Transcript: 5 Equity Plan Numbers to Have at Your Fingertips
Wednesday, February 20, 2019
4:00 – 5:30 PM, Eastern time
Never fear urgent calls from your leadership seeking data on the equity compensation plan. Be prepared and shine like a star by knowing five key figures you should always have on hand. Learn in detail how each figure is derived, plus to whom each figure is most relevant.
Also covered in this program:
- Monitoring your share pool to ensure an accurate count of shares available to grant;
- Preparing an accurate earnings per share, dilution and overhang calculation;
- What your burn rate means and why it matters;
- Calculating your covered employees under the revisions to 162(m).
- Valarie Dennis, TAE Life Sciences
- Lisa Klevence, CEP, Plan Management Corp.
- Elena Thomas, CEP, Plan Management Corp.
Shares Available to Issue
EPS Dilution/Overhang
Share Plan Run Rate/Burn Rate
New Covered Employees & 162(m) Calculation
Executive Grant Status
Kathleen Cleary, CEP, NASPP: Good afternoon, everyone. Welcome to our webcast, “5 Equity Plan Numbers to Have at Your Fingertips.” Our panel today will be discussing vital numbers to keep up-to-date at all times, and that will ease your dread of those urgent phone calls from the CFO or CEO looking for a data on your equity plans.
First, we’ll start with some introductions. My name is Kathleen Cleary and I’m the Education Director for the NASPP. I’m very happy to welcome an exceptional panel of industry experts, Valarie Dennis from TAE Life Sciences; Lisa Klevence, CEP, from Plan Management Corp.; and Elena Thomas, CEP, also from Plan Management Corp.
Just a couple housekeeping items, the slide presentation for this webcast is posted on our website, NASPP.com and you can download it or print it out if you’d like to take notes on the slides. If you are logged into GoToWebinar, you should be seeing the presentation slides move as we go through the webcast. We will have a couple of polling questions, and, of course, you’ll also have the opportunity to ask questions throughout the webcast by typing them into the GoToWebinar panel.
If for any reason we run out of time and are unable to get to your question, we’ll follow up afterwards by email. You can always email me directly as well. We will post an archive of today’s program within the next day or two and then a transcript will be posted to the website in the next few weeks.
OK, let’s dive into the webcast and I will turn it over to Elena to get us started.
Elena Thomas, CEP, Plan Management Corp.: Thank you for joining us today. Just to briefly introduce myself a little further, my name is Elena Thomas. I am the Head of Operations for Plan Management Corp., the provider of the OptionTrax software and administration services.
We focus on private companies through public companies with up to approximately 5,000 participants and we’ve been in the space serving both private and public companies for quite a while. The company is about 25 years old and I’ve been with them about six years now.
Now I will turn it over to Valarie to introduce herself.
Valarie Dennis, TAE Life Sciences: Hi there, my name is Valarie Dennis and I’m a consultant for TAE Life Sciences. I have been working primarily with small private companies—startups for the most part—but also mature private companies. I’ve been doing this kind of work for the last 15 years or so, both for the company itself and also for law firms that service those kinds of companies.
Thomas: Great, thank you, Valarie. Lisa Klevence is due to be with us as well. I apologize in advance, but we are on the East Coast, and under some snow currently, so she was having a little trouble connecting. Hopefully, she will join us soon. On that note, I have got a couple of little children running around downstairs, so if you hear some small voices, please excuse the background noise.
Let’s jump in, as Kathleen mentioned, what we wanted to talk about today are five equity plan numbers to have at your fingertips. Currently, most everybody is just coming out of year-end reporting, and likely have produced a lot of numbers recently. We really wanted to focus on the numbers that our clients have told us over the years are the ones that they get those urgent end-of-the-day calls and have to turn around quick numbers. They always wish they had a better quick grasp of the information. As administrators, it’s good to take a step back and think about who the different parties are that are looking for this information and why.
Each of these groups has their own interests and motives, and to the extent that we can keep that in mind rather than just trying to memorize and have numbers that we spit out into our annual filings, that can help us be better administrators, and facilitate our executive teams, compensation committees, et cetera to succeed which therefore helps us succeed in our roles.
In addition to all the regulating authorities that we’ve all just submitted a lot of information to, today we want to talk about who the parties are that are most interested in the equity plan numbers. The board of directors and comp committee, of course, are often making a lot of the decisions regarding the equity plans based on the information that we, as administrators, are providing to them. Our investors and shareholders, of course, have an interest, both institutional, individual and then, of course, the proxy advisory groups that advise them. And finally, our participants and the auditors supporting the organization, who again, are often only able to be as good as the information that we can provide them.
Often, folks get thrown into equity compensation and find it near and dear to their hearts, as we all do. I think we don’t often find folks who necessarily set out to find a career in equity comp, instead they end up there, with some twists and turns. Sometimes not by desire, but just the way things end up as you go along. The worst part of that process, of course, is hearing that phone ring when there might be a question on the other line that you’re not ready to handle. So today, we really want to talk through how we make sure we’re not going to get caught off-guard by ad hoc requests.
There are a lot of things that could come from a lot of parties, but what we’re focusing on today are really on the ones that we’ve heard from our clients, both public and private, are the ones that they most often get questions about from various parties. We’re going to talk about shares available to issue, EPS dilution and overhang, run rate, burn rate, and, of course, the updates to covered employees and executive grants. For all of these, we’ll also talk about some recent updates that have come out either related to tax reform or changes from ISS.
For each of these, we’ll go through who is most likely to make that call, what exactly they’re looking for and the quickest way to get to that number.
