Ed. Note: This week, we feature excerpts from our
recent publication 2018 U.S. Equity Compensation
Plans Overview and Trends. To access the full
- The repeal of section 162(m) is having a dramatic impact on the number of equity plan proposals. The number of Russell 3000 equity plan proposals submitted this year declined by approximately 40 percent. Also, some companies removed the exceptions under section 162(m) for qualified performance-based compensation, individual grant limits, and references to performance cash awards in their plan documents in response to the new tax law.
- Shareholder-friendly plan features are gaining traction year over year.
- Equity compensation plans that stipulate a one-year minimum vesting requirement have increased from 35 percent in 2017 to 44 percent as of October 2018.
- The percentage of companies that prohibit liberal share recycling
in their equity plans continues to increase.
- Sixty-one percent of companies prohibit the payment of dividends on unvested equity, compared to 57 percent of companies last year.
- An increasing number of companies prohibit the use of repricing and cash buyouts.
- Specific aspects of equity plan proposals lead to higher levels of shareholder opposition. High dilution, high burn rate, repricing provisions, and evergreen provisions are associated with higher levels of shareholder opposition to equity compensation plan proposals.
- Pharmaceuticals and technology companies grant the most equity. Available data indicate that the median three-year average burn rate in these industries is more than double most other industries.
- Equity grants in the real estate and utilities industries are concentrated at the executive level, but their median dilution level is low.
Dilution generally refers to the reduction in the equity ownership of a shareholder due to the issuance of new shares by the company. Investors understand that dilution is a normal part of the investment process, which may impact them differently depending on the maturity of the company. For investors in high-growth companies, dilution could mean a potential increase in the value of their investment over time despite a decrease in their equity ownership. However, for a business in a challenging market environment, increases in share issuances could raise concerns, as investors experience a low or no return on their investments, in addition to reductions in equity stake.
Burn rate is one of the most common ways of measuring a company’s dilution. Burn rate refers to the rate at which a company grants equity to employees, and it is measured as the ratio of the company’s grants of stock to the company’s weighted average common shares outstanding during a given period.
Investors frequently support grants of equity to plan participants if they do not result in excessive dilution. Because burn rate provides insight into how quickly companies utilize their equity plan shares, it is a factor used by many investors when evaluating equity plan proposals.
The way companies use equity varies according to
industry. Some industries, such as technology and
pharmaceuticals, are known for their large equity
grants. Historically, many biotech and technology
companies have compensated employees with stock
options and restricted stock, especially during
their early stages when they have limited cash
flows. Thus, it is often more common for companies
in these industries to use stock-based compensation
for a broad employee base.
Consistent with past experience, industries related to pharmaceuticals and technology have the highest levels of equity dilution in terms of burn rate. Interestingly, the retail sector exhibits one of the highest burn rate figures. Companies that experience high volatility or falling stock prices may end up granting more shares in order to meet the set equity grant value for compensation. Suppose a company has set its target equity compensation value for an employee to $1 million per year. In prior years, the company’s average stock price was at $10/share and as a result the company granted 100,000 shares. The following year, their stock price declined and was only at $5/share. Consequently, the total granted shares increased and became 200,000 shares.
In addition to burn rate, which is a backward-looking measure of actual dilution, many investors also evaluate potential reductions in existing shareholders’ positions through the measure of potential future dilution. This potential dilution (a forward-looking indicator) can be measured as the total number of shares allocated to all company equity compensation plans divided by the total number of common shares outstanding plus all shares under the plans. Full dilution (as this calculation is called) calculates the amount of maximum dilution as represented by the number of shares reserved over the life of the plan.
Similar to the burn rate results, available information on median dilution levels by industry group show that pharmaceuticals and biotechnology as well as software and services exhibit the highest rates of dilution, while utilities, real estate, and banks are the three industry groups with the lowest levels of dilution.
In accordance with the widespread investor interest in potential dilution, ISS will use a basic dilution measure (shares under all equity plans divided by common shares outstanding) as part of its updated 2019 Equity Compensation Scorecard policy.
Minimum Vesting Requirements
Vesting requirements refer to the minimum amount of time that must pass before an employee can earn the right to the actual payment of any portion of an award. This specific provision supplements the retention goals inherent in providing equity awards and ensures that plan participants’ interests are aligned with those of shareholders during the specified period before vesting. However, some companies choose not to have vesting requirements in their compensation plans to preserve flexibility in award agreements. For instance, it will be harder for a company to bring in a new executive if the employment agreement stipulates a one-year minimum vesting requirement for inducement or “make-whole” grants.
