Putting Out the Equity Compensation Fire? Let’s Talk About Burn Rates

Stickman Burn Rate 2014Once again proxy season is just about upon us. Over a few of my next posts, I am going to discuss different components of what ISS refers to as the “cost of equity plans.” Today it’s all about burn rate. The ISS burn rate limit is generally based on the mean burn rate plus the standard deviation of burn rates for each given GICS code.

Once again, we are working to balance our compensation philosophy, the continued inflation of executive compensation and our long-term deficit in broad-based long-term incentives, like stock options and restricted stock units. We must do all of this while ISS once again reduces their acceptable burn rates for most industry categories.

Passable burn rates went down for more than two-thirds of industries. Some have opined that this shows better governance on the part of companies. I would suggest that is more like a person being squeezed by a python. Each year there is more pressure to conform. As things become more vanilla the standard deviation goes down and correspondingly so do the burn rate caps.

The process for determining burn rates is a pretty good argument for being in the Russell 3000. ISS calculates the burn rates for Russell 3000 and non-Russell 3000 companies differently. While the average change for 3000 companies was -0.20% the average changes for non-Russell 300 companies was -0.50. More importantly seven non-Russell 3000 industry groups had negative changes greater than the largest change for the Russell 3000 group. Two of the changes would have been even worse if not for the 2%* cap on annual changes. This disparity puts smaller companies at a distinct disadvantage in planning.

Here’s how it works. Let’s say you had a fairly high burn rate last year and chose to take advantage of it. You modify your compensation philosophy to use less cash and more equity (seemingly good for the company, employees and investors.) You set an expectation for the participants in your equity compensation plans. 2014 comes around and the mean burn has barely changed, but the outliers have moved to the middle.

As a result, your burn rate has dropped and you cannot offer new equity without risking a negative say on pay vote!  Even worse, the larger institutional investors are less likely to do any special analysis of a smaller company and ISS is less likely to have the time to talk to you or make any concessions. Your new compensation philosophy is torpedoed before it gained any momentum. And you look like an idiot to your board of directors, executives and possible your employees. And, you don’t have the budget to fill the gap.

Equity compensation has become more volatile and complex during the past two decades. While it isn’t about to go away, it does require more planning, expertise and pragmatism than most companies realize. Burn rates are just one component. Wait until we cover overhang, share recycling and some of the other exotic aspects you need to navigate.

*The 2% cap changes to no greater that 2% more or less than the prior year. But, if you prior year cap was 9.46% and this year it dropped to 7.46% we are really talking about a new cap that is only 78% of last years!  Download your own copy of the somniferous 2014 ISS U.S. Voting Summary Guidelines here.