5 Challenges of Share Pool Tracking for Equity Plans

Companies can do everything right with a new equity plan—successful shareholder approval, thoughtful design of terms and conditions, high-quality reporting systems—only to stumble over tracking exactly how many shares are available to grant at any given time.

When not done carefully, we’ve seen companies lack the necessary shares to make new grants. At best, this is embarrassing and can lead to difficult decisions, like delaying grants or issuing cash-settled awards with adverse accounting treatment. At worst, it may force management to ask shareholders for more shares earlier than expected, or even hinder the company’s ability to hire and retain talent.

Share pool tracking isn’t only about knowing the number of shares available for future issuance. It also informs key stakeholders, such as the compensation committee and proxy advisors, about key governance metrics like burn rate, expected dilution and equity pool sizing.

It’s natural to think that an approved equity plan allows for a number of shares to be granted, and the pool is simply reduced by the number actually granted to employees. However, there are more variables to consider, with each equity plan having its own unique rules. Here, we’ll examine the nuances that complicate share pool tracking so practitioners can develop robust tracking, reporting, and forecasting processes.

1. Equity Plan Diversity

Not all awards are created equal when it comes to share pool tracking. Each equity plan specifies how shares are counted against the share pool.

Performance Awards

Consider plans with time-based restricted shares/units. For those, the available pool is simply reduced by the number of shares issued at the time of grant. However, performance awards have a range of possible payouts based on the achievement of performance criteria. That means counting shares against the pool can be tricky.

Some equity plans explicitly define how to account for performance shares (e.g., threshold, target, or maximum). But in many cases, the equity plan is silent. Since performance shares typically vest three or more years after the grant date, the available shares in the pool may not account for above-target payouts that are not yet known. The most conservative approach is to deduct shares based on the maximum potential payout and add them back if the actual shares earned are less than the maximum. In any case, it helps to track payout factors in real time to update the share tracking model. This gives the compensation team a more accurate estimate of share usage.

Plans With Fungible Ratios

Separately, some equity plans introduce the concept of a fungible share ratio. With a fungible share ratio, counting shares against the equity plan depends on the award type. For example, issuing a stock option may reduce the share pool by one, but issuing a full-value share like an RSU may reduce the share pool by more than one. The reason is that the full value of the share is delivered at vesting (unlike a stock option, where the strike price means a fraction of the value is delivered). Usually, companies that grant both options and full-value awards include fungible ratios to maximize the size of their share pool allowed under ISS guidelines.[1] Nonetheless, fungible ratios create additional administration complexity since the share pool tracking must account for the type of award while adjusting the shares from the pool.

2. Multiple Equity Plans

The presence of multiple equity plans also creates complexity. Reconciling share balances already combines internal tracking, equity administration platform data, and, often, a separate transfer agent. The best practice is at least quarterly reconciliation of exercise and vesting activities to ensure the share balances are in sync across systems. This allows for informed decisions about new grant issuance and avoids the risk of an insufficient share pool.

However, reconciling hundreds or thousands of vesting/exercise transactions is time-consuming. Stock plan administrators must review each transaction to ensure the activity is properly recorded in both systems and adjusted for all tax withholdings. With multiple equity plans, reconciliation is more complex because there’s a good chance at least one of the following circumstances apply:

• Issuances are coming out of multiple plans simultaneously
• Forfeitures from old plans result in shares being returned to a newer plan
• Unused shares from one plan may be transferred to another

Many HR teams rely on manual worksheets and share pool reports from an equity administration platform. We’ve seen enough instances of this happening to highlight it as a risk factor. The risk occurs when discrepancies between the systems build up over time, so that no one knows which system to rely on for future granting decisions. This makes periodic, complete reconciliations an essential control.

3. Liberal Share Recycling Features

To maximize available shares and the plan’s overall longevity, companies can build in liberal share recycling provisions. It’s standard for companies to at least return forfeited shares to the pool for future issuance. But a liberal share recycling strategy can include returning shares that are:

• Withheld for taxes
• Withheld to cover the exercise price of stock options (or repurchased using exercise proceeds)
• Not issued upon exercise of stock appreciation rights (SARs)

If the equity plan allows for liberal recycling of shares, administrators must account for the added complexity of adjusting the share pool after each relevant transaction. Companies may be able to use system-generated reports to monitor shares returned to the pool. However, certain transactions, such as using treasury shares or cash instead of shares in the equity plan to settle exercises, require additional oversight to ensure the available shares in the equity plan are calculated accurately. This may involve communicating with the transfer agent to make manual adjustments.

