HIGHLIGHTS
FROM THE 2005 DELOITTE STOCK COMPENSATION SURVEY
A survey
conducted by Deloitte & Touche LLP addresses future equity
compensation practices and implementation issues as it relates
to the adoption of the Financial Accounting Standards Board's
(FASB) newly revised accounting standard for stock-based compensation,
FAS 123(R)*. The 2005 Deloitte Stock Compensation queried 343
companies (69% public, 31% private) which represented most major
industries. Surveys were conducted during the second quarter of
2005.
Five years
after the economic boom ran out of steam, giving way to a stock-market
rout and a wave of corporate scandals, the world of business accounting
is still feeling the shock waves. New rules designed to protect
investors are transforming the ways in which companies state their
income and expenses, reward executives and balance the interests
of employees and shareholders.
Some of the
most dramatic changes are brewing in the area of equity compensation.
Barring a last-minute reprieve, all companies will soon have to
expense stock-option grants (including Employee Stock Purchase
Plans (ESPPs)) to employees at grant-date fair value. Some already
do so. Others, especially in the technology sector, have waited
until the last minute in hopes that FAS 123(R) will be delayed
or at least modified. But the move toward some form of fair-value
expensing has momentum on its side with some estimates putting
the number of publicly-traded companies that have already started
expensing at close to 1,000. As it currently stands, calendar
year-end companies, both public and private, will have to adopt
by January 1, 2006.
Shareholders
have also been given new powers to vote on option plans before
they're put into effect or modified. This, combined with the expensing
rule, is forcing companies to cut back on options and employee
stock purchase plans (ESPPs). With a spotlight on options, employers
are looking for new ways to attract, retain and motivate employees.
Deloitte's
2005 Stock Compensation Survey documents these trends and shows
how firms are grappling with a new question: If stock options
are increasingly out of favor, what should replace them? Employers
still place a high priority on competitive rewards and employee
motivation - needs that stock options were designed to address.
They are weighing a number of alternatives to fill the compensation
gap, such as time-vested restricted stock, performance-vested
shares and share-settled stock appreciation rights (SARs). At
the same time, they are trying to satisfy newly empowered shareholders
with tighter limits on share usage and equity overhang. One thing
is clear: The compensation game is more complex than ever, with
more rules to follow and more stakeholders to please. And its
future shape is still up in the air.
Key findings
of the stock compensation survey
Special Note: This report reflects responses across all industry
groups except where noted otherwise. "TMT" refers to
companies in the Technology, Media and Telecommunication industries
as well as the Life Sciences industry. Where significant differences
exist in the survey results between TMT companies versus companies
in the general population, these differences are called out and
reported in the text of the report.
Employers
Cutting Back
- While
the vast majority of respondents (more than 80%) will only adopt
fair-value expensing when required to do so, most companies
are already cutting back on option eligibility and grants, particularly
below the executive ranks.
- Overall,
75% of respondents said they are reducing the number of options
granted. Not surprisingly, public companies are cutting back
on options more so than private companies.
- The majority
of companies, both private (55%) and public (89%), are considering
alternative forms of equity-based compensation. The first choice
among public companies was time-vested restricted stock/units
(52%), followed by performance-vested restricted stock/units
(40%). The first choice of private companies continues to be
time-vested stock options (39%), and the most popular alternative
was performance-vested stock options (33%).
- In a clear
indication that many employees will receive less of a stake
in the companies they work for, among companies reducing overall
equity-based compensation, 42% of all public companies and 31%
of all private companies surveyed are reducing or eliminating
employee participation in equity-based compensation programs,
with no other benefit being offered in return.
- ESPPs are
losing some of their appeal, both for employers and employees
as companies reduce the benefits available in order to minimize
the accounting charges. Among public companies making changes
to their ESPPs in the U.S., 51% said they would reduce discounts
and/or eliminate or shorten look-back periods (look-backs provide
employees with higher discounts in a rising market). Twenty-nine
percent said they would conform to the FASB's strict safe harbor
in order to avoid any expense recognition, and 8% said they
would eliminate their plans altogether.
Impact
on Stock Price
- Most respondents
do not believe expensing will have a significant effect on their
stock price. Among public companies, 82% (79% of TMT companies
and 86% of non-TMT companies) said expensing would have no or
only a small negative impact on share prices. Among private
companies, 87% (83% for TMT and 94% for non-TMT companies) answered
this way.
- Among private
companies, very few expect that expensing will have an impact
on their plans to go public. Only 20% of all private companies
(24% of TMT and no non-TMT) that anticipate going public said
they expect that expensing will negatively impact or delay their
plans to go public.