Cleary: That brings us to our first polling question. I’m going to put it up on the screen here.
Thomas: We thought it would be fun and we did this at the conference as well, just to get a sense of how many of you on the line have ever received an urgent request for some of this information, somebody looking for a quick turnaround or claiming that it’s desperately needed for a meeting tomorrow or maybe even sooner.
Cleary: Yes, like I need it in 5 minutes. I think we’ve probably all been there, we’ll see what the poll says. It should be up on your screen now, please enter your response. I’ll put up the polling results in a minute and it will be interesting to see what your other colleagues listening to this webcast with you are experiencing.
Okay, I’m going to close the poll and I share the results with you.
Thomas: These results are about what we saw at the conference. I think this is the reason it was one of the highest registered events last year—I think everybody has been there and, of course, we all know that we’re going to be there again. We’re all in the same boat. Hopefully, at least, that makes you feel a little bit better and after this session, hopefully, we’ll feel a little bit more prepared.
Now I’ll turn it over to Valarie who is going to talk us through the first section here.
Return to Index
Shares Available to Issue
Dennis: Okay, our first equity plan number to have at your fingertips is how many shares are available in your plan to be issued to your employees or consultants in the form of a grant. In my role, I get this question most often from the CEO. When he wants to solicit a new executive, he needs to know how many shares are available for the prospective person’s offer letter as part of his compensation package.
The CEO is certainly a person you’re going to get that call from. You might also get it from your head of H.R., depending on how big your company is and how they delineate responsibilities.
Your compensation committee is certainly going to be looking for shares available to grant because they are typically the ones responsible for the overall compensation plans, of which equity compensation is a portion. Depending on how your plan is written, your board of directors may have responsibility for authorizing grants and will need to know the number of shares available.
Thomas: I think a lot of times we think, “OK, we know annual reviews are coming up and they’re likely to do a big bunch of grants,” and so we make sure we have this number in mind at the end of the year or the start of the year, whenever your big grant period is. But as Valarie mentioned, often where people get caught off-guard is when your company has an individual in mind that they really want to attract—and it’s totally out of cycle or ad hoc—and they want to know the number immediately because they’re already working on drafting an offer letter.
It’s one of those numbers that I think is more often a surprise—it can be ad hoc as opposed to generally being prepared with that number when you’re going into the annual comp committee review.
Dennis: Absolutely. A lot of times what happens is there’s a negotiation process and it will go back and forth. The CEO may be looking for a new chief financial officer and they’re going back and forth negotiating and they think, “Oh, this extra 20,000 shares shouldn’t make a big difference.” Then they come to you and say, “So, I just negotiated this offer with this new executive employee and we’d like to be able to make this grant,” and then you need to be the one to tell them, “Well, that could be a problem because we don’t have that many shares available to issue—no one bothered to check or to really understand what these numbers mean.”
I’ll give you a real-life example. We have a consultant who works for the company and he was given, as part of his consulting fee, options. I don’t know why you do that for a consultant, but he was given options and those shares, of course, came out of the available pool. When we talked to the attorneys, he’s no longer a service provider. Now we have an issue with, “Oh, dear, the plan is written that these options will go back to the plan if they’re not exercised.” That isn’t how the consultant understood their agreement.
The CEO is thinking, “Well, that’s fine. I will just issue him stock instead,” not understanding that all of those numbers tie together. You just can’t issue a grant or stock and not have it impact each other because we’re talking about all derivative instruments and issuances.
This is an opportunity for you to be a true value-add to your company. The CEO doesn’t understand the big picture for how these numbers work together. That is really your responsibility to be sure that you’re on top of things and that you alert them.
If you know that there’s going to be a big hiring boost, you just got a new contract to build something at your company or there’s going to be a massive increase in personnel, you’ll need to find out from your H.R. department or your executive team the potential shares that may be granted.
If you can get out in front of it, you can tell them things like, “Oh, by the way, we need to get enough shares in the plan that are available to issue. You’re looking at issuing 50,000 shares but we only have 30,000 available, that’s going to be a problem.” Or, “We need to look at whether we’re going to be giving grants to salespeople as part of their sales incentives.” Be sure that you always have enough shares onboard.
It’s so much easier if you ask those questions earlier rather than later. I would much rather go to the CEO or to the head of H.R. and say, “Hey, what are the quarterly projections for new employees, and are we hiring mostly rank and file, or are we looking to hire new executives or new middle-management? Oh, and by the way, here is where we are with the number of shares we have available to issue.”
Those are things that you really only have an understanding of and that your CEO and your board really don’t understand. They think it’s just an unlimited number of shares that they can offer, not understanding that these things impact what they can do and the kinds of contractual relationships they’re going to be entering into.
It’s just so much easier if you get ahead of it, and that way, you can look like a white knight and say, “You know, we’re getting down to less than 10 percent or less than 5 percent of the shares available for issuance.” If you’re going to be approving grants, we need to talk. You need to talk to the board strategically about how we increase the size of the pool and what kinds of things we need to do in order to get in front of potential shortfalls. It gives you a higher visibility in the company to be able to do those things.
Thomas: Yes, and I’ll just add, there certainly are companies where the CEO and comp committee are quite aware of how these things work, but they’re still not going to have their fingers on the weeds of exactly what is left at what point in time.
