Is Equity Still Earning Its Keep? Stock-Based Compensation in Technology

Jake: In this season of Pearl Meyer Unscripted, we're looking at executive compensation through an industry lens. Our co-hosts, Mark Rosen and Aalap Shah, are joined by several colleagues who specialize in different industries, including technology, healthcare, oil and gas, and more, to examine the aspects of compensation design that are unique to each.

We're wrapping up our technology discussions with a closer look at stock-based compensation expense and how boards should evaluate whether equity is being used effectively.

Mark and Aalap are joined by managing director Eric Myszka from Pearl Meyer's Chicago office. Eric advises boards and management teams on executive compensation programs that are market competitive, aligned with strategy, and responsive to stakeholder expectations. Together, they discuss whether companies are getting the right return from their equity spend, how cash and equity should be evaluated together, and why technology companies may need to be more targeted in how they use equity as they mature. Let's listen in.

Mark: Eric, thanks for joining us. Really excited to have you on the podcast today.

Eric: Thanks for having me. Looking forward to it.

Aalap: Yeah, Eric, I'm so glad you're here because there's a question that is coming up kind of very often to me, and so it's very top of mind. Many of my clients, specifically the board directors, are asking whether their company's stock-based compensation expense has become too high relative to revenue or EBITDA. How should boards think about that issue?

Eric: Yeah, it’s something that I've been hearing as well, and a lot of times the question is, yeah, is it too high? And I try to rephrase the question with the board. It's not necessarily, is our stock expense too high? It's more of, are we getting the return? Are we using our stock expense or stock compensation appropriately, and are we getting the return that we expect? So, more of a strategic question around expense versus a quantity, or is it just too high compared to peers, for example?

Aalap: And when you think about sort of the overall financial makeup of a company versus their stock-based expense, are there any sort of guardrails that you think are important?

Eric: I would say, thinking about stock expense or stock-based comp, thinking about it strategically, you see companies that, as they progress through their life stage—you've got early-stage tech companies who are maybe doing more broad grants to employees, and as they mature, really start being more targeted about what they're trying to achieve with their stock, with all compensation. Whether it's cash or equity, but really, I think companies take a good look at cash compensation and manage that effectively: fixed compensation, salary, bonus targets, and things like that. But equity tends to be focused more on dilution as an overall metric. And now we're looking at stock-based comp expense as well as part of that. But looking at it holistically: comp expense, dilution, financial performance. And as that all matures, being a little bit more targeted with how they use that stock expense, similar to how they treat cash compensation.

Aalap: So, is stock-based expense just another way of companies trying to emphasize differentiation?

Eric: Yeah, it can be. You think about what the objective of your stock compensation is, right? It's generally to align participants with the performance, long-term performance of the company, and align with shareholders. Whereas cash compensation, it's more short-term incentives, maybe recruiting folks into the organization, some retention capabilities as well.

So, when you're thinking about aligning with shareholders, who are those folks who are really going to drive the company value and targeting those rewards, as well as critical talent? If they're maybe entering new markets or new technologies and they need to attract new talent into the organization with new capabilities and skills, those might be targeted rewards that you need to focus on, in addition to key employees you're trying to retain as well.

Mark: Are you seeing more use of cash? Certainly, with more mature companies in the general industry, we will sometimes see long-term incentives pay out in cash, if only to reduce that burn rate. Doesn't necessarily reduce the expense, but it certainly reduces the use of equity and also allows people to diversify.

Eric: Yeah, in some instances it does make sense. Mature companies, maybe even private companies who have delayed an IPO or liquidity event. Employees are looking for liquidity, and so those employees or those participants who may be lower in the organization, who may not be primary drivers of growth, it may make sense to, at that point, start settling some of those rewards in cash.

I would be hesitant to say we should do a wholesale change or advise our clients, or my clients, to say, "You've been granting equity; let's replace these with cash-based rewards." I think that's the wrong answer, but being a little bit more targeted and focusing the rewards on what the talent challenge or objective is that you're trying to achieve. And in some cases, that may be settling the rewards in cash, but I wouldn't say it's a wholesale change.