Implementation
Issues and Trends
- Companies
appear to be paying more attention to institutional shareholders'
demands around equity dilution, with 73% of public and 64% of
private companies saying they want to limit overhang to no more
than 15% of shares outstanding over the next two to three years.
In addition, 77% of public and 63% of private companies indicated
that they would try to keep annual share usage to no more than
2%.
- A number
of respondents were considering the somewhat controversial strategy
of accelerating vesting for underwater options (options with
an exercise price that is less than the current stock price)
before having to implement fair-value expensing, to eliminate
future expense recognition in their income statement. Twenty-eight
percent of public companies with underwater options said they
were considering this strategy, and 10% said they already had
or were going to accelerate vesting. For private companies,
the responses were 39% and 3%, respectively.
Emerging
Compensation Strategies
The survey suggests a number of possible answers about the future
course of equity compensation, with nothing close to a consensus
at this point. One thing is clear, however: Whatever pressure
employers may be feeling from institutional investors and regulators,
most of them see compliance and cost as secondary issues in crafting
compensation strategy. Attracting and motivating employees still
come out ahead as strategic goals, and will presumably drive the
decision on what, if anything, to do with options, ESPPs and other
stock-based plans.
Respondents were asked to rank five concerns regarding compensation
practices on a 1-to-5 scale, with 1 being most important. Across
all sectors, and among both publicly traded and private companies,
two issues stood out. "providing competitive compensation"
was ranked 1 by 45% of the firms and 2 by another 26% (for a total
top 2 ranking of 71%). "motivating executives and employees"
also was ranked 1 by 45%, with 24% giving it a 2 (for a total
of 69%).
Many companies still consider option grants an important part
of that strategy. But when asked what alternate form of long-term
equity-based incentives they were considering (that is, forms
other than "plain-vanilla" option grants), private and
publicly-traded firms had different preferences. Private companies,
especially in the TMT group, favor options with some type of vesting
based on performance. Publicly-traded firms leaned toward grants
of restricted stock or stock units, and we have already seen a
significant shift towards these "full-value" awards
in the marketplace.
Overall, 21%
of the respondents said they were not considering any alternate
equity-based compensation. Among those who were, the choices in
order of popularity (frequency of mention) were:
- Time-vested
restricted stock/units - 45%
- Performance-vested
restricted stock/units - 36%
- Performance-vested
stock options - 25%
- Performance-granted
restricted stock/units - 24%
- Share-settled
SARs - 18%
- Performance-granted
stock opportunity - 13%
- Phantom
stock paid in cash - 11%
- Indexed
stock options - 1%
- Other -
10%
How well might
these alternatives move companies toward their goal of recruiting
the best people and motivating them to do their best work? In
theory, at least, performance-vested options or restricted stock/units
would be the most direct route, as long as the potential payout
is viewed as sufficiently big and achievable to attract and motivate
good employees. Investors, who want pay tied to results, would
also be pleased with workable performance-based incentives. But
performance-based compensation systems are not easy to set up.
Companies need to decide not just how performance is to be measured,
but over how long a period. One quarter, one year, three years?
The answer depends on company strategy, employee influence over
results, and what measurement fits the strategy (for example,
cost-cutting, working capital or market-share gains, or research
breakthroughs all might make sense in certain contexts). Performance-based
goals also run the risk of promoting unintended, and sometimes
undesirable, behavior as well. Time-vested awards, on the other
hand, are simple to execute but much more doubtful as a strategic
motivator. They reward continued service, not necessarily exceptional
service. They may make life easier for a company, but they may
not pass muster with increasingly demanding investors.
As long as
investors have a significant say in management decisions regarding
equity compensation, as they do now, equity compensation should
continue evolving in the direction investors prefer - toward practices
that make employees more productive and align payouts with increases
in shareholders' wealth. The 2005 survey suggests that companies
are willing to cut back on equity incentives to deal with the
near-term issues of dilution and expensing. They may not like
the new accounting ("I would like to see the rules changed
back to the way they were!" said one survey respondent),
but they are making the needed adjustments. The next step, which
is less clear now, will be to revise equity compensation so that
it truly serves managers, investors and employees.
* The original
standard, Statement No. 123, Accounting for Stock-Based Compensation,
was issued in October 1995, and is referred to as FAS 123. The
new standard, Statement No. 123 (revised 2004), Share-Based Payment,
was released in December 2004, and is referred to as FAS 123(R).
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For
more information about Deloitte's stock compensation survey,
or to request a full copy of the survey, please contact Tim
Lovoy, National Audit and Enterprise Risk Services Leader
(AERS) for the Technology, Media & Telecommunications
practice of Deloitte & Touche LLP. He can be reached at
tlovoy@deloitte.com |