Dennis: Absolutely, and it’s really easy to not understand that all of these things have an interplay. You are in a unique position to be able to pull those numbers immediately. What you don’t want is to get a phone call while they’re sitting in a meeting—and I have had that happen—the comp committee or board is meeting and they want you to pull those numbers immediately. That’s when it’s really hard, so it’s great if you can get in front of the CEO or the chief H.R. person in your company and say, “Hey, what kinds of things are on the agenda so that I know and I can be prepared?”
The other thing I would recommend that you keep an eye on—because this also came up recently in a board meeting for a company that I worked with—what is your 409A valuation and when is it going to go stale? This is only for private companies, but if you work for a private company, know what your share price is. I have a CEO who promised grants and the company can’t make them because their 409A is stale.
Those are just a couple of things that nobody really thinks about and it really makes you appear as a true value-add for the company if you keep an eye on them. You keep can help keep them out of trouble and informed.
Cleary: Great, let’s talk about how we get there.
Dennis: Okay, you have your total number of shares that are available for issuance, whatever that number is. That’s your total number and has to include any shares that are granted or issued, any performance-over-targets, any shares canceled or shares held for taxes, any DEUs.
When you subtract that from your total share issuances, that’s the number of shares you have available to grant. For a lot of the companies I have worked with, their number actually could be hardcoded into a stock issuance document. I have worked with private companies and a lot of times in the most recent stock purchase agreement where the company is selling their preferred stock, there will be a hard number coded in the share issuance number. It’s a hard number, and could still be above or below the basic shares that are available for issuance once we’ve subtracted all of these things. It’s something else you also need to be aware of, whether there are any artificial hardcoded contractual obligation numbers that you have to keep your plan under. You may also have a plan with a cap of say, a million shares.
Even if we increase our authorized share total, I still have the contractual requirements that I can’t issue more than a million shares unless that number is changed by a superseding contractual obligation. Just something else to be aware of, especially when you’re dealing with private companies. You’ll want to check with your corporate plan documents, and check with whatever your SEC plan registration is, sometimes in your plan itself. It may require stockholder approval to change the number of shares. And always be sure you have the latest shares authorized number, in case it has changed.
For me, even with small companies, I really prefer to use a cloud-based tracking program that will give me these numbers so I can just log in and I can look immediately, rather than trying to track them on Excel. For me, that’s easier and I would definitely recommend it. I’ve used a cloud-based program with companies as small as five employees or for companies with hundreds of employees. It’s just easier for me.
Cleary: Before we move on, I do have a couple of questions that have come in. I’m happy that our audience is asking questions and I probably should mention—just in case you’re hesitant to put forward a question—nobody sees your name, so please feel free to ask anything you would like. Let me stop the panelists here and ask you to define what a DEU is? We had several questions about that.
Thomas: That’s basically a dividend equivalent unit. Generally, you’ll see DEUs on RSUs that are accruing dividends while they’re vesting. When the award pays out at vest, not only the underlying shares for the award are released, but additional shares that have accrued as part of the dividends that were paid during the period the award was vesting.
Cleary: Thank you, and let me back you up just one slide. Can we explain what a 409A is? I think Valarie mentioned the valuation when she was talking about a private company.
Dennis: Private companies have to have their common stock valued because they don’t go out in the marketplace like public companies do. They have to have their common stock valued no less than annually unless there has been a material change in the business that would warrant a new valuation of the shares.
It’s really to protect the shareholders, so that the company is not responsible for just saying, “Our common stock is worth $18.” What’s the basis for that? Private companies hire a valuation firm that comes in and runs an analysis based on the financials, the kinds of contracts, overhead and risk factors the company has.
The public market is where you file your 8-Ks and 10-Ks, so the public knows what’s happening in a company. In a private company, there’s a lot less public oversight. The shareholders don’t have as much access to information as in the public market. So, valuation companies come in and take an exhaustive look at the company and prepare a report. The reports are 30 to 70 pages long, based on the risk factors and various things. They have to show their methodology and then compare them to other companies in the same kinds of fields and determine that the price of your common shares should be “X” and that’s the price you will use to issue options or awards.
If you’ve had a material change in your business, you need to get a new 409A valuation and go through the process again. You also have to do this at least annually; it’s only good for one year and then you cannot make any more grants until you have the analysis run again.
Thomas: Just like in a public company where you can’t backdate your options—although the prices aren’t moving as often in a private company—that’s why the expectation for an updated 409A valuation is annually. There are a lot of specific accounting firms that focus on that. For companies, there are some providers who offer a 409A subscription, or external valuations can usually be fed into your software to use as an equity award price.
Dennis: Actually, in the board minutes of a private company, every time you make grants, the board has to certify that the 409A is still valid; that’s part of their fiduciary responsibility as being a board member when approving grants. There isn’t as much public oversight in a private company, so the board has to take on that responsibility. If you work for a private company, you will likely work very closely with your CFO to ensure that your 409A is up to date and keep track of when it expires, so that your CEO does not promise grants at a certain stock price that isn’t current.
Cleary: Let’s go ahead and move on. I believe the majority of our members listening are working at public companies, but that’s great information on the 409As if you should find yourself at a private company.
I do have a number of questions that came in. Valarie mentioned cloud-based platforms and we don’t necessarily recommend one platform over another. For those of you who had that question, I would encourage you to reach out to Valarie directly.
Just a couple more, we had someone ask if you’ve ever heard of a company who allows shares held for taxes to go back to the plan, but for shares withheld for taxes above the statutory maximum rate, the shares over withheld don’t go back to the plan.
Dennis: Elena, will you answer that question? I have not heard of one.
Thomas: I have not seen that yet, but it doesn’t mean it’s not happening.
