Are Stock Options Back? Rethinking Long-Term Incentive Design

Jake: We're continuing our Top Five series with a look at whether long-term incentive plan design may be due for a refresh. Mark and Aalap are joined by senior managing director Jan Koors and managing director Greg Stoeckel, both longtime advisors to compensation committees and executive teams on incentive design, pay for performance, and governance.

Together, they discuss why market volatility and the difficulty of setting meaningful three-year performance goals are prompting some companies to reconsider the traditional mix of PSUs and RSUs, whether longer vesting restricted stock has a larger role to play, and why stock options may be finding their way back into the long-term incentive toolkit. Let's listen in.

Mark: Jan and Greg, really excited to have you on the podcast today, we're talking about some long-term incentive issues.

Greg: We're excited to be here, Mark.

Aalap: Yeah. Greg and Jan, really appreciate you taking the time. I wanted to start off with what factors are driving companies to reevaluate their long-term incentives?

Jan: I would say the biggest thing I hear when I'm in boardrooms or talking to executives is the concern about the ability to be able to set meaningful three-year performance goals for PSU plans. Over the course of the last few years, we've seen PSUs really dominate the long-term incentive landscape, and in the current market volatility, it is so hard to see in a crystal ball three years out. Companies can barely set one-year goals, let alone three-year goals. And that makes it really hard when that PSU plan dominates the total long-term incentive opportunity.

Greg: Yeah, Jan, I completely agree with you. A consequence of that is compensation committees being asked to consider a lot of adjustments for things that have happened during the three-year performance cycle. So, at the time they set the goals, you're exactly right, it's very difficult to set a specific target. But then once those cycles are active, having to go back in and consider adjustments to in-flight incentives for who knows what—we went through COVID, we went through tariffs, we have wars impacting performance. And so, I think comp committees have taken a step back and said, is the complexity here really worth it?

Jan: Well, especially when you look at over a 10-year period, the majority of PSU plans, given all of the time and effort we put into setting those goals and the angst around it, end up paying more or less on average at target anyway.

Mark: So, Jan, you're talking about all the issues with PSUs. Not everybody has issues, but if you really have problems, why don't you just go with time-based stock with longer vesting periods? It seems as though, from a governance perspective, some of the advisors are suggesting they would accept that in lieu of performance.

Jan: That's a really good question, why don’t we do that! I do think that this longer-term vesting on restricted stock has some merit to it if you believe that the role of the long-term incentive is solely to align the interests of management and the shareholders and to encourage long-term stock ownership on the part of executives. I think the challenge that we've always heard about restricted stock is that some shareholders and investors end up looking at that like pay-for-pulse.

Greg: Yeah, Mark, I would also say I've been a little surprised that management has resisted, in some cases, moving in this direction. Jan's point, I think, is it pay-for-performance? That's a great question. I really thought there'd be some interest in this because I think management teams are tired of trying to pick metrics, set goals, and have that annual negotiation with comp committees. I thought they would jump at the chance to just have time-based equity awards with multi-year vesting, but it hasn't really happened. From what I've seen so far, it's like, okay, interesting, but let's kind of stay the course and keep doing what we're doing. But who knows what'll happen over the next two or three years.

Mark: Yeah, I think that management really has a, perhaps overblown, concern about the risk that they may not be there for the full, let's say, five-year time-vesting period, when in fact they tend to be there at least that long. So, it works much better with management teams that are there for long periods of time. But I think even with those groups, they fear that they lose the ability to at least consider moving somewhere else.

Jan: Well, and how much of that do you think is also tied into the fact that when you don't have the controllable measures of financial performance, do you think that impacts the fact that more of my pay is linked to the stock price performance, which has become increasingly outside of my control and subject to forces that have nothing to do with how well I did running the business?

Mark: Well, short-term perhaps, but not long-term.

Jan: Yeah, I mean, if you were looking over multi-year, over a five-year or six-year vesting period.

Greg: And related to that, I think one of the things I've heard is, a little bit of concern about giving up the leverage of PSUs, right? Most of these have a 200% of target max. So, for the same stock price appreciation, getting twice as much, twice as many shares, if you hit your goals certainly has some appeal that you don't get with just pure time-based RSUs.

Aalap: Yeah, and I think all these things culminate in a particular incentive vehicle that we affectionately call moonshot awards. They tend to have longer time periods. They are focused on long-term stock price performance. Greg and Jan, what are your thoughts on the PSU on steroids, if you will, known as a moonshot?

