Performance-Based Equity Awards and Other LTI Trends

Transcript

Jake: Given the current macroeconomic environment, are long-term incentives still relevant? And if so, should boards be thinking about them differently? Welcome to another Unscripted episode. I’m Jake George, CMO at Pearl Meyer, and my colleagues Mark Rosen and Aalap Shah are discussing hot topics likely to be on the minds of comp committee members as we head into the fall meeting season. Today, they’re joined by our colleague Steve Van Putten to discuss the latest trends in performance-based equity and where it fits into a company’s 2026 equity program strategy. Let’s listen in.

Aalap: Hey Mark, I was wondering if I could pick your brain.

Mark: Yeah, sure.

Aalap: Yeah, I've been struggling with this sort of what I'm framing as an existential question. We're finding ourselves at a time when we have an increasing frequency of macro conditions that impact our incentive programs. It seems like every year there's something that's happening in the macro environment that is leading us to question, do we set the goals right? Do we need to use discretion? Do we need to calibrate differently? Does it continue to make sense to struggle with this long-term forecasting on PSUs?

Mark: Yeah, I've been, I won't say struggling and I'm not sure it rises to existential for me, but I have been having this conversation with Steve Van Putten and he's really thought about it a lot. So, let's bring him into the conversation because I think we both can probably learn a lot from him... Hey Steve.

Steve: Hey Mark, Aalap, nice to chat with both of you. 

Aalap: Thanks for coming into the conversation. Yeah, so the question is, Steve, that, at least I'm struggling on an existential basis, that the continued relevance of performance-based long-term equity grants, because there are so many macro conditions that we seem to be occurring every year that oftentimes when we're setting goals, a few months later, we're thinking that, you were those goals the appropriate goals? So, are your thoughts on the continued relevance long-term performance vested equity?

Steve: Great topic, Aalap, and it's very timely too. Most of our clients are just getting started on the 2026 Equity Program Strategy Planning Process. You know, specifically as it relates to performance-based equity. I don't anticipate or expect to see any notable movement among companies away from performance-based equity, at least not in the near term. And there are a few reasons for that. 

First of all, most investors still prefer performance-based equity. I know there's been headlines out there questioning the rigor of performance-based equity. And you talked about the macroeconomic environment and how that could impact things. But in my experience, investors want to hold management accountable for results and outperformance. And if companies are out there telling investors they're going to grow earnings, bid single digits or expand their operating margins. They want the opportunity to hold management accountable for delivering on those results. And I don't see that going away.

And as for alternatives, you're really left with time-based vehicles. In my experience, investors tend to be concerned with over-reliance on time-based equity. Sometimes they call them ‘fog the mirror’ grants because you just have to breathe in order to invest in them. Or the dilutive impact of options will want to stay the course with equity. And I expect the same thing from compensation committees and management. They really see those as an opportunity, performance-based equity to align management's incentives with those of shareholders in terms of value drivers. What's going to drive value for the organization? They spend a lot of time in terms of identifying the right metrics over the right time period that will lead to long-term value creation. I don't think they're going to lose sight of that. And don't forget that the annual incentive, which has financial metrics, is a relatively small piece of the executive compensation pie. So, it would be a missed opportunity not to be able to leverage the long-term incentive with performance-based equity.

Aalap: I mean, if performance risk equity is here to stay, are you seeing any changes in the metrics companies are using?

Steve: Well, relative TSR still remains the most prevalent metric by a fairly wide margin. And I think that will continue. If anything, it may increase Aalap. And that's because of what you mentioned at the outset, the challenges of setting multi-year financial goals in a very uncertain and volatile environment, which we are certainly experiencing right now. And I think investors generally like relative TSR, but we need to keep in mind that relative TSR has its shortcomings. I view it as less of an incentive metric and more of an accountability metric. It's less within the control and influence of management and it has its challenges. You have to establish the right comparison group to compare your TSR against. It's a point in time measurement so subject to quite a bit of volatility. 

So, where companies have relative TSR, I recommend that you balance it with a line of sight financial metric and not solely rely on relative TSR. And really that is an opportunity. It's an opportunity to create dynamic tension with your short-term incentive. So, for example, if you had your short-term incentive, and it's based on profitable growth, EPS or EPS in revenue, your long-term incentive financial metric could create a counterbalance to that. Things like balance sheet metrics, like return on invested capital or operating or free cash flow with the statement of cash flow statement, really create a more holistic assessment of performance and hold your team accountable for delivering on all ends of that spectrum.

Mark: Are you getting any pushback or we've seen any pushback from proxy advisors or investors for that matter on these metrics or do they prefer one or another?

Steve: Well, certainly you're always at risk with ISS and Glass Lewis of getting pushback because they have a very narrow lens in terms of evaluating the designs of long-term incentive programs. For example, they expect performance periods to be at least three years. You shouldn't have overlap or redundancy with your short-term incentive metrics. You shouldn't do anything outside the normal course of annual awards. You know, retention type issues, avoid granting one-off type of awards or front-loading grants. And so they have a prescriptive way of how they look at long-term incentives and it doesn't often reflect the reality of what companies are dealing with on a day-to-day, month-to-month or year-to-year basis. And now you see them looking to push companies to disclose forward-looking goals.