Cleary: I’m sorry we don’t have an answer for this participant, especially if that’s what you’re doing at your company. You might want to do a little more investigation and just be sure whatever you’re doing, you are consistent and you document your methods. Let’s move on to the next slide and talk about fungibility.
Thomas: Sure. This is just one example of showing how all these numbers that seemed pretty basic, seem to end up getting more complicated, which I would say, seems to be exactly what happens with most things equity comp.
Valarie just went through the basic shares available to issue math, which is fairly straightforward, and she said, making sure you know the rules of your own plan about what goes back to the plan is important.
However, the other piece of this is fungibility. Increasingly, there are companies out there that account for full value awards at a higher ratio of stock value than options, because they are full value and won’t expire unexercised like an option might.
In that case, you would have to make sure that you’re also applying that same fungibility ratio to your shares available to issue math. The same basic premise except in this case, you’ve got a one-to-one ratio for options and a one-to-two ratio for full value awards. Then you’re basically going to have to apply that ratio to each area of the shares available to issue by both subtracting the granted as well as anything that gets added back to the plan.
One important thing to note here is that however you are tracking your own plan internally, the proxy advisers—ISS in particular—uses different ratios for options and full value awards. Whether you’re doing it or not, the advisory groups will apply a particular ratio when tracking your shares granted.
We thought it would be interesting just to see here how folks listening are managing their share pool, in terms of some of these factors.
Cleary: All right, I’m going to go ahead and launch the next poll, please make your selection. Do you return the held shares? No fungibility, do you not return them? With fungibility, return to the plan or don’t return to the plan?
Thomas: Basically, do you return your withheld shares and you do not have fungibility, you don’t return shares with no fungibility, you do return shares and you do have fungibility or you don’t return shares and do you have fungibility?
Cleary: Hopefully, it’s clear, I’m sorry for the confusion. While everyone is entering their responses about shares held for taxes, one of our participants today had a question, what do you with the shares? Do you return them to the plan? Elena or Valarie, do you have a comment on what might happen with the shares that are tendered for taxes?
Thomas: We see a few different things. Sometimes, they aren’t retrievable but they actually are held in treasury by the company and could be reallocated again at some future time. Sometimes we see shares directly added back to the equity plan pool, meaning that they could be directly issued again as new equity plan awards.
Cleary: All right, let’s close out the poll and I will share the results with you.
Thomas: It is interesting to note that we did see similar results at the conference and there’s a significant number—about a third of the folks listening—who aren’t sure. And that’s fine. As we said, this is really in the nitty-gritty, but hopefully a helpful flag for you—if you are in that “not-sure” bucket, it would be a good thing to get a handle on.
I think sometimes, folks don’t realize—particularly if you were at one company for a long time and then switch—that there is so much flexibility in this. You may just assume, “Oh, we did it this way and I have no reason to think otherwise.” But it is a good reminder to check what’s in your plan documents.
Cleary: Can we just give a quick definition for fungibility so we can make sure we’ve covered all our bases?
Thomas: Sure, fungibility basically means that you’re applying a ratio that may differ to the different types of awards. While one option is worth one share from the pool, perhaps a full value award is worth more, maybe two or more shares from the pool. Fungibility is generally the term used to apply different ratios to different award types with regards to share counting.
Cleary: Okay, let’s put away the poll and we can move on to EPS Dilution/Overhang.
Return to Index
EPS Dilution/Overhang
Thomas: Most of the folks listening are at least familiar with the term, to the extent that shares authorized or issued as part of the equity compensation plan will dilute the earnings and voting power of your existing shareholders.
Just like every full share issued impacts dilution, so does the potential of those shares being issued as a result of equity awards. The big ones here are really your investors, and in particular, proxy advisory groups. I will talk in a bit about some changes that have come around from that.
This is pretty straightforward in terms of why shareholders care. They’re concerned about how the plan activity is going to impact the value of their own securities and their voting rights. A big area in terms of shareholder rights and securities are tangential, but a related area making sure plans don’t have terms like repricing and things like that.
Basically, what your investors are holding out for is to ensure that you’re minimizing the impact on their value and that your equity plan participants aren’t receiving any rights or benefits that your shareholders aren’t receiving.
For them, the higher the EPS, the greater the return on investment, so to the extent that you are increasing the denominator, that does not make them happy if it’s out of line. Dilution is also specifically an issue on the ISS scorecard, calculated both with and without overhang and we’ll touch on that.
Your basic overhang calculation is three factors: your equity plan shares authorized but unissued (as we said in the previous topic, your shares remaining in the plan pool), your outstanding equity plan shares and then your total outstanding common shares. Your existing overhang is basically just the sum of the authorized but unissued annual outstanding over the sum of all three of those.
The example here on slide 13 shows, if you’ve got somebody who has got 10 shares and the company approves a plan for 20 new shares, if all of those are actually issued, that’s 120 shares of common stock. The dilution impact is 16.66 percent. It’s basically a way to quickly show how is that impacting the dilution of the overall shareholder group.
Once you get into diluted EPS, your net earnings are divided by your common stock and your potential common stock. Most commonly, at least in the U.S., we see the treasury stock method used to calculate EPS dilution. Some of the main assumptions here are that any underwater options at the time you’re making this calculation will be excluded, and you’re going to always weight shares for the full period if they were outstanding prior to the period or based on the grant date.
Just to take a step back more academically and understand where this is coming from, the thought here is that the exercise proceeds (what your participants pay you in order to exercise their awards) are used by the company to buy back shares on the open market based on the average market price. Even though you’re going to be diluting, you’re also getting cash in, and if you were trying to manage for dilution, you could use it to buy shares back.
