The challenges for creating an effective executive compensation package are many. The executive wants more pay but less taxation, while the company wants incentive-based benefits that bind the executive more closely to the company.The traditional solution for these needs is a nonqualified stock-option program. The executive gets both a potentially high payout and the ability to time the taxation of the payout. The employer likes the program because stock options are a cashless, incentive-based package with vesting restrictions.
The executive benefit market has, however, changed significantly in the last few years. Stock options have lost much of their allure, while other plans have come to be seen as offering similar benefits in a more effective manner.
OPTION PROBLEMS
While nonqualified stock options are a well-known and popular benefit for top officers in many companies, employers are now looking for alternatives. Marketing and regulatory changes in the last few years have limited the attractiveness and usefulness of stock options as an incentive program for the highly paid.
First, there have been market failures, which have brought these plans into question. When stock options became a staple executive incentive for the high tech industry in the 1990s, they also became a lightning rod for criticism. They were largely undisclosed to investors, and they tended to generate concerns whether they succeeded or failed. When the options failed and ended up underwater, the executives were dissatisfied. When they succeeded and were in the black for the executive, investors were disgruntled because exercised options diluted stock values. More recently, the backdating scandals have further eroded the popularity of these benefits.
Compounding the market challenges to stock options is a change in corporate ownership and financing. Particularly with private companies, there are reasons that owners may not be willing to share ownership with their executives. This has always been the case with family-owned businesses, but more recently the privatization of public companies by private equity firms has generated a whole new group of corporations that don't want to use stock ownership as an incentive. Many of these companies obtain capital through private financing and do not want to -- or cannot -- diversify ownership, even to their executives.
Corporate tax structure has an effect on ownership as well. Now that the majority of companies filing as corporations are S corporations, there are limits on how many shareholders a company can have. As stock options are exercised, the company has new owners, and the company may be approaching the 100-shareholder limit for S corporations. Stock options may be viable for the very top officers, but are limited as a general incentive for the highly paid.
BLAME TAX AND ACCOUNTING
One of the most significant reasons why stock options have recently lost their luster is focused on tax and accounting. In the area of tax law, even though new Internal Revenue Code Section 409A is thought of as the deferred-compensation tax statute, there are a number of provisions in the law that limit popular stock-option features. For example, discounted stock options are considered deferred compensation for IRC Section 409A. This creates the challenge of properly documenting and administering these arrangements consistent with the rules of Section 409A. An even greater challenge for stock options is in the area of accounting.
Accounting standard FAS 123(R) is essentially the regulators' response to the unbridled use of stock options during the dot-com era. It was felt that huge executive benefits were being granted through stock options, yet companies didn't have to reflect this liability on their books until far into the future. Companies would book the liability only if and when the stock options were exercised.
Under FAS 123(R), the company is required to reflect the liability when the stock option is granted. The practical effect is that the liability for a stock option appears much earlier on a company's financial statement, and is therefore far less attractive from an accounting standpoint. This adverse effect is compounded by the fact that stock options are inherently difficult to value.
The effect is that companies are forced to reflect a liability that, in reality, may never generate any actual monetary value. These challenges have led a number of companies to curtail or eliminate their nonqualified stock-option programs.
WHAT'S AN ALTERNATIVE?
The concept of deferring compensation has been popular for decades. Employers either offer to pay supplemental income to key employees in the future or allow the employees to defer their own income. These plans often permit the executive to choose a measuring index for the deferred amounts, providing the employee with increased control and diversification.
For years, companies provided sophisticated deferred-compensation arrangements as a "golden handcuff" benefit for their executive ranks. The lack of a specific statutory framework for these arrangements has, however, caused some companies to avoid offering such plans.
Until recently, the rules applicable to deferred-compensation arrangements have largely been a mix of regulatory rules and court decisions. With the adoption of IRC Section 409A in 2004, the concern over statutory authority was eliminated. Section 409A has codified the flexibility of deferred-compensation plans, and now offers a way to use these plans as an alternative to stock options.
WHICH APPROACH TO USE?
Some benefits, such as health insurance and a qualified plan, are almost perceived as a given by employees. Executive benefits are, however, typically provided only if executives can demonstrate bottom-line value.
Nonqualified stock options and nonqualified deferred-compensation plans both have their advantages and disadvantages. For a publicly held company, either or both plans can provide significant incentives to executives. In general, however, a NQDC plan would make better sense for a privately held company. Stock options are cashless to the company and offer significant tax-timing opportunities to executives. But with these advantages come a host of accounting and design shortfalls.
In contrast, the NQDC plan can offer significant benefits to both the company and the executive. The company gains more control, certainty and exactness of incentives. The executive still has tax advantages, and clearly gains in predictability of benefits. Times have changed, and we may see NQDC plans frequently used in lieu of traditional stock-option plans.
