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Arriving at the right equity split.

A walk through the four steps of the compensation committee's most important decision: to determine the appropriate equity allocation for their company.

Based on our 20 years of working directly with compensation committees, we have reached the conclusion that most of them spend their time on the wrong subjects. Guided by executive compensation consultants who are peddling the latest mousetrap, committees devote precious hours to reviewing and approving gimmick stock incentive programs that allegedly link executive pay to company performance, while minimizing expense and dilution. In reality, most of these programs dramatically increase compensation levels without growing shareholder value beyond standard levels.

The mistake these compensation committees make is to focus exclusively on the "how much" and "how" of executive compensation. Too many executive compensation studies consist of two steps: first, comparing pay levels to competitive practice ("how much"); and second, designing the new program ("how"). While these are useful second and third steps, they sidestep what we believe is the committee's most important decision - the appropriate allocation of equity between management and the shareholders, and, subsequently, the split between the CEO and other employees.

The competitive pay trap

Many compensation committees back into an equity allocation strategy because they overrely on compensation surveys that tell them how many options they must grant the CEO and other senior executives if they want to stay "competitive." While these surveys can be useful tools, they are usually too homogenized to provide reliable guidance. For example, the leading long-term incentive surveys express competitive option grants as multiples of base salary, based on Black-Scholes option values and general industry data bases dominated by the Fortune 500.

There are a number of reasons why we believe the popular surveys' salary multiples overstate competitive long-term incentives - such as the inclusion of mega-grants, the use of the Black-Scholes methodology, and the increasing popularity of stock-for-cash exchanges. However, the greatest weakness of the salary multiples is that they force the compensation committee into a "one-size-fits-all" approach to executive compensation. This approach ignores the performance expectations of shareholders, the relative contributions of the executive team and investors to value creation, and the company's location on the organizational life cycle, all of which should influence the committee's equity allocation decisions.

Rather than using this traditional, pay-centered approach, we would encourage compensation committees to use a radically different, performance-centered approach. (Interestingly, this is what many venture capital and investment firms do.) Committees should start by identifying the performance level shareholders expect - 10% average annual total return, 15%, 20%, and so forth. How much wealth should the CEO, the management team, and other employees receive in exchange for achieving the targeted performance level? What does this translate into in terms of equity allocation? Each company has its own unique answers to these questions - they can't look them up in the survey books.

The equity allocation model

There are four steps compensation committees must take to responsibly determine the appropriate equity allocation for their company:

First, they must establish an equity allocation philosophy.

Second, they must translate this philosophy into a specific "deal" between shareholders and employees, which also allocates the equity between the CEO and other employees.

Third, they must develop programs that implement the equity allocation philosophy over a specified period of time, consistent with the achievement of expected performance levels.

Fourth, they must report to shareholders on the impact on performance of the equity allocation program.

Step 1: Conceiving the philosophy

Compensation committees can develop an equity allocation philosophy by addressing such questions as:

* How does our company create value? What are our principal drivers of value creation - capital assets or people assets? How do successful companies with similar value-driver profiles allocate equity between shareholders and employees?

* Where is our company on the organizational life cycle? Are we a start-up, IPO candidate, turnaround situation, potential high-growth candidate, or low-risk mature business? How do successful companies with similar life-cycle profiles allocate equity between shareholders and employees?

* What are the performance expectations of our shareholders? How risky are the expected returns?

The accompanying exhibit (see page 36) illustrates how the answers to these questions can influence a company's equity allocation philosophy. However, we urge compensation committees to use such a matrix as a guide, not established doctrine. The aim is to create your own equity allocation philosophy: It is the essence of your performance deal with both the shareholders and the management. You must not rely on compensation consultants to pull the magic allocation percentage out of the hat!

Step 2: Making the deal with shareholders

This step has two objectives: first, to arrive at the equity split between shareholders and employees (along with the period of time over which it will be accomplished); and second, to divide the employee slice between the CEO, other members of the senior management team, and non-executive employees. Competitive data can provide useful guidance, as long as it focuses on successful companies with similar value-driver and life-cycle profiles.

Some companies mistakenly overlook the role of performance in determining the equity split. Most shareholders would happily support a bigger percentage for employees, if they were assured of higher performance. Thus, we would encourage compensation committees to at least partially link employees' equity percentage to company performance.

In this step, compensation committees also allocate the total employee share among the CEO, other members of senior management, and non-executives. Again, the key question is: How does the organization create shareholder value? How much is created through vision, leadership, and external relationships (the CEO); strategic and operational planning (senior management); and tactical implementation (other employees)?

Step 3: Developing the programs

Once the committee has developed the equity allocation philosophy and determined the splits, it is time to enact new programs for implementing the strategy. We offer three pieces of advice:

First, we strongly favor programs that include performance components that require management to stretch, instead of the traditional approach of distributing equity by a strictly time-based formula.

Second, while we understand that accounting treatment matters, we urge compensation committees to focus on the motivational issues first and the accounting issues second. After all, if the new programs are truly performance-based, then the accounting issues will take care of themselves.

Third, we encourage compensation committees (and shareholders) not to get too hung up on simplistic dilution analyses, such as the proposed option authorization as a percentage of shares outstanding. These rudimentary analyses vastly overstate the dilution impact of the new programs, because they ignore the shares that could be repurchased with the cash generated from option exercise. Worse, though, they focus attention on the relative size of each equity slice instead of on the growth in the overall pie. Intelligent shareholders care about the return on their investment, not on the percentage of the company they still own. If the new programs are doing a good job of linking equity allocation to performance, then shareholders will earn superior returns.

Step 4: Reporting to shareholders

As part of its regular annual report to shareholders, the compensation committee should also discuss the company's equity allocation strategy and its implementation. By doing so, shareholders will understand that the new programs are designed to reward the CEO and other equity participants at the same time shareholders benefit - not before and not after.

Equity allocation decisions are the most important ones a compensation committee makes, because they focus directly on the pay and performance deal between shareholders and the CEO. Compensation surveys can help compensation committees make these decisions, but they cannot substitute for a well-thought-out and well-articulated philosophy and strategy of equity allocation. Today's effective committees undertake an organized process of developing an equity allocation strategy that is specifically tailored to the company's value-creation profile, its location in the organizational life cycle, and shareholders' performance expectations.
Equity Allocation Philosophy

 Principal Driver of Value Creation

Life Cycle Capital Assets People Assets

Start-Up Medium Very High
IPO Medium High
Turnaround High Very High
High Growth Low Medium
Mature Low Low

Each company should develop its own unique equity allocation
philosophy. As shown in the matrix, two key questions are: What are
the principal drivers of value creation, and where is the company on
the organizational life cycle? For example, capital-intensive
turnaround companies should allocate a high percentage of their
equity to employees - perhaps as much as 10%.

Jack L. Lederer is national compensation practice leader and Carl R. Weinberg is a principal with the Coopers & Lybrand Human Resource Advisory group. Based in Westport, Conn., they are partners of Coopers & Lybrand.
COPYRIGHT 1997 Directors and Boards
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1997 Gale, Cengage Learning. All rights reserved.

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Author:Lederer, Jack L.; Weinberg, Carl R.
Publication:Directors & Boards
Date:Mar 22, 1997
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