The other proceeds used in the calculation are your average unamortized expense proceeds. I have yet to find a great rational explanation for that, but sometimes the rules are the rules. Basically, you’re taking your shares that are weighted outstanding and you’re going to subtract the shares that could have been repurchased with these proceeds and then the additional dilution from your equity plan. That gets baked into the broader EPS calculation.
A couple of things to keep an eye on, we recently brought on a public company that had been calculating this in Excel. They actually were taking their restricted awards as a full outstanding addition in the dilution. I know it gets confusing because we’re talking about fungibility and the full value awards count for more, but in terms of EPS dilution, the restricted awards also get run through the treasury stock method in the same way as the options do. They’re not just added in directly. You also have to make sure that they are removed from any outstanding numbers that you get from your transfer agent as the starting base for common stock outstanding.
Next slide, we’ll talk a little bit more specifically about this calculation. As Valarie mentioned, a lot of you are using a tool to calculate this, but it’s always good to at least understand where that numbers are coming from. To make this calculation, you would disregard your underwater options, and calculate the weighted shares outstanding in the period, considering whether the award was granted or settled in the period, and how many days it was outstanding.
Then the assumed proceeds, as I’ve touched on, are the exercise proceeds, which is really just the exercise price times the shares outstanding. For most restricted awards and units, there is no exercise price, but your options, SARs and other awards will be based on your option price.
Then your average unamortized expense on each grant at the start and end of the period divided by two, for your average, and then also weighted by your weighted shares outstanding.
I don’t know, Kathleen, if anyone else on the line has ever heard a great academic reason for that, but that’s how it is. Please send us a note if you have any insight on that.
Calculating the buyback shares is basically adding all your proceeds and dividing by the average share price, assuming the company uses the proceeds to buy shares back in the market. If your buyback shares are greater than your weighted shares outstanding, it is considered non-dilutive. Otherwise, your weighted shares outstanding minus your buyback shares are going to be how many shares are dilutive usually on a grant-by-grant basis and then summed. They are going to get added into your overall EPS calculation.
Hopefully that helps you to understand the background of this number, why folks are looking for it, and as we said, just a couple of things to keep an eye out.
One other thing to note is for performance awards, both from proxy advisory firms and generally, best practice is that the performance awards—if well-documented as performance awards, with clear criteria—do not have to be included in the EPS dilution calculation for your plan until they are considered contingently issuable. In whatever reporting period they become contingently issuable, then they need to be accounted for in that entire period. Until then, they can basically be excluded from the EPS dilution calculation.
We can move on to the next topic if there are no questions on that.
Cleary: There is a question about tax effects. Do you want to comment on tax effects and why that’s not considered in the treasury stock method anymore?
Thomas: That’s a great question and tax effects were formerly included in the treasury stock method until ASU 2016-09. Basically, it goes kind of hand in hand with the removal of the APIC pool. Once ASU 2016-09 was adopted, your net tax effects go directly through the P&L. As of that ASU update, they are no longer included in the EPS, but previously, they were an additional source of proceeds.
The other thing I’ll note is that generally, investors will evaluate the overhang of a company by comparing it to peers and the industry. It really isn’t just a standalone number where you’re trying to do as well as you can, it is also something that will be looked at comparatively. Also note that the ISS dilution calculation is a little bit different, it’s called a shareholder value transfer. You may see that SVT model and again, your full value shares are weighted more heavily than options.
Now I’m ready to turn it back to Valarie.
Return to Index
Share Plan Run Rate/Burn Rate
Dennis: We’re going to talk a little bit about run rate or burn rate, and the terms are interchangeable. What they refer to is, how quickly are you going through the remaining shares you have for equity incentive purposes? How many shares do you grant on average on an annual basis? That will give you an idea of how long your pool should last.
As long as you don’t have certain unexpected things happening, for example, if you replace one of your executive officers, that could certainly result in having an unexpectedly higher number of shares issued in the plan year.
It’s going to be asked by your comp committee, your board, and your investors, because every time you increase the share pool, you have made their investment a little more diluted, and their shares are worth a little bit less. Every time you have to go to your investor base for another 500,000, a million, 2 million, 3 million, (however many shares), it means that their percentage of ownership in the company is going down, which is why it’s always a little challenging to get additional shares approved.
In a private company setting, we usually sandwich this in when we are going to be doing a new capital raise, which will increase the value of their shares, so although we’re going to take a little bit away, their shares are worth more money afterwards.
If you can get them to sign on to expanding the share pool, especially if you can promote it because the company is doing well and needing to be able to attract talent, which also will make your investment more valuable, that may work well.
In a public company, you have proxy advisory groups that are going to be asking for this information. If you know that you are going to be hiring a large number of employees, you’re opening a new plant or buying another company, maybe increasing the number of executives who will be granted larger awards, your burn rate or run rate is going to be significantly higher. If you’re going through a period of time where your company is stable, you have a year or two where people are coming and going, shares get returned to the plan and then they get reallocated to other people. It’s relatively constant, then you don’t have a run rate problem.
It is nice to be able to anticipate, so you can get ahead of it. If you know your plan is running low, maybe within 10 percent of the number of available shares for issuance, I always send an alert to my chief H.R. officer or my CEO and say, “Hey, what are the thoughts? What are the plans?” You’re probably not in those executive strategy sessions, so you’re not necessarily aware of things that are coming down the pipe in the next 6, 8, 10, 12, 15 months. But if you alert them, “Hey, if you’re planning to do something, you need to be aware that we are running low on the numbers of shares that we could issue for equity compensation.” It’s always just nice to get ahead of it.