Aalap: Yeah, because it seems that the question of cash really just pushes the stock-based expense from one bucket into the other. It sounds like what you're saying is that you shouldn't let the expense factor lead the way, but really focus on providing equity to individuals that are going to have a meaningful impact on long-term value creation. Is that right?

Eric: That's right. Yep, exactly. Especially when it comes to refresh grants, for those companies that are doing that, being a little bit more targeted as well.

Aalap: Do you see, like, an overall contraction happening in the tech market when it comes to the philosophy of everyone has skin in the game with the organization?

Eric: Depends on where they are in the life stage. I think you've got a lot of tech companies that are early stage, high growth, not profitable, looking just to focus on revenue. And in those cases, still looking to conserve cash, and we're still seeing large equity usage. But as the companies mature, that's definitely leveling out, I would say, and looking at cash and equity together and determining what is the best vehicle for the particular challenge at the time.

Mark: Are you seeing anybody, in an effort to reduce the compensation expense but not necessarily the burn rate, use any techniques to reduce the expense? So, change the plan design from just a plain vanilla option or restricted share to something that can reduce the value with maybe a post-vest holding period or some other things?

Eric: I would say accounting is probably not the driving factor of equity design. But we see companies who are adding post-vest holding periods for strategic reasons, for corporate governance reasons. We also see companies who are moving away from purely granting options to performance-based rewards, though I'd be hesitant to say that's to reduce comp expense from an accounting perspective. Depending on what the performance metric is, that may or may not be an effective way to reduce the expense between a financial metric versus a market metric. But we are seeing companies not just thinking about the expense, but thinking about the reward type and the design of that and making sure that it's supporting the company's growth objectives, as well as just overall good corporate governance, especially as these companies mature.

Mark: What about moonshot awards, where we've got these extremely large grants that are potentially not achievable, at least from an accounting perspective, at the time of grant?

Eric: Yeah, with a financial metric, if those are not probable, then you can kind of factor that into your recognition of the comp expense. But some of these we've seen recently have a market metric tied to them as well. In that case, there's not much you can do from that perspective.

If the performance is not achieved, the expense is still going to be recognized. However, those companies that are issuing those moonshot awards tend to be companies who are really focused on significant innovation. And we see less interest in stock-based comp expense percent of revenue, for example, in those instances. Usually, they're using equity to bring in some unique talent, new unique skill set, and really be a driver in the market in terms of innovation. And in that case, you kind of need to spend to get that talent. And so, there's a little less focus in those instances.

Now, five years from now, if those companies, for whatever reason, aren't achieving the objectives that they set out to achieve, shareholders may have some pushback or have some thoughts on the comp expense at that point in time. But at least right now, I think the focus is more on the terms of the moonshot award and the performance goals and whether or not they're achievable. In public perception, I would say the shareholders are less focused on the accounting expense in those instances.

Aalap: Right. And I think it ends up being sort of a risk-reward conversation here because the loftier some of those moonshot awards are, even if they're 100% on a market-based metric, the potentially lower compensation expense they could have if they truly are sort of deemed quite improbable. There could be an extreme benefit to shareholders with that type of moonshot structure but not have that much of an expense impact in the overall scheme of things. I think it's definitely a conversation to have.

So, Eric, one of the things you mentioned about compensation vehicles makes me think of a situation I had recently where the board wanted to put in place a special incentive program with a two-year performance horizon. And the key design question was whether the reward should be delivered in cash or equity. While the equity probably was more of the preferred traditional approach, the stock price of this company is very low, currently. And so, the comment from one of the directors is that right now equity is king because it's at such a low value, and there was a little bit of a reticence to use equity when they could do the same thing with cash. Any thoughts on that?

Eric: I guess a follow-up question would be, while the stock price is low today, what's the two-year horizon? Do they expect a turnaround in the stock price over the next two years in terms of performance? Or what is the objective of the reward? Is it purely retention-based? Are they looking to turn around and increase share price over the next couple of years?

