Executive Compensation: Complex and Complicated

Fred Whittlesey
Compensation Venture Group, Inc.

A photographer took a photo of a man walking down the street. When the picture printed out, only half the photo printed on one sheet and the other half on the next sheet. A journalist concluded by looking at the first half of the photo that a miracle had occurred – a man was able to walk down the street with only one leg, his left one! The next week, the journalist found the second photo and claimed yet a second miracle had occurred. This same man had his left leg surgically transplanted to his right side (no doubt because he is right-handed, the journalist concluded) and was already able to walk again! That story is only slightly less ridiculous than the one I read in the Wall Street Journal (page B1) on Thursday. It is what may be one of the poorest and most misleading articles every written on this topic: “Tech CEOs’ Pay Falls as Firms Cut Out Options.” If I put my 4-year old behind the wheel of the car and sent him off down the street I think he’d fare slightly better than this reporter did in covering this topic.

That same day I attended the Annual Conference of the Silicon Valley Chapter of the National Association of Stock Plan Professionals - a gathering of over 150 equity compensation professionals (plus one writer from the Wall Street Journal, not the author of the article cited above) - and made a presentation about understanding the increasing complexity of executive and equity compensation. From a selfish standpoint the timing of the WSJ article couldn’t have been better.

I was once in a Board of Directors meeting in which one director said the compensation plan I proposed was too complicated and his fellow director corrected him saying that it was not complicated, just complex. Merriam-Webster helps us with this distinction:

Main Entry: com·plex
Function: adjective
COMPLEX suggests the unavoidable result of a necessary combining and does not imply a fault or failure

Main Entry: com·pli·cat·ed
Function: adjective
1 : consisting of parts intricately combined
2 : difficult to analyze, understand, or explain

Executive pay is complex. In this article, the reporter concluded that, like the one-legged man incident, a CEO had received an “86% pay cut” from one year to the next because he had received a large stock option grant, with multi-year vesting, when hired in 2004 (a "new-hire mega-grant") then only a small RSU grant in 2005. The company confirmed this was the rationale, but this didn’t affect the Journal’s reporting of it. The story went further and interpreted that - because companies have successfully lowered the expense they are reporting for stock options through actuarial tactics and because many companies’ stock prices continue to deteriorate – the same number of options granted on lower-priced shares represent a “pay cut” compared to the options on those higher prices shares that are now underwater and currently worthless. At the Conference, data was presented by the same firm that provided the WSJ with the data, showing that the mix of options and restricted stock (and restricted stock units) is changing for paying CEOs, but that data had some of the same problems and the presenter made some of the same misinterpretations.

In my presentation at the Conference, I cited an example of a Seattle company, Cutter & Buck, that just announced an intricate performance-based vesting schedule for its stock awards to executives. The award is divided up into literally dozens of different pieces that vest either over time or as a result of performance. Complex, but fairly easy to understand. I have to include some of the disclosure here for you to fully appreciate it:

Under each of these grants, the vesting of Sixteen and Sixty-six hundredths percent (16.66%) of the granted shares is subject only to the continued employment of the recipient by the Company, and Eighty-three and Thirty-Four hundredths percent (83.34%) of the granted shares are subject to certain performance-related vesting contingencies. Specifically, the vesting of Forty-one and Sixty-seven hundredths percent (41.67%) of the granted shares is conditioned upon the achievement by the grant recipient of certain pre-established individual performance objectives, which may include, for example, sales growth within the Company’s sales channels during the Company’s fiscal year ending April 30, 2007. Similarly, the vesting of Sixteen and Sixty-seven hundredths percent (16.67%) of the granted shares is conditioned upon the achievement by the Company of at least Eighty percent (80%) of its pre-tax operating income target (the “Income Threshold”) during the fiscal year ending April 30, 2007, and the vesting of Twenty-five percent (25%) of the granted shares is conditioned upon the Company’s achievement of pre-tax operating income levels in excess of the Income Threshold, with each additional percentage point by which the Company surpasses the Income Threshold resulting in the vesting of an additional Six Hundred Twenty-five thousandths percent (.625%) of the total grant, up to a maximum of One Hundred Twenty percent (120%) of its pre-tax operating income target for the period.

Executive pay is complicated – salary, annual incentive, stock options, RSUs, performance plans, multi-year cash bonuses, annual incentive awards paid out in restricted stock, deferred compensation programs, and more. Add to that vesting schedules, performance acceleration, and performance vesting features and it is indeed “difficult to understand, analyze, or explain.” Because journalists insist on measuring pay annually and don’t take the time to understand the complexity, however, articles like the one in Thursday’s Journal article end up reporting something that didn’t happen and is simply not true.

Pay will continue to get more complex. As it does, sometimes it will be clearly disclosed as likely to be required by the SEC’s proposed rules. Sometimes it will be so complex, or so poorly explained, that it will seem very complicated. Compensation professionals have a responsibility to design plans that are appropriate for the business situation, no matter how complex that may be, and ensure it is properly communicated as to not appear complicated. Journalists have what is perhaps an even greater responsibility to take the time to understand these complex plans, no matter how complicated, and report them accurately to ensure the public does not misunderstand them and arrive at false conclusions about executive pay.