So, my view is that companies need to design their programs that reflect their own unique set of circumstances. For example, take a company that operates in a highly uncertain or a cyclical environment. They may want to have financial goals in their or LTI because as I mentioned, so much of compensation is tied to long-term incentives, but it's too difficult to set three-year financial goals and they don't want to solely default to relative TSR. And setting three-year financial goals could actually be counterproductive. If they have early tailwinds, they could be easily exceeding maximum early into the cycle or vice versa in the case of headwinds. So in that situation, may be appropriate to have one-year financial goals. I think it should be counterbalanced maybe with a three-year relative TSR program to ensure accountability to long-term results. But a one-year or even two-year type financial metric may make more sense for that company.

I would look at counterbalancing the metrics like I talked about before, having different metrics in the short-term and the long-term even when you're measuring it on a one- or two-year basis. For example, I have a client that has their annual incentive based on profitable growth and they have two performance-based equity groups. One is economic profit on a one-year basis and the second is three-year relative TSR and it works for that company. So you need to figure out what works for your particular company.

Mark: So do you think boards will overreact to feedback because I suspect that particular client probably gets some feedback on the one-year performance period, although it's offset by that three-year relative TSR.

Steve: Yes, Mark, it certainly can happen. In my experience, committees are aware of how ISS and Glass Lewis view long-term incentives, but for the most part, they don't let them dictate what they do, with one exception. I think this is what you're getting at. At some point, companies will themselves running afoul of the ISS or Glass Lewis Pay and Performance Test, and that's because their tests are fundamentally flawed. They measure compensation on the basis of grant date value rather than realizable value. And so they don't reflect on the fact that options could be underwater, performance-based shares are not hitting a minimum performance requirement, they're taking what's disclosed in the proxy statement, they're using that as the basis.

So at some point, companies are likely to run afoul of that Pay and Performance test, and then they will be critical and potentially recommend against those metrics that don't meet their requirements, like for example, one-year performance metric. And in that case, when they’re recommending against, you know, large investors are more likely than not to align with their vote recommendations.

So in those cases, you do need to show some degree of responsiveness, but it doesn't mean you throw out everything. I've seen companies that actually bifurcate their program such that the named executive officers or the executive officers have a more ISS compliant type of an approach, whereas the rest of the population, they do what they've been doing all along just to maintain the efficacy of that design. Not necessarily works for every company, but that's some of the things I've seen.

Aalap: And Steve, that actually brings up an interesting question. These LTI design shifts don't just affect the C-suite. We've been talking a lot about the executive officers and the names of the executive officers, but your point about the broader population, the design shifts often cascade into broader equity strategies across the organization. What are the implications for how companies think about equity down the line?

Steve: Yeah, great question Aalap, and a great opportunity really to think about the culture that you're trying to create. If you're trying to create a culture of ownership, broad-based equity, however structured, employee stock purchase plan, broad-based RSU grants, one-time all-employee awards, can be very effective in creating alignment down into the organization and creating that culture of ownership. Or maybe you're trying to instill more of a merit-based culture, meritocracy, where you're more selective.

Maybe it's not broad-based, but you go deep into the organization and you target grants at high performers and high pose. That can be a great way to reinforce a merit-based culture. You know that more commonly below the executive level, you don't tend to see performance-based equity. There it tends to be more time-based equity awards, and there is an opportunity to deliver real value. But you need to keep in mind that equity has a cost, and you need to make sure you're getting a return on that investment you're making into the broader employee population. Would those dollars be better spent on a more employee favorable cost sharing split on health care or an additional percentage point on merit? You could actually do a conjoint study that looks at how employees perceive the value of different potential compensation spends, whether it be cash, equity, or benefits. It's great thing to take a look at.

One other point is, and I find this works very well with my clients, don't lose sight of special equity award programs deep into the organization. Things like the Chairman's Circle or CEO type awards, special awards, because oftentimes I find it's more the recognition that employees receive than the actual value that comes from receiving equity awards. So don't lose sight of those as well.

Aalap: Yeah, so, but do you see a growing divide between executive equity program design and opportunities for broader employee groups?

Steve: You know, Aalap, I think most employees understand how things work. They read the newspapers, they see the company's proxy statement. They know how many millions their CEO makes and that the bulk of that is in equity. I think for the most part, they just want to make sure they're being fairly compensated for what they do and the value they provide. As I mentioned, I think broad-based equity programs can be great at promoting a culture of ownership and alignment.

But the broader employee population may be more concerned with shorter-term needs, and I really think a lot of it depends on the company itself, the sector that it operates in, the maturity. You know, PE-backed companies, high-growth tech companies, biotech companies, they're going to be more aggressive in terms of equity spend at lower levels in the organization than say, you know, Fortune 500 utility companies or consumer product companies. So you need to make sure that you're being competitive in the sector that you operate in and it reflects the maturity and growth profile of your company.

Aalap: Yeah, that makes complete sense. It's something I'm seeing across the industries as well, exactly that. It's very industry dependent and what you're trying to do is make a case for the appropriateness of it.

