10 Smart Questions Finance Chiefs Ask About Stock-Based Compensation

Clients in the compensation space often ask us what concerns chief financial officers and chief accounting officers the most when it comes to stock-based compensation (SBC). Ironically, CFOs and CAOs often ask us the same thing. Given this curiosity, we assembled 10 of the most common questions we hear from finance leaders. They fall into three categories:

Financial Reporting Stewardship (topics 1–3)

Insight Beyond Compliance (topics 4–7)

Incentive Design (topics 8–10)

CAOs often focus more on process stewardship and insight, whereas CFOs get more involved in the incentive design process and external matters. In any event, leading companies make sure that SBC reporting is a center of excellence so CFOs and CAOs can interact with the process effectively.

With that, let’s discuss the topics one by one.

Financial Reporting Stewardship

First and foremost, finance leaders are charged with producing reliable financial reporting and maintaining a robust system of internal control. These are table stakes that lay the groundwork for delivering insights and contributing to incentive design.

1. How resilient is our SBC process?

Finance leaders (especially CAOs and controllers) constantly search for vulnerabilities in their processes. The calculus is simple: For any given process, what’s the risk (likelihood) of something going wrong and what’s the potential magnitude (quantum) of a problem?

SBC can have moderate to high risk because of:

• Large amounts of data
• Data that’s constantly changing
• Employees moving to another state or country
• The rollout of new award designs
• Existing award modifications
• Awards assumed through mergers and acquisitions
• Legal entity reporting
• Spreadsheet reliance

Magnitude depends on the extent to which SBC is used and its impact on EPS. But even when use is low, you still need to manage the possibility of a material weakness or a problem at the legal entity level where the materiality thresholds are different.

Process failure often occurs during periods of change. So, after determining the risk and magnitude of a topic area, the next step is to identify trigger events—internal or external situations that introduce change to the process—then assess how the process reacts to changes. The question boils down to how resilient the process is. For example, does an award design change complicate an already manual process? How is employee mobility taken into account? Is it treated the same way in the expense accrual process as it is (or should be) in tax’s determination of excess benefits and shortfalls?

When clients outsource their SBC reporting to us, we automate the SBC reporting process end to end, with detailed checks to address the moving parts. Common trigger events like modifications should be organic to the process, whereas others (think acquisitions and divestitures) are more appropriately handled as they occur.

One final thought: The skills required to do SBC reporting are specialized and technically complex. Before the Great Resignation, CFOs sometimes used to tell us, “I’ve got a person who does that.” Now we’re more likely to hear them say, “I’ve got a person who does that and I’m deeply concerned about key person risk.” The people they’re talking about are often deeply concerned themselves because it’s hard to take on new challenges and opportunities when they’re so central to the process.

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2. What are our inter-department handoff risks?

With SBC, multiple departments enter information, run reports, and use the results. This gives rise to handoff risks between:

Compensation and accounting. If award design changes aren’t communicated to accounting, they may either misconstrue what’s in the data or apply an assumption different from what’s intended.

In one example, the board of directors decided that the lower-end financial goal in the budget was the most appropriate level for target pay, because it was the most probable outcome given recent negative events. However, accounting interpreted the board-approved budget differently and began accruing expense according to a 200% assumed payout. This led to a disastrously high disclosure of reported pay in the proxy.

Stock administration and accounting (data integrity). Stock administration is primarily focused on the participant experience, which includes helping participants understand their equity awards. This can clash with how data needs to be set up for accounting purposes. Multi-metric performance awards and modifications are two of many examples.

Accounting and forecasting and planning (FP&A). FP&A functions often rely on their own home-built, top-down models that tee off reports from the core accounting team. Then FP&A will make various on-top assumptions. However, this can be a recipe for budget-to-actual variances.

Accounting and tax (tax provision). Accounting often hands its core expense reporting models to tax, then steps away. However, data changes, modifications, employee mobility, and more can create disconnects between the time tax sets up the deferred tax assets and when they unwind them.

Accounting and compensation (proxy). This risk manifests in the proxy, since the proxy is tethered to the core ASC 718 accounting framework. Relative total shareholder return (rTSR) award valuations are frequent culprits, as valuation surprises lead to either deflated or inflated grant quantities (or reported pay surprises in the proxy).

These aren’t the only handoffs. A few others to consider are those with:

• Treasury (dilution forecasts, buyback plans, and cash flow forecasts) 
• Legal (award agreement drafting, proxies, and modification plans) 
• International controllers (statutory reporting, international tax, and recharging) 
• Technical accounting (policy formulation and accounting memo drafting) 
• Payroll (FICA tax management, early exercises, and mapping data) 

These activities can be part of the ones we mentioned earlier, but often they’re discrete and require separate management.

CAOs and CFOs are well-served to make sure there’s ongoing dialogue among the key functions. This should exist at both the most senior levels and execution levels. There should be touch-base sessions before every reporting period to discuss changes and, depending on the need and volatility of operations, post-mortems after every period to identify improvement opportunities.

As usual, there are people, process, and technology solutions to mitigate these risks. When we’re engaged, we try to bridge the functions. We’re usually connected to each one (a people and process approach), and we leverage an integrated calculation platform (a technological approach). We make it a priority to speak each function’s language.

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3. What’s the SBC impact of accounting standard changes?

CAOs and CFOs are well-versed in adopting new accounting standards. Each one gives rise to a four-step exercise: what’s the new conceptual framework, what’s the exposure to the company, what systems and operational changes are needed, and what impact does this have externally?

