February 3, 2012

We have long taken the position that despite current compensation reporting practices, the most meaningful way to assess and calculate executive pay over time is to evaluate “realizable pay.” The biggest difference between realizable pay and current required methods centers around that tried and true whipping boy—stock options.  Regulators seem more interested in “shock value” pay reporting by using models that while theoretically justifiable do not hold up well in practice and that do not reflect actual events as they unfold.  Something similar to realizable pay was once required reporting, but the hysteria of the last decade has caused a shift that has been misleading and has warped the tools of analysis and reward.  The pendulum seems to be swinging back, though any progress is tentative—the winds of compensation political correctness can blow fiercely with any new firestorm.  To put this in perspective, here is a little background.

FAS 123R (now referred to as “Topic 718”) was implemented amidst great hue and cry.  Prior to FAS 123R, no compensation expense was required to be deducted on the income statement of company financial statements in connection with the typical grant of employee stock options.  For years the accounting standard setters argued for the need to better match income and expense.  Their solution was the imposition of Topic 718, where under the present value of options granted is charged to the company’s income statement for the year in which the options are granted.

Since the 2005 adoption of FAS 123R by the Financial Accounting Standards Board, there has been a fixation on measuring executive compensation stock awards by fair valuation methods, the most popular of which, by usage, is the “Black Scholes” model.  Using inputs such as the current stock price, past stock volatility and option term, the models take historical data and compute, as of the date of grant, the expected dollar value of the option at the term of the option.  While no doubt a useful tool for providing some way to attribute an economic value to options granted, it is likely that once the years have played out, the actual dollar return for any particular stock option grant will not equal the original Black Scholes value.  Most likely, the actual value will be higher, perhaps it will be lower, but almost certainly the original reported value will prove to be incorrect.  On that basis, it is evident current valuation methodologies result in much less meaningful and reliable measurement of the value of executive compensation.

It is worth pausing to note that the great concern at the time FAS 123R was adopted has not materialized: that corporate profits would be so ravaged by the grants of options that option usage—considered by many in the tech communities to be vital to economic growth—would dry up.  Fortunately, public company financial analysts essentially ignore this particular non-cash expenditure and many companies present pro forma financial statements that also ignore it in computing profits.  As for private companies, little attention is paid to the FAS 123R expense as most users of private company financial statements focus on such metrics as cash flow and net current assets.

Thus, even though there are defects in the valuation models as applied to stock options, some of which are discussed below, the accounting implications of Topic 718 have been rendered benign by the practice of simply ignoring the adjustments.  However, regulators, experts and users have not only built on Topic 718 methods, they have added to them in their successive turns, constructing a mythology that has little usefulness for compensation management and administration.  Unfortunately, their use by such constituencies creates large hurdles that need to be worked around despite their relative uselessness.

The SEC quickly joined the party in 2006 by requiring that annual proxies use the same fair market value estimates for options in reporting compensation paid to named executive officers (“NEOs”).  Not only that, but SEC rules, pandering to the political correctness notion that shock value is more important than accuracy, require that the entire award be reported in the year of grant, thus providing award numbers that are exceedingly high.  Not missing an opportunity to pile on, ISS, the most frequently watched adviser to public and union pension funds, computes awards by a Black Scholes method that uses the contractual term in its calculation, not the shorter expected life of the option before exercise.  This typically results in yet a much higher value.

We have long viewed such valuation presentation as unreliable in terms of measuring actual compensation.  Not only is the portion of compensation attributable to options calculated at grant almost certain to be wrong, in most cases it is likely to be highly overstated.  The calculation assumes the optionee has the ability to pick the moment, really the best moment, within the entire term of the option to exercise and then to sell. But that is not the way executive stock options work.  Clearly, vesting and restrictions on insider trading frustrate freedom of choice in many cases.    Also, either the executive will exercise options shortly after they partly or wholly vest (assuming the option is in the money) or the executive will hold the vested options for the long term—either to send a good signal to the markets that the executive believes in the company’s stock or because ownership is mandated by company guidelines.  So the presumption underlying the models that the executive can freely exercise his/her option and then sell the shares at any time during the term is just not the case.  Actual exercise often occurs in very small windows.  To this extent the Present Value  models likely overstate the real value of options.

As an alternative to current required valuation methods, we have long argued that the most appropriate means of measuring and presenting executive pay data is “realizable” pay, which computes, at any particular point in time, actual cash and bonuses paid, the unvested value of restricted stock and, in the case of stock options, the intrinsic (“in the money”) value and not the Black Scholes or other measures of fair market value.  In recent months we have perceived increasing sentiment in favor of realizable pay.  For example, see Kay, Ira, “Realizable Pay: An Effective Measure of CEO Pay,” November 7, 2011.  Mr. Kay’s research supports the intuitive supposition that realizable pay more closely demonstrates the link between pay and performance—when a company performs badly its stock price will be deflated and realizable pay will be appreciably lower than realizable pay to executives at well performing companies.   Also, significantly, Equilar, the most prominent provider of public company proxy compensation data, has unveiled a new metric based on realizable pay, the significance of which was discussed in Gibben, Kristin, “New Service Could Change Say on Pay Votes,” published on the Agenda website January 17, 2012.

We have witnessed many instances where high values reported on the basis of current requirements suddenly become very modest once a realizable pay analysis is performed.  What is more, in the cases of companies that rely much more heavily on options as opposed to full value shares, i.e., restricted stock and restricted stock units, the value of executive pay often drops dramatically when pay is computed on a realizable pay basis.  Applying Topic 718 makes peer-to-peer comparisons of executive pay required by public companies much less accurate and reliable.

Prior to Equilar’s product breakthrough, an impediment to realizable pay was the lack of data—to do this analysis on a multiple company basis takes quite a bit of manual effort that requires data from a number of sources.  Now that the data are available, more institutions seem more willing to consider it, a development that augers well for the public acceptance of realizable pay as a useful tool.  The real problem with realizable pay, from a political correctness standpoint, is there is little or no value at grant because the exercise price is at least the fair market value of the stock at the date of grant.  Regulators and shareholder advisers and their groups believe that reporting no value at the date of grant is misleading.  There is an emotional justification to this position.  However, over time, as grants accumulate and / or age, their value is realized (or not) and the facts are revealed. The intrinsic component of an option, if there is any, becomes apparent, particularly in the current required reporting format for public companies where multiple years of data are presented.  We believe it is important for public companies to become familiar with realizable pay computations.

For more information on realizable pay, please telephone Garth Gartrell at (415) 485-5513 or email to garth@croner.biz.