The Real Problem With Long Term Incentives

Originally posted December 2009

What is missing in the December 7, 2008 opinion piece in Financial Week authored by Gregg D. Polsky, professor of law at the Florida State University College of Law is an understanding of time.  Stock options for most organizations’ executives fully vest over 3, 4, or 5 years. In fact almost all of the long-term incentives are stock option based and vest ratably over these periods. So a stock option that vests ratably over 3 years is therefore 1/3 vested after 1 year, and 2/3’s vested after 2 years, and so on.

Some might think that 3 or 4 or 5 years is a long time, but it is my belief is that the strategic plans for large organizations are executed over a much longer time frame, perhaps seven to ten years.  So how can stock options really be effective as “performance based pay” when the goals (i.e: performance period) of the company is measured over seven to ten year but the payment happens much sooner?  Performance based pay is effective only when it’s correctly matched to the performance period and sends the right message.

Here’s the point: Stock option programs were never intended as long-term incentives. First, they vest over a fairly short period of time, and, second, they reward for volatility and not sustained performance that would be consistent with a strategic plan.  The only thing they have going for them is that the tax code made them nearly “free”.  And we all love free.

For those of you that may be skeptical, just consider the number of organizations that are caught up in the backdating scandal. By some counts well over 2,000 of the 10,000 publicly listed organizations are under review for backdating. Executives in these companies not only loved the volatility but also found a way to optimize the gain by awarding the options at the lowest price or near lowest price for a particular year.

Let’s see how it might sounds as a board member gives stock options to an executive:

Board Member: “Mr. Exec, I’m going to give you “something” that is worth more to you if the“something” has a great deal of volatility. I’d like you to run the company for the long-term, let’s call that 2 years, and don’t worry, I’m not subscribing any actual performance objectives to this “something” from our strategic plan because that would be too difficult and confusing. So, now as they said in Star Trek ‘go forth and prosper’!”

Executive: “I understand!  You are telling me that for the next two years no amount of volatility is too much!”

I just don’t understand why everyone else can’t understand why any company’s performance is so volatile.

A Possible Solution

Performance Based-Wealth Accumulation and Retention Plan (PB-WARP). The PB-WARP is a hybrid option/full value grant (restricted stock)/Supplemental retirement plan which has performance goals. Performance goals are set based upon either the strategic plan or a market index such as the S&P and are measured over at least 5 years and more often 7 to 10 years. Each performance period is a cycle and the cycles are overlapping. Vesting is partial at the end of the cycle i.e. 5 years (50%) and partial (50%) at retirement. The awards are denominated in company stock.

The messages this sends are:

1. Give us a strategic plan that the Board and the executives can believe in.
2. Tie the rewards to the goals of the strategic plan.
3. Make the executives hold a significant portion of those stock gains until they retire.

My bet is that the volatility would decrease and the long term investments would increase. Other side effects might be that the executives’ long-term strategic plans would become more realistic, or that the executives that didn’t accomplish those plans would leave voluntarily since their “effort” was not rewarded competitively in their minds. Oh, and by the way there would be a real link to the real long term performance of the organization and the executives’ wealth accumulation.