Jan: These are the Elon Musk awards, right? You set a really big, far-out-there goal and say, man, if you can manage to hit this, we'll make you rich, walk-away money. And I think while those can have some appeal for shareholders, because they're almost always tied to stock price performance, I think the challenge is, they also usually only go to one or two people, and you kind of leave the rest of the management team behind. That can have some big issues around team dynamics and culture. And I think, what happens if you put all your eggs in that basket and nothing happens? And then you end up having to redo.

Greg: Yeah. My personal opinion, I've never been a big fan of the traditional moonshot awards. And by that, I mean, awards that have incredible amounts of value, as Jan just said, like the Tesla case, but a very low probability of achievement. But I would contrast that with doing something a little more reasonable, off-cycle, special awards.

We had a case recently around succession planning, new CEO, align the team around the new five-year plan, do something specific tied to achieving those objectives. It's not a moonshot. It's literally just hitting their longer-term plan, but it was supplemental to their core long-term incentive program, that's fine. But something that is truly a moonshot, again, where the probability of achievement is so low and the amounts are so high, that just seems like you really got to take a step back and say, is the juice worth the squeeze on something like that?

Aalap: When you look at the data, it's clear the vast majority of those types of moonshot awards don't get earned. And so, your point about having other vehicles that are in play that have different time periods can be very helpful in balancing a long-term incentive program. But what are other design features, Greg, that can make traditional PSUs more effective in today's environment?

Greg: Yeah, I think you're going to see companies that stick with PSUs, they're going to do things like have a little more emphasis on relative measures versus absolute. That goes directly to the goal-setting challenges that Jan mentioned. Companies are going to try to tolerate wider performance ranges to keep a greater probability of being in the money on these awards in the future, although you got to be careful there.

We've seen that flat part of the payout curve, both in short-term and in PSUs, where we say, look, if the budget's only so good or the target's only so good, then why are we paying 110% of target for being 2% above a goal that was kind of a swag anyway? So relative metrics, wider ranges, strike zones are certainly some strategies that can be deployed to make PSUs a little more effective. And I would add that I think these moonshot plans are very specific to a certain kind of company at a certain point in its development. I think for most companies, just traditional PSUs, not moonshot awards, is where the market's going to continue to be.

Jan: To your point, Greg, around using it, maybe not go to the moon, but sort of orbit the Earth. Using PSUs as milestone awards for particular strategic goals, where I'm not at least bound by that issue of what happens in an arbitrary three-year fiscal measurement period. But I've identified what success looks like, and you will get this award at whatever point you manage to hit that mark, whether it's two-years or five-years.

Mark: So we've been talking a bunch about PSUs and potentially moonshots, which will probably stay a minority practice, as you suggested, but we're starting to hear more about options. Are they really back in the mix? I thought companies, except for certain industries, had moved away from stock options for good.

Greg: I think stock options are coming back. I really do. I know that seems counter to the trend that we've had for the last 10 years. But if you go through the list of reasons why stock options are attractive, it's a pretty long list. So, they're very simple. They are truly long-term, right? Options have a seven-year term, a 10-year term, versus a three-year measurement period on PSUs. It's direct shareholder alignment. It's the outcome that we're looking for, not betting on the drivers that are going to deliver stock price appreciation. There's no multi-year goal setting, there's no adjusting outstanding cycles. And so, the list is pretty long on the benefit of options. I think options came under fire when the accounting rules changed. They came under fire when the proxy advisory firms were 100% opposed. But I feel like a lot of companies really liked stock options.

There's some interest to saying, look, if conditions are appropriate, let's not go 100% stock options, but let's really give it some serious thought as to whether stock options should be in the long-term incentive mix. I don't know if, Jan, you have any different thoughts on that.

Jan: I actually 100% agree with you. I am a big fan of stock options, especially for a company that has decided that for their PSU plan, they're going to use some kind of stock price-based metric. Well, but that's what an option is.

However, just for argument's sake, let me just say that if options were perfect, everybody would use them all the time. So obviously options have some downside too. They tend to burn through your shares faster because if you think about LTI value that's delivered to executives as a dollar grant target, I need to use three options for every one share of restricted stock. So, I burn through my shares faster. That's a potential downside where you've got ISS, Glass Lewis, and others that put constraints on the amount of shares you can get authorized. That seven-year, 10-year term, while it's really beneficial for executives to be able to ride through economic cycles to get to an uptick, it means that those options sit out in your overhang longer.

