Wednesday, 29 May 2013

LONG-TERM PERFORMANCE INCENTIVES FOR EXECUTIVES


Long-Term Performance Incentives for Executives
Long-term Performance Incentives Reward Executives for achieving superior long-run performance that provides above average returns to shareholders. 
Long-term incentives encourage executives to take risks with firm assets leading to shareholder gains that they might otherwise avoid.
       Example: Investing in a risky project that leads to a radical innovation that changes the rules of competition. 

Types of Long-term Performance Incentives (Source: R. Bernstein, 1998: Foundation for Enterprise Development)
            Performance-based
            Non-Performance-based
       Founders’ equity
       Restricted stock tied to Executive tenure - golden handcuff
       Stock options given as a Recruiting Bonus
Performance-based LT Incentives for Executives
            Vested Stock Bonus - An award of stock given to executives to reward specific performance.
       Outright Award
       Taxable to employee based on full market value at the time of the grant
       Deductible to employer at same time and same amount
            Restricted Stock Bonus - an award of stock that has further restrictions that must be satisfied before the stock can be owned. 
       Requires that the executive must stay with the company during a vesting schedule or meet some specific performance goals.
       Taxable to employee when restrictions are removed
       Deductible to employer at same time and same amount   
            Stock Option Plans - gives the executive the right to purchase company stock in the future at a price that is fixed at the date of the grant.
       Value of options not reported on accounting records
       Options given to executives dilute value of stock owned by other shareholders
       “Strike price” of stock options are set at time of grant and may be set at market price of stock on day of grant, or some other price of the stock. 
       Stock options are given a period when they can be exercised which in most cases is around 10 years. 
Types of Stock Option Plans
            Incentive Stock Option (ISO)
       Limits on number, length, price and who may participate
       Non-taxable to executive until stock is sold and then taxed at capital gains rate of taxes.
       No corporate tax deduction
            Non-Qualified Stock Options (NSO)
       Flexible to apply compared to ISO
       Taxable to employee at exercise date
        Taxed as ordinary income if sold when options exercised; taxed as capital gains if held for more than 12 months.
       Corporate tax deduction at exercise date
        Most high technology firms use non-qualified stock options for flexibility and tax reasons.

Stock Appreciation Rights (SARs) and Phantom Stock - cash based plans that simulate stock perf.
            Advantages
       long-term incentive without issuing stock; less complex from legal perspective
       does not dilute voting control
       avoids admin. & regulatory complexities, more flexible designs
            Disadvantages
       no real ownership provided to executive
       company must book value of outstanding SARs or phantom stock as compensation expense periodically


            Stock Appreciation Rights (SARs)
       SARs mirror stock options - receives cash difference between strike price and market value of stock
       No investment on part of executive required
       Gives executive “feel” of ownership  without giving up control to executive

            Phantom Stock
       Phantom stock mirrors stock bonuses
       Executive receives units of value in firm, tied to value of stock appreciation
       Results in a cash distribution
Problems with Stock Option Plans:
1.  Windfall effects - between 1995-1997 there was a 100% increase in stock indexes resulting in huge gains for below average performers.
2. Fixed price options are problematic - poorly related to strategic performance goals
3. Downside on options is minimal
           Improving the Relationship between Stock Options and Performance (Source: A. Rappaport, 1999)
Proposed Solutions
1.  Premium priced stock options
       price must exceed a premium above market on day options are granted, such as 25% or 50% above market price: used by Monsanto, Colgate-Palmolive
2.  Indexing:
       tie options to an index of competitors or market index such as S & P 500
       “in the money” when index is exceeded
       discount value of options when index is not reached
       more indexed options needed than fixed to encourage execs to bear greater risk