September 7. 2022

4 Pitfalls to Avoid In Equity Compensation

Creating a well-structured equity compensation is crucial because its ultimate goal is to motivate employees and foster their commitment to the company.

This article addresses the most common “mistakes” and potential pitfalls to consider when designing an equity compensation program. A well-structured equity compensation agreement can have many positive effects for the company. There are also some possible unintended effects if the agreement is not adapted to the company’s needs and wishes. Here are some things to keep in mind:

Options usually have an vesting period, as well as an expiration date. The employee must exercise the option in the period between the vesting date and the expiration date. The option also has an exercise price (also often called a redemption price and strike), which is a pre-agreed price for which the shares can be purchased. It is usually a condition that the employee works in the company from the option is granted until an vesting date (vesting date) in order to have earned the right to the option. This means that the participant as a general rule does not lose the option if he / she quits after this. The employee can exercise this right from the time of vesting until the options expire.

Dilution of the stock

As the options are exercised, the number of shares increases, and ordinary shareholders risk diluting their shareholdings. Some companies introduce a buyback scheme and / or hedging instruments (such as total return swaps) in order not to affect the number of outstanding shares. The results and the cost of this can be affected by interest expenses if the repurchases are loan-financed.

 

Long-term and healthy perspective in decisions

History has unfortunately shown that managers can prioritize short-term results over long-term growth if they can sell the shares immediately after the options have been exercised if time aspects and goals have not been thought through. One solution is to order everyone to sit on the shares a few years after the option has been exercised. For the financial industry, there are separate regulations (Remuneration schemes in financial institutions, investment firms and management companies for mutual funds) that regulate this – something we will return to in a separate article.

 

Tax and employer’s contribution for illiquid shares in relation to expiration

Share salary instruments (as options) often give a high tax bill to the participant and employer’s tax bill to the company. In the event of a win, it is important that the liquidity of the participant and the company is considered. In the worst case, we have seen variants where options with a large “paper gain” have expired as it has simply not been possible for the participant to finance tax and redemption price. If the company is listed on the stock exchange and the share is liquid (there is a certain frequency in trades), some shares can be sold off to cover this capital requirement. So mainly this is a challenge where it is tricky to sell off a share of shares.

 

Unwanted high payouts

In some cases, stock pay programs (especially options) have yielded sky-high payouts. This is positive for participants, but not always desired by shareholders and this can also affect the company’s reputation. There are also mechanisms here that can counteract this. So-called Cap’s (roof) and Brakes (brakes) are effective mechanisms for removing the risk for the “front page of the financial newspaper” due to sky-high payments.

 

It has become more common to make a new price assessment when the options are ‘out of the money’, preferably to get top management to remain. Many believe that such a practice is unsustainable because it is a way of saying “done is done” that does not benefit ordinary shareholders who have bought and sat on the investment.

It is often said that it is better to own a small share of Coca Cola than a large share of Jolly Cola. Used correctly, share pay can create organizations where all good forces are oriented in the same direction, for the company’s long-term and healthy development.

 

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