Liberal share recycling has historically been less common, as it results in lost points in the ISS Equity Plan Scorecard (EPSC). However, it has become more prevalent recently because sometimes the extra shares from recycling more than make up for the smaller pool of shares that is approved. If this is of interest to your company, we would be happy to discuss further.

4. Burn Rate

The equity burn rate is a metric used to understand how much shareholder dilution the company caused by issuing equity compensation. Given that burn rate plays a large role in the ISS’s EPSC, managing it is crucial for gaining shareholder support for new equity plan proposals.[2] But ISS’s calculation is just one approach. Shareholders, analysts, and compensation teams in different companies have developed their own flavors, resulting in a lack of consistency for companies hoping to assess the effectiveness of their equity plans.

At a basic level, the burn rate is the ratio of all forms of new equity grants as a percentage of the total shares outstanding. In practice, burn rate calculations may do any of the following:

• Adjust the numerator for shares repurchased, forfeited, and withheld for taxes (often called a “net burn rate”)
• Apply different weighting for full-value awards and stock options
• Define total outstanding shares as either current common shares outstanding, weighted common shares outstanding, or diluted shares outstanding
• Exclude or include cash-settled awards

In addition to the aforementioned factors, burn rate calculations are significantly impacted by stock price movements. Most companies use stock price on the grant date to convert grant value to share units, so companies with volatile stock prices especially struggle to maintain a steady burn rate. They end up leveraging more share units when stock prices fall and fewer when they rise. Since burn rate and equity usage tend to have a strong correlation both within an industry and across peer group companies, companies should run a benchmark analysis to understand different burn rate ratios and calculation methodologies.

Vital to managing burn rate is detailed forecasting and scenario modeling. These provide companies with insight into the dilutive impact of their equity plan under different scenarios and market conditions.

One often overlooked wild card is the impact of dividends on an equity plan. Many companies have equity plans that allow the accrual of dividend equivalent units (DEUs) that are paid in shares at vesting. Such plans dip into the share pool more because they use additional shares to pay out the accrued dividends. The impact of DEUs on the share pool can be compounded by performance awards with above-target payouts and influenced by the stock price on the dividend payable date. Even short-term volatility in the stock price can create a larger-than-expected impact on the share pool’s burn rate.

5. Corporate Transactions

Equity awards come with many challenges during a corporate transaction. There are unique administrative considerations when assuming an existing equity plan during acquisitions or creating a new equity plan for spin-off companies.

In the case of acquisitions, companies usually incorporate the assumed equity plan under their share tracking process to facilitate payments of outstanding awards assumed. However, the rules of the assumed equity plan may differ significantly from the company’s existing share tracking process regarding share recycling, dividends, and other conventions.

An additional question that has to be answered during acquisition is how to treat the assumed equity plan going forward. If the equity plan has enough shares left, companies can typically use them for post-acquisition issuances and extend the life of the equity plan without returning to shareholders for more shares. The tradeoff from keeping the plan open is that the company will have to administer multiple plans, likely with different rules. Additionally, keep in mind that once the assumed plan no longer has shares available, there will likely be a larger population of equity recipients drawing on the acquirer’s pre-acquisition pool.

With spin-off transactions, the critical issue is determining the size of the equity plan for any new entities without creating excessive dilution for the existing shareholders. As a rule of thumb, all post-spin entities should have enough shares to last at least three to five years. Since there may not be data on the new company’s granting practices or stock price estimates, determining the share pool size to fund the company’s equity compensation program can be tricky. The best approach is to develop a model to forecast dilution under different stock price assumptions and granting practices, then compare it with peers to understand if share pool size falls within the industry standards.

Wrap Up

Tracking share pools within equity plans may not be rocket science, but there are more moving pieces than most people realize. Issues with the share tracking process often go unnoticed until a discrepancy is found or a dwindling pool triggers a fire drill. We recommend companies be proactive by developing a robust, automated process to regularly monitor share balances within their equity plans.

We’ve helped many companies with share pool tracking and modeling. Please reach out if you need any guidance or assistance with the above topics.

[1] Shareholder value transfer is a dilution metric that ISS developed to calculate the potential cost of the transfer of equity from shareholders to employees.

[2] ISS calculates value-adjusted burn rate as ((number of options * Black-Scholes fair value)+(number of full value awards * stock price)) / (weighted average common shares outstanding * stock price).