Arriving at the right equity split.

• Author: Lederer, Jack L.

A walk through the four steps of the compensation committee's most important decision: to determine the appropriate equity allocation for their company.

Based on our 20 years of working directly with compensation committees, we have reached the conclusion that most of them spend their time on the wrong subjects. Guided by executive compensation consultants who are peddling the latest mousetrap, committees devote precious hours to reviewing and approving gimmick stock incentive programs that allegedly link executive pay to company performance, while minimizing expense and dilution. In reality, most of these programs dramatically increase compensation levels without growing shareholder value beyond standard levels.

The mistake these compensation committees make is to focus exclusively on the "how much" and "how" of executive compensation. Too many executive compensation studies consist of two steps: first, comparing pay levels to competitive practice ("how much"); and second, designing the new program ("how"). While these are useful second and third steps, they sidestep what we believe is the committee's most important decision - the appropriate allocation of equity between management and the shareholders, and, subsequently, the split between the CEO and other employees.

The competitive pay trap

Many compensation committees back into an equity allocation strategy because they overrely on compensation surveys that tell them how many options they must grant the CEO and other senior executives if they want to stay "competitive." While these surveys can be useful tools, they are usually too homogenized to provide reliable guidance. For example, the leading long-term incentive surveys express competitive option grants as multiples of base salary, based on Black-Scholes option values and general industry data bases dominated by the Fortune 500.

There are a number of reasons why we believe the popular surveys' salary multiples overstate competitive long-term incentives - such as the inclusion of mega-grants, the use of the Black-Scholes methodology, and the increasing popularity of stock-for-cash exchanges. However, the greatest weakness of the salary multiples is that they force the compensation committee into a "one-size-fits-all" approach to executive compensation. This approach ignores the performance expectations of shareholders, the relative contributions of the executive team and investors to value creation, and the company's location on the...