Paul Gryglewicz is senior partner and Peter Landers is partner at compensation consulting firm Global Governance Advisors
With the global pandemic a few months in, we are starting to clearly see the impact that COVID-19 is having on certain industries. Technology and precious metals companies have witnessed a large increase in share price from the prepandemic period. In contrast, airlines, energy and retail companies have experienced monumental decreases in market value.
These changes present different, but equally challenging, issues for the boards responsible for determining executive compensation at these companies. What we know from past market crises is that their decisions today will be critical in ensuring that shareholder value is preserved both now and also over the long run.
Equity-based compensation at publicly traded companies typically makes up 60 per cent to 80 per cent of a chief executive officer’s annual compensation award. This can be seen in our recent top-100 CEO compensation research conducted with The Globe and Mail. When a board approves an annual grant of equity units to an executive, nothing is earned at that point. The executive must work to earn value through the vesting period, which is usually 36 or 48 months. In many cases, a portion of the award must also be earned by achieving a set of predefined performance criteria.
Since the equity award is valued on the company’s underlying share price, a lower share price at the time of grant results in granting more units. If those equity awards later settle by granting actual company shares, these grants are dilutive to existing shareholders. This makes it important for boards to get grants right, and for shareholders to watch carefully.
Our recent CEO compensation research shows that 2019 was generally a good year for company performance and that executive compensation trended higher than 2018. However, 2020 has shown very mixed results because of the pandemic. Therefore, boards were faced this spring with the challenge of setting compensation to retain executives who are navigating an uncertain economy to drive or salvage as much shareholder value as possible.
The issue is complicated by some organizations being forced to lay off or place employees on temporary leave because of various government shutdown measures. This difficult decision puts a large emphasis on finding the right balance at a time when the capital markets expect organizations to have a robust approach to environmental, social and governance issues.
It is relatively safe to say that at this time next year, we will likely see inconsistency in executive bonuses, with the potential that 2020 bonuses will be substantially lower than 2019 bonuses in many industries. Boards must be prepared to potentially incorporate more discretion when determining cash bonuses for 2020. This also means that if a board approves lucrative bonuses for an executive team because they had to work harder in this economy than ever before, large institutional shareholder groups may not be as sympathetic if the bonuses are outside the company’s normal formula.
Boards will need to ensure there is a well-governed approach to applying discretion, and that it is clearly explained in public filings. In the interim, boards should evaluate whether performance expectations set before the pandemic outbreak are still reasonable. If not, they should discuss whether to revise targets to ensure executives are still motivated to achieve important objectives over the remainder of the year.
Finally, as boards weigh strategies for attracting and retaining executive talent, they must consider stress-testing their equity plans to examine the impact on shareholder dilution from awards made in the first half of 2020. For companies with a large share price increase, it is important to understand the value of executives’ long-term incentive plan awards, and the potential windfall gain that could be realized immediately.
For those companies that have seen large share price decreases, boards must consider whether previous LTIP grants made at significantly higher share prices have any value, and what the prospects are for the value to increase over the next few months and years.
For companies that only grant stock options, is there a chance for options with no current value to get back in-the-money? If the probability is low, then executives are a flight risk as competitors will be able to offer them new LTIP grants at significantly lower exercise prices. This may necessitate discussion of the need for new grants at a lower share price to act as a retention device, but should not result in the repricing of existing option grants, unless the board is prepared to seek shareholder approval, as that is a governance no-no. Ultimately, boards must balance new grants with the potential equity dilution they cause to existing compensation plans.
As 2020 unfolds, boards must be critical of the quality of executive talent running the organization. There should be no tolerance for underperformance. Boards should be prepared to adjust leadership as necessary. Where executives are demonstrating exceptional leadership, they must be retained through appropriately designed performance-based compensation arrangements that will reward them only if shareholder value is created over the next few years.
The decisions boards make in the current environment will ultimately shape the long-term success of their companies. Will boards blindly make LTIP grants that overly dilute their equity pools and cause tensions with institutional shareholders? Or will they successfully manage the equity pool to attract and retain talent while remaining onside with shareholder concerns? If a board can successfully navigate this pivotal time in a company’s life cycle, it should set them up to weather any further challenges that may come ahead.