So Steve, one question that's actually coming up from a client of mine. It's a company that's undergoing a transformation, multi-year transformation. The PSU programs have actually been paying out below target. And one of the things that we're contemplating is adopting at least a portion of their long-term incentive program, a structure where the restricted stock vest over a five-year period. So currently it's a three-year period. And so it would be a big shift. But I'm wondering your thoughts on that.

Steve: Yeah, Aalap, any time that your company's going through a transformation, that's the exact right time to be looking at the design of your long-term incentive program. And again, I view it as an opportunity, right? So you're going through a transformation. As part of that transformation, you're setting a new direction for the company in terms of business strategy, markets that you compete with, talent strategy. Perhaps you're going through leadership succession planning as well. It's a great opportunity to take a fresh look at your long-term incentive design to make sure it's meeting your needs. And I don't think it's solely because it's not paying out. It just may be as you chart a future direction, how can we best align management and incentives with that future direction. Now maybe it's such an uncertain type of environment that you're operating in and this transformation you don't know exactly how it's going to play out, so it's very difficult to determine which are the right financial metrics or how to set multi-year performance goals. In that case it could be fully appropriate to use a time-based vehicle. Could be time-based RSUs, could be time-based stock options.

At least until you get a little bit more stability on the organization. I still believe in the efficacy of performance-based equity as an opportunity to align management incentives with long-term value drivers. So while you may use time-based equity in the short term, I wouldn't lose sight of the opportunity to create that alignment over the long term. And maybe it's a balance. Maybe there's some form in time-based equity with multi-year vesting, and maybe some is in the form of shorter vesting with shorter measured financial metrics.

Aalap: I really like that and it reinforces some of my thinking as well because I do think this might be a good time for them to go with that longer time-based vesting.

Mark: Steve, you know as you look ahead, what do you think most important trends are that boards should prepare for? And if you had to give one piece of advice to a board or comp committee that's reviewing their plans today, what would you have them focus on?

Steve: Well, you know, one of the things that's getting a little bit of attention is that shareholder advisory firms, our friends, ISS and Glass Lewis and investors are increasingly pushing companies to disclose forward-looking long-term incentive performance goals. So, as you know, right now, most companies, vast majority of companies, only disclose goals after the fact, both in the annual incentive program, as well as in a multi-year long term incentive program. They don't disclose the performance goals and the attainment until after the performance period is complete. So we could see greater pressure and ISS and Glass Lewis pushing companies to do this to disclose forward-looking goals. Some companies have actually done this. I do think the vast majority of companies will continue to not do so with long-term incentive programs because in essence you're providing guidance on one hand and also you're sharing what's competitive information in terms of what you expect to grow at in relation to broader market trends. So that's one thing that's getting attention that you should at least be aware of and have a discussion around. 

The second one is I would say don't throw the proverbial dirt on stock options just yet. I don't think that they're necessarily done and dusted, particularly if preferences shift away from performance-based equity. I actually think you could see a renaissance in the use of stock options. With one important caveat is that I think options, to the extent they are used, and many companies still use them, they'll be restricted to the more senior executive level because the executives tend to be the ones that have a longer term horizon and they're the ones that tend to hold on to options beyond the vesting period that really make them more cost-benefit efficient because options have quite a cost. There's both the share-based cost in terms of dilution and then there's PnL expense and the efficacy of options apparent until you hold them for six, seven, eight or even up to 10 years. But options are also quite tax-effective. With RSUs and performance shares, they're taxed upon vesting. With options, you have a lot of flexibility with higher tax rates that may be more advantageous for executives. So, I think options still have a place at the table from a compensation design standpoint, but with the caveat that it's more restricted at the executive level.

And then on your last point, Mark, in terms of what advice would I give a comp committee reviewing its program today? Two things I would say. One is first test the efficacy of your current design. I came out in favor of maintaining performance-based equity, but you need to make sure that your program is still operating as intended. It's still aligned with your current priorities in terms of your business and people strategy, and that it evolves appropriately with your changing priorities. Are the goals appropriately rigorous such that your actual pay is aligned with your relative performance? Every company should be doing a historical Pay and Performance test which helps analyze whether or not the program is delivering on your intended performance outcomes. 

And the second most important thing would be around making sure your employees understand the program. I hear this quite often that even senior executives really don't understand the structure of performance-based equity, which causes you to lose the motivational and retentive value of the program. So make sure your company is spending sufficient time and resources on internal communications. We spend a lot of time on proxy statements and getting the messaging right there, but internal communications is equally, if not more, important in realizing the effectiveness of your program design.

Mark: Well, Aalap, I think Steve's given us an awful lot to think about here. It may not be as existential as we thought.

Aalap: I don't know, I'm still having a crisis, but this has been really informative, Steve. It's given me a lot to think about. 

Jake: A lot to think about indeed. I hope this has been as informative for you as it was for me. And we have several more Hot Topic discussions to share in the coming weeks. Be sure to look for new episodes each week on Spotify, pearmeyer.com, or wherever you get your podcasts.