, shareholders and individuals alike.