Author: James Reda
Retaining key leaders through equity awards has served as an important strategy in the for-profit sector. Recently, retention through equity has become even more critical as the Federal Trade Commission (FTC) issued a new rule on April 23, 2024, banning new non-compete agreements in all employment contexts.*
The FTC's new rule represents a significant shift in the employment landscape, particularly retention of key talent. Companies historically have used non-compete agreements to prevent employees from joining competitors or starting their own ventures in the same industry for a certain period after leaving their current employers. With these agreements no longer an option, companies may need to rely more heavily on alternative methods such as equity awards to retain their key leaders.
Aligning incentives
Equity awards, such as stock options, restricted stock and performance shares, can serve as powerful retention tools. By granting equity, companies ensure that executives share in the company's performance, both in its successes and challenges, aligning their interests with those of shareholders.
These awards typically vest over time or upon achieving specific performance milestones, creating an incentive for executives to stay with the company and contribute to its long-term success. This alignment is particularly important for executives who play pivotal roles in driving the company's performance and growth.
With the traditional method of using non-compete agreements off the table, companies may need to revisit and potentially enhance their equity compensation programs to ensure they remain competitive in retaining top talent. This enhancement could involve adjusting the structure or size of equity grants, implementing more robust vesting schedules or introducing performance-based metrics tied to equity awards.
Furthermore, the removal of non-compete agreements may lead to increased mobility among senior talent in the marketplace, as employees feel freer to explore opportunities with different companies. In this environment, attractive equity packages could offer a crucial differentiator for companies looking to attract and retain the best executive talent.
Equity awards may promote retention without the attention
Overall, the FTC's new rule underscores the importance of for-profit companies using equity awards as a retention strategy, particularly in light of the changing regulatory landscape around employee agreements. Companies that adapt and optimize their equity compensation programs accordingly are likely to find themselves better positioned to retain their key leaders and drive sustained success.
Companies sometimes consider "mega grants" as a tool for retaining key talent. These large allocations of equity are meant to provide executives with a strong incentive to remain with the company over the long term. However, while mega grants may be effective in promoting retention, they also carry certain risks and considerations, especially regarding shareholder and proxy advisor perceptions.
Publicly traded companies may be better positioned to secure shareholder support and avoid negative vote recommendations by adopting a more balanced and performance-driven approach to executive compensation, such as increasing the maximum limit for performance-based long-term incentive (LTI) awards. Historically, companies have set the typical maximum for performance-based LTI awards at around 200% of the target. This limit means that executives could potentially receive up to double their target LTI award if they achieve exceptional performance against predetermined metrics.
More and more, we're seeing companies adjust this maximum percentage upwards beyond 200%, depending on factors such as company size, industry competitiveness, need for retention and shareholder expectations. We've reviewed the most recently filed proxy statements for 938 publicly traded companies across various industries to better understand the incidence of companies that set performance based LTI maximums above 200% for top executives.
Of this total sample, 136 companies (or 14%) set the LTI maximum at greater than 200%, and of these 136 companies, 46 (or 5%) set the maximum at 300% and higher.
When broken down into industry categories by Global Industry Classification (GICS) code, we see the greatest incidence of LTI maximums over 200% within the consumer staples and the materials and energy industries:
| Industry | Number responding | % with maximum over 200% |
| Consumer staples | 48 | 31 |
| Materials and energy | 128 | 27 |
| Consumer discretionary | 148 | 13 |
| Information technology | 233 | 12 |
| Industrial | 271 | 11 |
| Life sciences | 110 | 7 |
Increasing the maximum limit for LTI awards above 200% of the target award can provide retention incentives, which shareholders and proxy advisory firms like Institutional Shareholder Services (ISS) may view more favorably compared to a single mega grant.
