Equity Plan Reserve Management: How to Avoid Share Shortfalls

Managing your equity plan reserve to ensure the availability of adequate shares to meet your company’s needs is a critical responsibility, requiring you to both monitor current share usage and forecast future usage. Nothing derails an equity compensation program more than running out of shares! In this blog, I cover key strategies for equity plan reserve management to make sure your share usage (and your plan reserve) stay on track.

Adhere to Grant Guidelines

Virtually all companies establish guidelines that govern which employees are eligible for equity awards and how many shares they can receive. How well companies adhere to these guidelines can make or break their share reserve.

Most companies incorporate some flexibility into their guidelines so that managers can utilize equity awards to recruit, reward, and retain top performers. But too much flexibility can undermine the guidelines and result in higher share usage than expected.

• Educate Decision-Makers: Train managers on how to properly exercise the discretion afforded to them. Some companies make HR representatives available to help managers with their decisions.
• Implement Guardrails: Set appropriate limits on the use of discretion. This can be in the form of limits on the amount by which grant sizes can be adjusted, an overall cap on the number of shares available to each team, or a company-wide cap on the aggregate number of shares that can be granted during a specified period.
• Evaluate Exception Requests: Establish a robust evaluation and approval process for exceptions to your guidelines. Require managers to develop a business case to support requests for exceptions and convene a (small) team of stakeholders to review and approve these requests.
• Review Decisions: Complete an annual review of year-over-year decisions to identify managers whose share usage is excessive or who otherwise make questionable decisions. This review can also identify employees who are consistently overlooked or overrewarded.

Mitigate the Effect of Stock Price Volatility on Share Usage

Because most companies take a value-based approach to determining grant sizes, fluctuations in your stock price can have a significant effect on your plan reserve. Companies with volatile stock prices are wise to take steps to mitigate this effect.

One common approach is to use a multiday average stock price to convert grant values into shares, rather than a spot price. Not only does this approach result in more predictable share usage, but it also helps ensure that grants are more equitable.

Other approaches include capping grant sizes at a flat share amount, capping the number of shares that can be granted on a company-wide basis, or moving to a share-based approach to grant sizing. In years when the stock price is down, companies might simply keep grants at the same number of shares as in the prior year.

Forecast Future Share Usage

It is important to have an estimate of how long your current share reserve is expected to last, so you have an idea of when you’ll need to ask shareholders to allocate additional shares to your plan. This also gives you a guideline to benchmark your current equity award burn rate against, enabling you to assess whether your share usage is on track.

When estimating future share usage, you’ll, of course, estimate future grants. But don’t forget to also estimate forfeitures, which increase the shares available in your plan and can be an important offset to the number of shares granted.

One approach to this forecast is to start with the number of shares granted in the prior year, then work with your HR team and other stakeholders to evaluate how share usage in the current year might differ. Here are some factors to consider:

• Is the number of new hires expected to increase?
• Is the number of employees eligible to receive grants expected to increase?
• Is employee turnover (and, thus, award forfeitures) expected to increase?
• Are performance award payouts expected to be at, above, or below target?
• Are there any changes planned for the company’s grant practices that will affect share usage?
• How is participation trending in your ESPP? Will participant compensation levels increase in the future?

Because you don’t have a crystal ball, I recommend forecasting at least two scenarios—a low and a high. This share usage forecasting spreadsheet available from the NASPP website includes three forecasts: low, moderate, and high.

Monitor Share Usage Throughout the Year

Waiting until the end of the year to evaluate your share usage leaves you with little opportunity to course correct when usage is higher than expected. Instead, net share usage (grants less forfeitures) should be part of your monthly or quarterly reporting process. Don’t forget to include your ESPP in the report!

Ideas to Extend Your Plan Reserve

If the number of shares available for grant in your plan is running low (or if you’d just like to delay having to ask shareholders to approve more shares), here are some ideas to extend your plan reserve.

Inducement Grants to the Rescue

Inducement grants are essentially a get-out-of-shareholder-approval-free card and they can be a great tool for preserving your share reserve.

As I’m sure most of my readers are painfully aware, it is virtually impossible for public companies to issue equity awards outside of a shareholder-approved plan. One significant exception to the shareholder approval requirement is inducement awards. These are awards that are granted for the purpose of encouraging individuals to accept an offer of employment. Under both the NYSE and Nasdaq listing requirements, these awards are not subject to shareholder approval.

This almost seems too good to be true, but there are some catches:

• The grants must be issued to newly hired employees. Inducement grants can’t be issued to existing employees (even if you are trying to induce them to stay) and can’t be issued to nonemployees.
• The terms of the award must be communicated prior to the individual’s acceptance of the employment offer or as part of the hiring process.
• The award must be approved by independent directors. In light of Delaware’s relaxed approval requirements for equity awards, your board may have delegated authority to approve grants to an officer, other individual, or a committee. That approval process can’t be used for inducement grants.
• There are some required disclosures that must be completed and there are securities law considerations to address (the Form S-8 filed for your shareholder-approved plan might not cover these awards).

But even with these considerations, inducement grants are a great ace to have up your sleeve when your plan is running low on shares.

Alleviate Share Usage with an ESPP

Another great idea to alleviate some of the pressure on your long-term incentive plans is to implement an employee stock purchase plan. ESPPs can offer a fantastic economic benefit to employees and share requests for ESPPs generally aren’t subject to the same level of investor scrutiny that requests for other equity plans are.

ESPPs are on the rise, both in terms of prevalence and plan benefits. In the NASPP/Deloitte Tax 2024 Equity Incentives Design Survey, the percentage of public companies that offer an ESPP increased to 57%, up from 49% in our 2021 survey. In the NASPP/Deloitte Tax 2023 ESPP Survey, the percentage of ESPPs that offer a 15% discount and that offer a lookback increased significantly.

Increase Shares Available for Grant With Share Withholding

When shares are withheld to cover taxes, it may be possible to recycle those shares back into the plan. Although share withholding will result in cash outflow for the company, having the additional shares available in your plan may be an acceptable trade-off. If employees currently sell shares to cover their taxes, switching to share withholding can enable you to reroute shares back into the plan that would otherwise have flowed into the market as a result of those sales.

One caveat is that the plan generally must specifically stipulate that the shares withheld for taxes will become available for grant again under the plan. Companies obviously cannot recycle withheld shares if prohibited from doing so under the terms of their plan. 

Moreover, ISS considers recycling of shares withheld to cover taxes to be a liberal share recycling policy, which reduces the number of points the plan can earn under the ISS Equity Plan Scorecard. This could have the effect of reducing the share allocation for the plan that will receive a favorable ISS recommendation. When adopting a new plan or amending an existing plan, companies should model the effect of the liberal share recycling policy to determine whether the shares that are expected to be recycled will exceed the additional shares that could be allocated to the plan if the plan did not allow recycling.

Consider Cash Payments

An obvious way to extend your plan reserve is to pay employees in cash, rather than equity. Cash-settled awards and stock appreciation rights can mimic the economic benefit of equity awards without requiring the company to issue shares.

Of course, there are significant drawbacks to cash awards, most notably that they will be subject to liability treatment under ASC 718 and can result in significant cash outflow for the company.