Thomas: For public companies, you have to go back for shareholder approval, it’s really a significant event. Just like you want to know about the cash burn rate, how fast you’re burning through cash, there are a lot of groups interested in how fast you’re burning through your equity.
Dennis: Private companies also get shareholder approval. If you don’t receive it within a year of increasing the pool, all those grants are then canceled. It’s one of those things you want to stay ahead of and be able to alert people if the pool is getting low. If your company is planning anything big, you’ll want to be sure you’re ahead of this.
Thomas: Specifically, as we’ll touch on in a minute, ISS does include this, looking at a three-year average burn rate. Understanding there’s some room for fluctuations year-over-year, but it does directly matter as a number on ISS scorecard.
Dennis: In order to calculate the burn rate, you take the total number of shares issued in any fiscal year for incentives (options, RSUs, restricted stock grants) and divide that by the total number of common shares outstanding at the end of the year. That gets to the gross calculation of your run rate or burn rate, so you know exactly where you are.
To calculate your net run rate, subtract any canceled or forfeited equity awards from the total shares issued. Performance awards are added as they are earned rather than as they are granted because they are technically not yet issued to those employees.
Your run rate becomes the denominator and that will let you know how long your current plan shares should last. It’s really just an estimate—if you’re not aware of certain things that might be happening in the company then you can’t take those factors into consideration. You can provide big picture numbers, but you also want to show your numbers and rationale behind them to your CFO and CEO, so that they can validate your assumptions. You’re really only making an assumption of how long the shares you have in the plan should last, based on the factors that you were aware of. They really need to help you validate those numbers.
If you find out that your numbers are low because there are things happening that you were unaware of, you want to be sure you alert them because if you consistently run out of shares, that shows that your board as a whole is not keeping any eye on their governance, and that can reflect poorly on how you run your company.
Thomas: It is a factor that will generally be compared as well, so not just in and of itself, but compared to peers, particularly industry peers. Obviously, investors know you’re likely going to see a much different run rate on your equity plan shares at tech companies than you are at banks. But they still want to know within your peer group if you’re managing the share pool responsibly.
Dennis: Absolutely, and that’s for private and public companies. For private companies, their goal is to ultimately get merged or go through an IPO process, so they want to be sure they have good governance. This factor is a huge part of demonstrating good corporate governance, you want to be sure that things are clean and you’re not going to your investor base every six months saying, “Oh, we ran out of shares because we weren’t paying attention.” It makes you look bad. And it can reflect on your ability to get a good stock price when you IPO or a good sale price if you get purchased.
Thomas: Right, and obviously, for a public company, you’re going to end up with a “no” vote as a result of a few repeated requests.
Let’s go ahead and take a look at the ISS perspective in particular. As I mentioned, ISS uses a three-year average burn rate as a percentage of market cap, compared to the benchmark for recent years, at which basically the max is at or below 50 percent of the relevant industry benchmark. Similarly, they’re looking at the plan duration—and that’s something I will talk about in an update as well—but they want to make sure that you’re keeping an eye on consistency in the plan duration.
Similar to EPS, the specific language is performance awards are clearly and consistently disclosed. ISS will include those, again, when earned rather than granted. The way it’s being looked at, you’ve got your total options issued. You do have a multiplier on your full value shares, so they are still a higher weight for restricted awards and units, then over your weighted average, common shares outstanding—very straightforward actual numbers.
One thing to note is that ISS will not calculate a burn rate for companies with less than three years of history. If you’re newly public or recently had a bankruptcy, you get a little bit of time to get things in order before they are going to start calculating that factor.
Specifically, in this area, there have been some updates this year. ISS has created what they’re calling a new negative overriding factor. If your plan creates excessive dilution and it will be easy to dilute the shareholder’s earnings by more than 20 percent or 25 percent based on the model here, S&P 500 or Russell 3000, then that can immediately trigger this negative factor. This becomes even more important.
I think it is partially related to the second point here. There has been an increased weight on the importance of plan duration. Previously, Section 162(m) basically guaranteed that public companies would go back fairly often to have the plan submitted for re-approval to make sure that they could comply with the 162(m) rules for deductions.
Now that has been eliminated and even performance awards are not considered tax-deductible over the $1 million limit. They’re concerned about having less resubmission of the plan and that’s really the driving factor for the increased weight on plan duration that we’ll see on the ISS scorecard going forward.
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New Covered Employees & 162(m) Calculation
Thomas: That ties directly into this next section. Probably everyone on the phone has heard about this by now, so we won’t spend too much time here. Essentially, the status of your covered employees and the definition has changed, based on the tax reform. Employees that must be disclosed in the proxy have changed. The addition of the CFO, and other employees will be subject to the 162(m)-deduction limitation.
This year, you’re likely to get everybody asking to make sure that you’re on top of the changes. That will likely settle, but certainly in the next year or so, finance is going to want to know. Tax, of course, is tracking the deduction; the auditors and the proxy group advisories are going to make sure that you are complying with the additional tracking requirements.
It ties into the reason why do they care. These covered employees must be disclosed in the proxy report, so any auditors working with you and anyone from finance, will have to make sure that they’re on top of the real inclusive responsibilities there.
The changes to 162(m) make it even more important that we’re keeping track. As always, this type of information has gone into general corporate governance and say-on-pay assessments.
Moving on to what’s actually changed—previously, the CEO and top three highest paid executives, excluding the CFO were covered employees. The CFO has now been included, which frankly, a lot of folks thought should be the case for a long time.