In the last two years, we saw an increase in the number of Russell 3000 companies that adopted minimum vesting provisions in their compensation plans. Of all the equity plans submitted from January to October 2018, at least 44 percent stipulate a minimum vesting for all award types, compared to 35 percent of equity compensation plans on ballot in 2017.
Change-in-Control Vesting Conditions
Some investors view the automatic acceleration of equity awards
upon a change in control without an accompanying termination of employment to be problematic. With lucrative payments in mind, some investors raise the concern that an automatic acceleration of equity could potentially encourage executives to negotiate corporate transactions that may serve their personal interests but not those of shareholders. Furthermore, the acceleration of performance-based equity awards may be viewed as more problematic, because it waives both the time and performance conditions tied to the equity and severs the link between pay and performance.
A growing number companies are shifting away from problematic change-in-control equity vesting in light of increased scrutiny from shareholders. Several companies have come up with alternative approaches that maintain the retentive value of awards and achieve pay-for-performance objectives. Some of these alternative change-in-control vesting conditions include, but are not limited to:
Time-based Equity Vesting
- The assumption or conversion to equivalent awards of the acquirer's equity with vesting terms maintained;
- Conversion to cash-based awards with vesting terms maintained;
- Acceleration of vesting only if the awards are not assumed; and
- Acceleration of vesting only upon termination of employment following the change in control.
Performance-based Equity Vesting
- Performance equity will be forfeited or cancelled upon change in control;
- Lapse of performance criteria but with time-based vesting schedule maintained; and
- Vesting of performance-based equity based on actual achievement and pro-rata payment.
Although single-trigger equity vesting became less common, we continue to see resistance from companies to implement more restrictive vesting conditions. Available data suggests that, while we see an increase on the number of equity plan proposals that restrict the automatic acceleration of time-based awards, the majority of companies still choose to let the board decide on the treatment of equity. The same is true for performance-based equity vesting, as only one in six companies provide for the acceleration based on actual achievement with a pro-rata payment.
The ISS U.S. Policy Updates for 2019 include an adjustment to the Equity Plan Scorecard model to evaluate the quality of disclosure of change-in-control vesting provisions, rather than solely assessing the actual vesting treatment of awards. The updated model awards positive points to equity compensation plans that provide specific disclosure regarding the vesting treatment of performance- and time-based awards upon a change in control.
Changes in section 162(m) reduce the number of proposals submitted in 2018
Since the SEC approved the rules requiring shareholder approval of equity compensation plans in 2003, hundreds of equity plan proposals were submitted for shareholder approval each year. In 2017, we saw one of the largest number of proposals, with 793 equity compensation plan proposals submitted to shareholder vote from January to October.
Prior to the Tax Cuts and Jobs Act of 2017, section 162(m) of the Internal Revenue Code excluded commission-based and qualified performance-based compensation from the $1 million tax deductibility limit for compensation paid to each covered executive. With the repeal of the performance-based compensation exemption under section 162(m), we observe a significant decline in the number of equity plan proposals on ballot, as companies are no longer required to submit plans for approval to qualify for the exemption. In addition, some companies eliminated certain provisions in their equity compensation plans in response to the new tax law.
To date in 2018, only two percent of the equity compensation plan proposals have been submitted for 162(m) re-approval, compared to 13 percent of equity plan proposals in 2017. Despite the repeal, there were still a few companies that amended their plans to secure transition tax relief for grandfathered grants. At least 7 percent of proposals sought to remove certain plan provisions relating to section 162(m). Those provisions include but are not limited to: (i) exception under Section 162(m) for qualified performance-based compensation, (ii) individual grant limits that were intended to comply with the previous exemptions, and (iii) references to performance cash awards.
In light of the release of the initial guidelines by the IRS (Notice 2018-68) providing for tighter deduction rules and ultimately less tax benefits to issuers, we expect the number of proposals to continue to remain relatively low in the years to come, and we expect to see more companies removing specific 162(m) provisions from their equity compensation plan documents.
Potential drivers of significant opposition to equity compensation plans
Most equity compensation plans tend to receive high levels of support. In 2018 year-to-date, the median level of support for equity plans stands at 92.9 percent of votes cast "for" and "against." Below, we explore some factors that may drive higher level of oppositions to stock plan proposals.
In line with investors' keen interest in the dilutive impact of equity compensation plans, we discern a negative correlation between the level of potential dilution and the level of support that plans receive on the ballot. Plans with higher levels of dilution appear more likely to receive significant levels of opposition, as exhibited in the graph below.
An analysis of vote results by burn rate levels yields similar results to the analysis about dilution. Companies that have been granting stock in greater numbers during the past three years tend to receive lower support on their stock plans.
--Leah Dela Cruz, ISS Corporate Solutions