The impact of executive stock ownership on long-term incentive plan design 

Substantial stock ownership by corporate executives is an important facet of executive compensation governance. Aligning executive and investor financial interests is viewed as an essential part of executive pay design. However, there may be a point at which an executive’s stock ownership represents such extensive financial alignment with investors that linking further compensation opportunity to stock price performance may encourage leaders to de-risk corporate strategy to protect their personal financial security. Based on each organization’s unique facts and circumstances, it may be appropriate to de-emphasize stock-based compensation and/or stock price-based pay metrics for certain executives.

Companies promote executive stock ownership through equity awards and stock ownership guidelines, and regulate sales and purchases through insider trading policies. Corporate stock awards are a regular and significant part of annual executive compensation, often representing 50% - 75% of an executive’s target annual compensation. Stock ownership guidelines that require executives to own a minimum value of company stock (typically a multiple of base salary) have long been a bedrock of corporate governance for US public companies. Companies with stock ownership guidelines typically disclose only the policy requirements and whether executives are in compliance - most don’t disclose the total value of an executive’s share ownership. In addition, corporate insider trading policies and SEC rules prohibit sales of company stock by individuals in possession of material non-public information, making it difficult for executives to buy or sell stock during extended periods during the earnings release cycle.

However, whether or not there exists sufficient or “excessive” stock-based financial alignment between executives and shareholders is not clarified by current SEC disclosure requirements. Those regulations that do touch on executive ownership include (i) the Beneficial Ownership Table (which addresses the number of shares owned and the percentage of outstanding shares, but not the value), (ii) the Outstanding Equity Awards Table (which addresses value, but only for shares not yet earned, and therefore not actual ownership), (iii) the Pay-versus-Performance disclosure (which presents the fair value of equity awards at year-end), and (iv) Forms 3, 4 and 5 insider stock transaction filings. None of these explicitly require disclosure of an executive’s total stock price-based financial exposure.

Proxy advisor reports acknowledge whether a company has a robust stock ownership or retention policy, but Say-on-Pay (SOP) voting policies do not explicitly take stock ownership levels into account in assessing alignment of pay delivery with investor interests. However, they (and some institutional investors) will note whether there is a disconnect between pay levels (relative to target) and stock price performance. This has evolved to the point that their SOP voting policies have contributed to a landscape where more than half of large US public companies use relative total shareholder return (rTSR) as a material (and sometimes exclusive) metric in their long-term incentive plans to directly link pay to stock price movement. Since many compensation committees and management rely primarily on peer company practices to design their incentive plans, rTSR metrics have naturally become commonplace.

Many (if not most) compensation committees don’t explicitly consider the economic value (and associated financial risk) that stock ownership levels represent for executives. They also often don’t leverage the executive stock ownership data available to them when designing long-term incentive plans or constructing equity awards. Rather, their decisions tend to be driven by peer group practices and/or proxy advisory policy guidelines. If compensation committees don’t explicitly consider stock ownership levels and disclose how it was considered, investors have no visibility into the amount of financial risk executives already have to stock price volatility. Although some organizations present this information in the form of a “tally sheet,” the compensation committee may not explicitly discuss how or whether stock ownership should influence incentive vehicle or metric selection.

When considering incentive compensation plan design, companies should ask not just “is executive pay sufficiently tied to the investor experience” but also “to what extent are executives already sufficiently (if not excessively) financially aligned with investors.” In situations where sufficient financial alignment already exists, instead of using rTSR metrics, long-term incentives could include internal measures that executives are better able to influence and that promote strong and sustainable operations, e.g., operating earnings, return on invested capital, margin improvement, revenue diversification, etc. By the same token, organizations could also use cash (as opposed to equity) as a long-term incentive vehicle, which would also decrease share usage and reduce shareholder dilution. Where there is already significant exposure to equity value, reducing (or eliminating) additional exposure, through focusing on financial or operational metrics and using different LTI vehicles, may provide more effective incentives.

This begs the question “how much executive stock ownership is sufficient to evidence appropriate financial alignment to investors, while not creating so much stock price-based financial risk that corporate strategy is not optimized?” This is a difficult determination because it is subjective, varies by individual risk tolerance, and may be based on personal and confidential information, i.e., what are the executive’s other sources of income? What other assets does the executive hold? What percentage of the executive’s net worth is tied up in company stock? Several perspectives that could be considered to help navigate these questions:

1. Consider traditional benchmarks for how concentrated investors’ positions in a single stock should be – at a high level most financial advisors would consider having more than 20% - 25% of your net worth in a single stock is excessively risky. One approach would be to have executives disclose their net worth confidentially to compensation committees to understand their personal financial risk profile. Adding more stock price-based pay risk above reasonable investment benchmarks raises potential discord between management and the Board regarding corporate strategy.
2. Compare the relative ownership positions of executives to those of executives at peer companies. Since peer group practices are a relevant factor influencing incentive plan design, then the relative level of financial risk tied to stock price movement across a peer group spectrum is also a relevant consideration in designing LTI awards.
3. Consider how executive actual ownership compares to stock ownership policy guidelines, which ostensibly indicate “adequate and desirable” levels of executive ownership to align with investors’ financial interests. If stock ownership guidelines require a CEO to own $15 million of company stock, it may be unreasonable to tie future earnings to stock price performance if he/she already owns $30 million or more of company stock.
4. Consider the multiple of current annual cash compensation that is gained/lost when stock prices increase/decline by given percentages. If an executive’s stock ownership exposure could result in losing the economic equivalent of 1x annual cash compensation, that may be too much pay risk. Or perhaps the appropriate threshold is 2x or 3x. For example, a compensation committee could conclude that adding rTSR to long-term incentives is unnecessary when the CEO would lose the equivalent of 2x annual target cash compensation for a mere 5% decline in stock price. 

The primary objective of effective executive compensation governance should be to ensure that executives are financially aligned with investors. If executives have significant levels of financial alignment to stock price performance, companies should consider focusing on incentive metrics that promote operating, strategic and financial results because executives have more control over these metrics, they promote strong and sustainable operations and they are less susceptible to the whims of the market. In addition, companies should consider using cash-based long-term incentives, which can reduce stock price-based pay risk and help manage share utilization and dilution.