Previously, officers were covered employees as long as they were holding one of the highest paid positions at year-end. That’s changed. It’s now once covered, always covered. Even if a covered person changes roles, as long as they’re receiving any compensation from the company, they would be expected to be included in this covered employees list.
Obviously, the other big change, performance awards previously were completely deductible for purposes of 162(m). Now, they are no longer exempt, they are subject to the $1 million deduction limit. There was a lot of discussion back and forth when this came out. But we are not going to see a race away from performance awards or people saying, “Let’s not bother with these complex awards anymore.” There are a lot of other reasons why performance awards are important to align incentives for executives and for say-on-pay. They’re strongly preferred by investor groups as well, so, we don’t expect them to go away any time soon. But we do lose the deduction over $1M.
A quick example, in the old 162(m) math example, if you have an executive with a base $450,000 salary, $300,000 cash bonus, some service-vesting RSUs at $150k and then their performance award with a max of $150K payout. If it’s paid out at $125,000, previously, you would be under the 162(m) limit calculation because those awards are excluded.
Now, you would actually be $25,000 over that limit calculation. I think what complicates this is that most often, performance awards are evaluated at year-end. Not only are you doing this at the last minute where everything else is already going on, but often they’ve received all of the rest of their compensation and you are brought this last minute based on the payout range and the last-minute adjustments you have to make.
If you get ahead of it, understand the potential for any of the awards you have that could be at the max payout and could impact the 162(m) calculation—before your year-end rush—that would really make a big difference.
Moving into our last section, I’m happy to say it looks like our final esteemed panelist, Lisa Klevence, has been able to join us.
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Executive Grant Status
Lisa Klevence, CEP, Plan Management Corp.: Thank you, yes, I’m finally here. Next topic is executive grant status, which you might have guessed is not really a number or at least it’s not just one number, but it has to do with the grant itself, all the executive grants, all the details surrounding those grants.Various people are going to want to know this, not just the executives themselves but also your investors, your shareholders, and proxy advisory groups. Everybody is going to want to know, as we said, the details, what’s vested and unvested, the filings, and especially any special provisions surrounding these awards.
If you want to go to the next slide, the executives and HR want to know what’s exercisable, especially in the coming year because they want to have an idea of what your executives might be doing with their awards.
If there’s a 10b5-1 plan that your executive has on file, you should know the details about that as the administrator, and if HR asks any questions about it, you’ll have the details.
All your various forms, 3s, 4s and 5s, your executives will need to know that they have been filed timely. A lot of times, it won’t be your executives that will be filing them, it will be their assistants. You’ll need to make sure that they are all filed because of all the various factors and interested parties looking to make sure these are filed correctly. Any new grants, anything that was canceled, they’re going to want to disclose that on their various 4s and 5s.
Thomas: One of the things we see often is that these types of responsibilities are left out of executive onboarding. Obviously, the folks in these positions generally know a lot about the company, they’re great at all the business forms. It’s easy to forget that this is frankly a very niche area, and often, until the first transaction actually occurs with an executive, having prepared the forms but then they can’t reach the executive, they don’t know the broker, or crucial information for the executive—frankly, it’s super stressful for the administrator to try and meet this deadline.
I think the other concern here is that as executives, they’re not going to know to ask what the processes are, and sometimes they may not feel comfortable asking. A big win for administrator is to you make sure that this is part of an onboarding process for new executives and that they know their responsibilities related to trading restrictions and 10b5-1 plans, as well as these filing rules.
You’re not only helping them avoid an embarrassing situation down the road, but any time you can help them succeed, it helps everyone, and helps reduce the stress of the first transaction with an executive who is not aware of all their responsibilities.
Klevence: We’ve also found that often if someone is a current employee of the company and their status changes so that they become a reporting person, that’s often when they slip through the cracks. It’s not so much a new hire, because you often have this information as part of your onboarding process, a part of your new employee packet. It’s more when someone suddenly has new duties, new responsibilities, and now, becomes a reporting person. That’s when those things can slip through.
Dennis: I would even add, Lisa, that you want to be sure you find out—and this happens a lot with your new directors who come onboard—whether they’ve been responsible for these filings before because you need to get the information about their prior SEC filings.
It is sometimes hard to track down, especially when you have these really tight filing deadlines, like two business days for Form 4. That’s tough, you definitely want to be sure you have all the information as soon as you can.
Klevence: Your investors and proxy advisers are going to want to know all about your CEO’s grants—specifically, what’s performance, what’s not performance, what’s vested in the past three years, and what the vesting schedules are for your CEO.
They’re also going to want to know what can be clawed back if there is anything, any special provisions for clawbacks. It’s not just for financial restatements anymore in this era of the me-too movement.
If something happens, you might need to be able to clawback some of his shares—if there was something that could be a violation of a moral’s clause or something like that as part of the agreement with these awards.
The advisers will also want to know if there’s any holding period. Once shares have vested, and they’re exercisable, is there any amount of time that your executives need to hold their shares or can they turn around and sell them on the public market? Exactly what is the holding period for that executive, and any other special provisions that you, as the company, have in place for your executives?
Thomas: Again, this is definitely an area that ISS is looking at—CEO vesting and the proportion of their performance awards, which is one of the big reasons that we don’t think the amendments to 162(m) are going to dramatically change the use of performance awards, that holding period.
Looking for things like the full value of the awards received for at least 12 months or to the end of employment, again, there are a number of factors relative to your executive awards. They’ve also issued an update this year with regard to a number of related factors.