While increasing incentives and recognizing overperformance may lead to higher compensation values as reported in the proxy statement, it's important to understand how ISS evaluates equity grants for say on pay analysis. ISS typically focuses on the face value or target value of equity grants rather than their potential increased value due to exceeding targets. Therefore, simply increasing incentives may not directly impact ISS's evaluation. In other words, while proxy values will increase, ISS measures the face value or target value of equity grants. The target value won't increase the value of the equity grant to be included per ISS methodology for purposes of the ISS say on pay analysis.
Tying awards to performance
Increasing the LTI award maximum allows companies to structure equity grants based on performance metrics and vesting conditions. By raising the maximum limit for LTI awards, companies can provide ongoing retention incentives to executives without committing to a single large grant. This approach aligns with best practices in executive compensation, which emphasize the importance of linking pay to performance over the long term. ISS and other proxy advisory firms generally support performance-based compensation structures that align executive pay with shareholder interests.
Increasing the maximum payout levels is like providing a mega grant without the potential associated concern, particularly when spreading the payout over a three-year period. In other words, if the maximum payout is increased from 200% to 300%, the number of shares that can be earned increases by 150% (50% times 3) over a three-year period. Unlike a single mega grant, which can lead to significant equity dilution and shareholder concerns, increasing the LTI award maximum allows companies to spread out equity grants over multiple years. This approach can help mitigate dilution concerns and reduce the risk of a negative vote from ISS or other shareholders.
A higher LTI award maximum provides companies with flexibility to adjust equity grants based on changing business conditions, performance expectations and retention needs. This flexibility allows companies to respond to evolving market dynamics while maintaining a competitive executive compensation program.
The super-charged performance share award should be tempered by a restricted stock award to balance the amount of shares that are unvested/unearned. This tempering is particularly important if the company is going through a temporary decline in performance while the longer-term strategy is taking hold. For example, a mix of 75% performance shares and 25% restricted shares provides for a balanced portfolio.
Consider performance metrics to mitigate increased accounting expense
In choosing to set a higher maximum for LTI awards, employers should consider that the accounting expense and the amount reported for the performance share awards (PSA) in the proxy statement (summary compensation table) increases as the maximum payout increases.
Choosing financial metrics that are absolute rather than relative can help mitigate the accounting expense associated with PSAs as the maximum payout increases.
Absolute financial metrics — such as return on invested capital (ROIC), earnings per share (EPS) and revenue growth — are based solely on the company's internal financial performance. Such metrics don't require comparison with peer companies or external benchmarks, simplifying the measurement process and potentially reducing associated accounting expenses.
Absolute financial metrics provide a consistent basis for performance evaluation across different periods, making it easier to track and compare performance over time. This consistency can help mitigate fluctuations in accounting expenses associated with changes in maximum payouts or performance thresholds.
Financial metrics such as relative total shareholder return (TSR) often require gathering and analyzing data from peer companies to determine performance rankings. This step can involve additional costs related to data collection, analysis and benchmarking studies. Using absolute metrics can help reduce these expenses.
While absolute financial metrics offer several advantages for mitigating accounting expenses associated with PSAs, companies should carefully consider their choice of metrics. Such metrics should align with strategic objectives, relate to long-term value creation and be easily measurable and understandable for executives and shareholders alike. Additionally, companies should regularly review and adjust their performance metrics as needed to adapt to changing business conditions and stakeholder expectations.
Equity compensation programs could offer a win-win for companies and senior leaders
In the wake of the FTC's April 23, 2024, ban on non-compete agreements, companies can optimize equity compensation programs to attract top talent, retain key leaders and foster long-term commitment and alignment with organizational goals. As regulatory changes continue to reshape the employment landscape, companies that prioritize equity awards as part of their retention strategy likely will emerge stronger and more resilient in the competitive marketplace.
Ultimately, by embracing equity awards as a strategic retention tool and adapting to regulatory changes, companies can position themselves for sustained success by retaining their most valuable asset — their talented leadership.
Gallagher can help. Contact Gallagher's Executive Compensation Consulting team to discuss equity awards that could make sense for your organization.
