Bullet-Proof Vest(ing)

Fred Whittlesey
Compensation Venture Group




"And it seems these days that everybody wears a bullet-proof vest"


- Colbie Caillat, "Bullet Proof Vest"


In the current compensation governance environment, many (perhaps most) companies are seeking the bullet-proof vest to fend off criticisms of proxy advisers and institutional shareholders in the say-on-pay process.


One of the key components of the bullet-proof vest strategy is...the vesting schedule - and this is getting little attention in the media, compensation surveys and databases, and some consultants' analyses.


My firm's analyses of executive compensation include a detailed analysis of vesting schedules. Why?  Because over the past few years this has escalated from the analytically-interesting to the essential.  While vesting schedules are indirectly recognized in accounting fair value calculations (and we can debate whether that is really true) there are much larger issues with vesting schedules.


The days of simple decisions about 3 years versus 4 years, incremental versus cliff, are long-gone.  We now have, of course, both time and performance-based vesting (with a remarkable variety of the latter) applied not only to full-value awards (RSUs and PSUs) but options and increasingly-prevalent cash LTI plans.  We just completed an analysis of a client's 25 peer companies, and found 72 (yes, seventy-two) unique vesting schedules being applied to the past year's equity grants to the named executive officers in those companies. We have a methodology for rationalizing that diversity of vesting schedules into a few normalized metrics but it still is a lot for a Compensation Committee to digest when they ask a question like "what is the typical vesting schedule?"


In the extreme cases, companies are adding performance-based vesting to previously-granted awards due to say-on-pay pressure.  Other companies are proactively adding performance vesting to stave off future threats (given the number of companies that had comfortably-high say-on-pay approval ratings last year and failed this year). Yet in any given peer group we will still find a company that is granting all equity in the form of RSUs with a 3-year graded vesting schedule, or options with 25% vesting in the first year and the monthly vesting in the three years thereafter.


There is good news and bad news in the 72 vesting schedules.  Perhaps the say-on-pay process has forced companies to be more thoughtful about the conditions that should be applied to the earning of multi-million dollar equity awards.  That would be the good news.  The bad news?  That these are knee-jerk reactions to threats from self-anointed corporate governance pundits like ISS and Glass-Lewis, over-engineering of award design that might lead to reduced perceived value by recipients, and confusion for all.


Finally, it's important to note that surveys or proxy databases are not capturing the complexity of LTI vesting schedules and when LTI comprises more than half of executive pay, ignoring a critical design feature in reporting pay "values" renders that data less than valuable, perhaps useless.  For example, let's say that:

• Fair value of an option award with 3-year incremental vesting (33.3% per year) is $5 million.  
• Fair value of restricted stock units (RSUs) with 5-year cliff vesting schedule is $5 million.  
• Fair value of performance-vested stock units (PSUs) with a 1-year performance period and a 2-year subsequent time-based vesting period is $5 million. 
• Fair value of PSUs with a 3-year cliff performance period is $5 million. 

And the answer is:  $5 million.  But it's not.  That is merely the valuation firms and accountants' opinions of the value of each, under accounting rules. There are vastly differing strategic, financial, behavioral, and governance implications of those awards. One thing we do know about accounting for equity compensation is that the least likely pay outcome for each of those awards is $5 million despite what the actuaries tell us.


Colbie's song lyrics in "Bullet Proof Vest" imply that wearing an emotional one may not be optimal in the game of love.  Defaulting to a perceived bullet-proof vesting schedule may not be optimal in the game of executive compensation and say-on-pay.  Blindly following a consultant's statement of purported "best practice" without understanding the incredible complexity of equity award design may lead to the pattern we're seeing over the past few years: annual changes in equity grant design because last year's just didn't work.  It took a bullet, despite the vest.


Maybe we need to find the Titanium of equity award vesting.