The change-in-control vesting factor points will be based on the change-in-control vesting provision. If the equity plan discloses this specifically, the change-in-control treatment for both performance and time-based awards, it will be a full point. Rather than the actual change-in-control factors, it will be based on the disclosure of those. If it’s not stated for either type of award, it’s discretionary or it’s not clear, then no points will be awarded.
The other important change is the addition of what are called egregious features—their words, not mine—that may result in an immediate “against” recommendation, regardless of the other scorecard factor. Those include a liberal change-in-control definition with a single trigger rather than a double. If the plan is repricing for cash buyout of underwater options or SARs without approval—something I touched on earlier—that’s basically giving your equity plan folks a right and your shareholders don’t get the same rights.
If your shareholders buy a stock that goes down, they don’t get any retribution for that, and that’s why it’s an egregious feature if participants are given new awards because their stock price has declined without extenuating circumstances.
Basically, if the plan is viewed as a vehicle for problematic pay practices or pay-for-performance misalignment, that one is a little bit more concerning. I think you can see a lot of the problem comes out of cases like the Wells Fargo lawsuit and some of the other controversies where the pay practices are leading to types of behavior or pay status that is generally frowned upon by the investors and market as a whole.
Klevence: We know this seems like a lot of numbers, but you don’t have to memorize everything. Just make sure that you have everything updated in your system. I think that’s the most important thing, because when someone does want a number or wants information regarding an executive grant, that information is in your system. If it’s not current, then any information you give is going to be incorrect, and that could be a real problem.
You want to make sure that you update your system for any new grants. Anybody that’s a new executive, you need to have coded in your system as such—everything that you can have up-to-date and in a timely manner, that would be the best practice.
Thomas: The main issue is for folks to know how to do this before year-end reporting, and as we’ve touched on during the various sections, you never know when a CEO or somebody might be looking at a specific hire or they might be meeting with institutional investors. It’s some of this off-cycle work that often catches administrators unprepared. Make sure that you are keeping things up-to-date as often as you can manage, invest in the day-to-day, not just waiting for when you’ve got those big reporting deadlines.
Klevence: One other thing to keep an eye out on is our termination agreements, especially with your executive level. A lot of times, they won’t be following the rest of your plan. You want to make sure if there’s a termination, how their awards are handled because they usually are outside of the norm.
Also try to have detailed checklists, not just a step-by-step, but also as reminders to be sure to double-check information if you need to. Anything that will help you get your information to be as accurate as possible, that’s what you want on your checklist.
If you have any kind of ad hoc reporting within your system, that would be great also. This way, if there’s information that people are asking for on a continuous basis, maybe it’s not a standard report, but if it’s something that you can create in your system for future use, that would be great. You might want to talk to your software provider to see if they can handle that for you.
Thomas: All right, I think that wraps up the webcast, we’ve run pretty close on time. If there are any additional questions, we’re happy to take those.
Cleary: There are a few questions that have been sitting in the queue, because I wanted to make sure we got through all the content.
Let me take you back a little bit, if you don’t mind, if you could comment on why fungibility is used?
Thomas: I think the main driver is an acknowledgment of the fact that restricted awards and units are generally guaranteed to provide dilution and impact investors. You do have forfeitures, but whether the stock goes up or down, the recipients usually have a zero exercise price and they are receiving the awards automatically. Generally, they’re likely to provide more dilution and, again, they have value when they’re granted to the participants, whether the stock price goes up or down in the meantime.
On the other hand, your options and SARs, because there is an exercise price related to those, if they are out of the money or the stock price goes down—they bear more risk similar to shareholders in terms of potentially having awards that can expire with no value and they are less likely to dilute because of that risk.
Cleary: Thank you, I also have a couple of questions about cash settled units, and whether or not those have any impact on the burn rate calculations?
Thomas: This is a good question. They’re not going into your EPS dilution calculation, however, they are still coming out of the plan. For most plans, this is what we have seen— because they’re still being issued, there’s still compensation coming out of the plan, they would still impact the duration in terms of the validity or the burn rate of the shares available from your equity plan. But they’re not going into the calculation of the final dilution impacts like your share awards.
Cleary: I’ll squeeze in just one more and then I think we’ll have settled everything. The fungibility ratio that we discussed—does that have any relation to the burn rate calculation?
Thomas: Yes, so again, when you’re talking about particular things like ISS and your proxy advisory group, they are generally applying the fungibility ratio to any of the calculations. As we said, for the overhang EPS, it’s what they call the share value transfer and they are using fungibility as well.
Cleary: All right, thank you. I think we settled up all the questions that came in, but please email me if I missed anyone. I’ll make sure that you get an answer to your question or you can also email the panelists directly. They were brave enough to give you their email addresses back on Slide 2, so you can also reach out to them directly.
I hope that everyone listening is better prepared to pick up the phone and not dread those phone calls from your executive team when they’re looking for equity plan numbers. If you missed any part of the webcast or if you need to listen to a particular section of the webcast again, we’ll be posting an archive version in the next day or two. We’ll also post a transcript within the next few weeks, and that will be available for you to use as a reference as well.
I just want to say a huge thank you to Valarie, Lisa and Elena for all their time preparing for and presenting this webcast today. Lisa, I know you went to great lengths to jump on, I appreciate you braving the weather to join the panel today.
I also want to thank the audience for joining us today, and I hope that you will listen in next month on March 13th for, “Let’s Get This Started! Build Your Mobility Tax Compliance Program.” Thank you, everyone. That ends our webcast for today.
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