Aalap: Yeah, I mean, it was definitely a performance-based award for the team to execute on some financial results. I think the expectation would be the stock price would go up, but the concern was that if they granted equity now, at a low price, it would just be—to get to the dollar value they wanted—it would be a significant hit to the pool.

Eric: I think it's a valid question, and it's a good conversation to have with the board around maybe this is potential for cash to be something to consider. And not just because of the share price being low and, from a dilution standpoint, the number of units or shares that we need to issue, but also from a perspective of two years is kind of a short horizon focused on some financial metrics. Achieving those, paying out in cash, especially at a low stock price, the rebound might be a little bit delayed on the financial performance. And so, the upside at the end of the two years, they might not recognize a great increase in value in that stock. So, having the cash, it provides some fixed reward for the participants to realize in a couple of years and with less volatility in stock price. It could be a valid thought to shift from equity to cash in this perspective, or in this instance. I would think about rewarding that in cash.

Aalap: Yeah, I mean, I think that's why these sort of detailed conversations are important because ultimately the company did decide that cash was a better alternative for them. But your instincts on that were correct. But I think, again, worthy of having a deeper conversation as to the vehicle and not just assume that it should be one or the other.

Eric: Yeah. Just because a company's been doing one thing for the last five years doesn't mean the next two years they should continue doing it.

Mark: So, Eric, what advice would you give committees as they try and balance the investor expectations with the need to remain competitive for talent?

Eric: I kind of go back to what we first started talking about and thinking about cash and equity together, and then thinking about the talent objectives and challenges that you're trying to solve for and determining what the right vehicle is for that challenge. Cash might be appropriate where, especially in a company that's maturing, they're less focused on conserving cash at this point in time. They're profitable now, stock price is settled, they're looking at retaining talent as well as bringing in some new people, for example. But really focused on what the talent challenges are and not just defaulting to equity compensation, stock-based compensation, because that's what they've always done.

And the example that Aalap and I were just talking about with his client is a good example of that, of thinking through what the challenges are and using their resources appropriately, whether it's cash, whether it's equity, but being really thoughtful and mindful of what the talent challenges are and being focused on the right usage of their action.

I would say companies should be targeted in what they're trying to achieve with their stock-based comp expense. I think there's always been an idea in the tech world that everybody grants equity, and we're all going to go public at some point in time, or we're all going to have these windfalls. And we're seeing companies stay private longer. We're seeing some of the growth trajectories level off, especially in kind of the software space. And so, use of equity doesn't have the same appeal to participants as it used to, in some instances. And some boards really should be focused on thinking about cash and equity together and using those resources appropriately depending on the challenge. And that may be transitioning from equity to cash.

But I would not focus on purely shareholder concerns or just aggregate expense values or percent revenue and say, "We got to reduce this because it's too high." I think you got to think of it holistically and make the right decisions based on the challenges that are in front of them today. And that may be continuing to use equity, even if equity expense is high, but having a story of why that's the case is important.

Aalap: Well, thank you, Eric. I mean, really appreciate you taking the time to talk through some of these client issues and give us your perspective on the hot topic of stock-based expense.

Eric: Yeah, no, great to be here. I appreciate it. Always good to talk to you guys.

Mark: Yep, appreciate it. Thanks a lot, Eric. This was great.

Jake: Our thanks to Eric for sharing his insights and perspective on stock-based compensation expense and how boards should evaluate whether equity is being used effectively. Next week, we're shifting our focus to Pearl Meyer's annual series on the Top Five topics that should be on the Comp Committee agenda heading into fall committee meetings.

We'll have an episode on each topic for the next five weeks, and then we'll return to our industry focus by examining compensation dynamics for tax-exempt organizations. As always, you can find all of our Unscripted episodes on Spotify, Apple Podcasts, pearlmeyer.com, or wherever you get your podcasts. Thank you for listening, and we'll meet you back here next week.