So, they potentially create more dilution, more overhang that lasts longer. We've seen plenty of cases where options get granted at a high, the company stock price stays flat or goes down, and those underwater options sit out there forever. So, there are some downsides.

Greg: Absolutely. I also think that when I hear a lot of these arguments against, to me, they're very impactful if you think about being 100% stock options. And it's almost like we're going back to  what used to be the prevailing market practice—going back to this notion of a portfolio of long-term incentives, so that's not new. That's where companies used to be before we had this drastic movement towards just a mix of RSUs and PSUs, certainly for the largest publicly traded companies in the US.

So, when you think about a more balanced mix potentially going forward and say, okay, well, long-term comp is complicated because it has a lot of objectives. So, let's use RSUs with time-based vesting to address our retention objectives. Let's use PSUs in the mix to address our objective of aligning pay and performance with our business plan and achievement of our own specific goals. And let's use stock options to create direct shareholder alignment. That argument that was in vogue 10, 15 years ago, I think, is sort of coming back to say maybe a more balanced mix where the balance isn't even amounts, the balance is determined by the facts and circumstances that the company is facing. So that ultimate mix of these currencies is one that each company's going to have to sort out and decide what's best for them.

Aalap: And that's an excellent point, Greg. When you look at the market data, we've moved so far. It's about 10% to 15% of companies now use three equity vehicles in their mix. Such a small number in comparison to what it was before. But just a follow-up question on the options, does the longer life of an option actually create better long-term alignment than a three-year PSU cycle?

Jan: I think it does. We've gotten to this point around three-year performance cycles on PSUs as almost the standard that everybody uses and I find it hard to believe that everyone's business cycle is three years long. So, I just think that options have a better way of saying, over the long-term, Greg said this earlier, options actually really are long-term incentive plans, as opposed to what we have now with PSUs, which are sort of medium-term incentive plans.

Mark: So, would you do anything to the options? Would you use plain vanilla options, or would you do something like extend the vesting period to make it five years so that it is, in fact, longer term and you're not just going to get a quick pop from the option? Or are you going to set a premium base? What do you think is going to happen with options?

Greg: I think we already see, in a lot of cases, a little bit longer vesting schedule on options than RSUs, as an example. Companies that had the mix of RSUs and PSUs, as Jan said, because PSUs were three years, I think there was just this logical movement to have RSUs be three years. So that year's grant, both forms of award were aligned to a three-year period. But if we're going to put stock options back in the mix and we have this viewpoint from the proxy advisory firms, I think options are the perfect place to have a little bit longer vesting schedule because they're incremental value awards. It takes time for them to generate any real value. You want the participants to hold them longer. So to me, a little bit longer, four- or five-year vesting on a stock option makes sense.

I also think version 2.0 of stock options, if you're worried about stock price volatility, if you're worried about one of Jan's concerns around underwater stock options, we've had some companies that have said we're going to grant options twice a year instead of once a year, as an example, so that we're kind of taking the pressure off of the grant date by having more than one grant date in a year. I do think there's some interesting things that could be considered in options 2.0 compared to how companies used to do traditional stock options.

Jan: And I think there are some things you can do around the design to address some of the other concerns as well. If you put some kind of premium pricing on the option or some kind of indexed pricing on the options, you address the concern that ISS, Glass Lewis, and some others have that options are somehow not performance-based because of their long-life cycle.

You can do things like have an automatic cancellation on underwater options if the stock price drops and stays more than, pick a number, 50% below the grant price for some period of time, those outstanding options automatically cancel so you don't have the drag on dilution. I think there are some interesting things you can do from a design perspective to address some of the concerns around options coming back into the mix.

Aalap: Yeah, Jan and Greg, I mean, some really great ideas, and I would 100% agree I think there is a market environment right now where PSUs and getting the metrics right and the goals right for PSUs has become increasingly more challenging that looking at options, and frankly options 2.0 design, really makes a lot of sense. So really appreciate you sharing your thoughts here today.

Jan: Great, thanks so much. This was a fun conversation.

Greg: Absolutely.

Mark: Yeah, it's great food for thought. Thanks a lot, everybody.

Greg: All right, take care.

Jake: Our thanks to Greg and Jan for their fresh perspectives around how to think about long-term incentive design in the current environment.

Our next episode will be the last one in our Top Five series. We'll be examining leadership readiness and the role it plays before, during, and after a major transaction. Until then, you can find all of our Unscripted episodes on Spotify, Apple Podcasts, pearlmeyer.com, or wherever you get your podcasts. Thanks as always for listening, and we'll meet you back here next week.