Evolving Equity Like It’s a Flying Machine

untitled3Other professionals in HR, compensation and investing frequently ask why I am so passionate about changing the way companies use equity compensation. They point out that the majority of companies follow the same path and many companies (as well as many individuals) have been very successful with the current paradigm (see below for a quick summary). Why mess with something that seems to work at least some of the time?

I ask you to consider the evolution of the airplane. At first, the concept was intriguing, but the reality was disappointing. Some tried and failed miserably. Some were successful in proving the concept without showing much practical use. None were yet to be commercial successes.

Later the reality became pretty impressive. Planes were designed for specific reasons and those purposes were wide-ranging and imaginative. We flew over oceans and fought wars. Mail was delivered in record time. Passengers traveled faster than ever before. People and companies made money and changed the world. If this was the story of equity compensation, it would basically end here.

untitled4But, airplanes continued to evolve. They flew faster than sound. They grew to carry hundreds with ease. They changed the face of transportation and business. They morphed into vehicles that could explore other planets and space itself. Their potential is still being explored. Great minds and curious souls stretch to determine new and better ways to fly. No one asks why, even though relatively few understand how flight is accomplished or how these vehicles are designed and built.

At the same time, equity compensation seems driven by people who seem satisfied with occasional success and regular failure. Rather than reaching for the stars or even for significantly better or more consistent success, the focus is on fitting into investor models, compensation professionals’ understanding and limited administration tools. It is clear we can do more and be better, but a lack of understanding and/or desire seems to inhibit our ability to explore new ground.

So, in answer to those who ask why I so passionately work to help companies create better equity compensation programs, my answer is simple. We can and should provide the best possible solutions for businesses, stakeholders and participants. Potential is not an abstract thought. It is a constantly moving goal that is best when it drives improvement.

As a reminder, here’s the current equity compensation paradigm:

  1. Set aside a pool of 15-20% of outstanding shares for employee equity.
  2. Stock options with 4 or 5 years of vesting when the company is very small.
  3. The first 20-40 employees get about half of all the equity granted prior to an IPO or acquisition.
  4. As the company pushes against dilution, concerns switch to RSUs with three year vesting or transaction-triggered vesting.
  5. At IPO, move everyone eligible to a regular schedule of stock options and/or RSUs. Maybe add an ESPP.
  6. Use stock options or RSUs, with the basic vesting described above, for the top two-thirds of the company.
  7. At about 3 years post-IPO, as “Say on Pay” rears its head, add a performance component to executive RSUs and work to manage both overhang and burn rate.

The plans are fairly easy to create. Companies assume people understand the paradigm because it has been in place for more the two decades, so little is spent on education. Some people succeed (celebrated in some circles, demonized in others). However, most people do not win. The biggest component in attracting new talent is whether their stock price is increasing. The biggest motivation factor is whether the stock price is increasing. The biggest retention factor is how long the stock price stays high. I believe we can do better.

NOTE: While all of this is happening, a small percentage of companies (often the most successful) have created programs that are designed with new thoughts and goals in mind. Sometimes these plans fail, although seemingly less often than “vanilla” plans. When they do succeed it is more intentional and aligned with their own strategy and culture.

Dan Walter, CECP, CEP is the President and CEO of Performensation. He is passionately committed to aligning pay with company strategy and culture and has been deeply involved in equity compensation for a long, long time. Dan has written several industry resources including the recent Performance-Based Equity Compensation. He has co-authored ”Everything You Do In Compensation is Communication”, “The Decision Makers Guide to Equity Compensation”, “Equity Alternatives” and a few other books. Connect with Dan on LinkedIn. Or, follow him on Twitter at @Performensation and @SayOnPay.