New standards impacting SBC have taken different forms. For example:

• Accounting Standards Update 2016-09 revolutionized stock compensation tax accounting by causing excess tax benefits and shortfalls to hit the face of the income statement, adding both earnings and effective tax rate volatility

• The Securities and Exchange Commission’s pay vs. performance rule introduced mark-to-market fair value accounting to the proxy, forcing accounting to broaden its purview even further into proxy reporting

•  Accounting Standards Update 2023-07 expanded the scope of segment reporting in a way that will result in greater disclosure of significant expense types

The latter is an example of a simple revision from a process perspective (it requires disclosure of data already being produced) but may have interesting external implications. The FASB’s deliberations on income statement disaggregation will most certainly have external implications, but for some companies it could also require system rework.

After income statement disaggregation, the next big thing for CAOs and CFOs to monitor is the possibility of revised human capital management disclosures. Given the SEC’s decision to stay its new climate rule only weeks after its release, there may not be any new bold rule-making until after the election. We’ll see.

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Insight Beyond Compliance

Finance professionals deliver greater impact as they progress from reporting the news to forecasting and planning the future, influencing operational decision-making, and interacting strategically with investors and other stakeholders.

4. How do investors use financial information about SBC?

There’s been a decades-long debate as to how investors view SBC. Do they care? Do they back it out and ignore it? Should presentations of non-GAAP earnings proactively include or exclude SBC expense?  

Our view is that both SBC dilution and income statement expense matter.[1] Many investors incorporate income statement expense in their valuation models that are based on free cash flow projections. Similarly, the dilutive effect of equity impacts valuation as a hurdle that needs to be surpassed by growth to justify those price targets. 

 But different investors incorporate SBC with their valuation models in different capacities. As such, we suggest maintaining a dashboard of different approaches, taking care to not get your messages crossed. There are three gating decisions investors make: 

1. Whether and how SBC should be added back in measures of free cash flow
2. Whether to consider dilution from existing shares (and how to factor in stock options and performance shares given their payout uncertainty)
3. Whether to consider dilution from future equity granting 

Again, each Wall Street shop has its own approach and there’s a lively ongoing debate as to which approach is most predictive of future value. We think it’s worth running multiple lenses.

This is a topic that finance leaders work hard to understand because it’s an inevitable source of dialogue with investors and the board. Given the different views on how SBC should factor into valuation, it’s easy to operate under a set of assumptions that turn out to clash with those of a particular investor cohort or board member.

While this might sound academic, it’s not. Besides the negative energy burned when competing views on SBC dilution clash, these analyses are used in setting top-down SBC utilization budgets (see topic one in the next section). One of the most challenging curveballs for the CHRO to manage is when the board or CFO sets a hard watermark on the amount of SBC that can be granted, thereby requiring rapid changes to granting policies and the compensation philosophy itself.

Another important use for this information is deciding how to treat SBC in non-GAAP disclosures. Our research shows that companies are progressively more inclined to treat SBC as an expense as they grow and mature. The question is generally when, not if, to begin including SBC as an expense in non-GAAP measures of income. Usually, that’s when forecasting becomes reliable enough to understand and model SBC expense into the future. And that’s our next topic.

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5. How rigorous should our forecasting and visualization be?

Leading finance functions invest in excellent forecasting and visualization processes. They use granular assumptions, are disciplined in developing and analyzing fluxes and forecast-to-actual variances, and make sure stakeholders across the relevant functions understand the results.

 In part, this investment in best-in-class forecasting reflects the importance of SBC expense in the overall financial statements. When the company is growing quickly, it’s easy for SBC to grow at a faster rate than revenue or other expenses, in which case dilution and equity valuation problems can quickly materialize. Rigorous variance analysis uncovers whether unexpected jumps are linked to hiring, attrition, or other drivers.

Even at mature companies where hiring and attrition ebb and flow at more normal rates, or SBC is an important but medium-sized expense, detailed forecasting and variance analysis fit into a broader ethos of disciplined financial management.

We see the most progressive finance leaders using flux and variance analyses not only to set expectations and avoid surprises, but also to influence equity granting strategy. Many of our clients frown on even positive variances because this suggests they could have granted more equity, either broadly or in a specific domain.

Finally, more and more companies are using cloud-based analytical tools on their data. As we’ve illustrated, enormous amounts of information can be systematically captured in centralized databases with summarization delivered via platforms like Power BI and Domo.

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6. How can the SBC process support ad hoc analysis and planning?

CAOs and CFOs typically interact with the SBC process when unusual issues are going on or sensitive questions are on the table, prompting them to bring questions like:

• What happens if we divest division ABC and partially accelerate vesting? 
• Why did expense surge in division XYZ last quarter? 
• If we revise our retirement eligibility provisions, how would our expense run-rate change over the next five years? 

• What are the maximum and minimum expenses associated with rolling out a top-of-the-line employee stock purchase program? 
• How would a 25% share price increase or payout at performance maximum impact the following year’s expense?

This is when finance leaders discover how useful the overall process is for ad hoc analysis and planning.

To answer an ad hoc query, sometimes all the SBC team needs to do is filter a report. Other times, it takes highly customized analysis. Either way, it’s easy to miss the big picture. For example, if a CFO wants to understand the impact of removing retirement eligibility, it might be tempting to run an expense report into the distant future with and without retirement logic turned on. But this will produce a massive and deeply biased differential that overlooks multiple questions. Among them: How would any plan design change be grandfathered in? How will income statement expense change? Economically, how many more awards will forfeit?

That’s why it’s important to never embark on an analysis without knowing what’s motivating it and what strategic question is at issue. This will help the SBC team ensure the modeling is decision-useful and manage the tradeoff between precision and speed.

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7. How can we work with the compensation committee better?

Many CFOs recognize they have a better chance to gain board appointments in the future when they broaden their horizons beyond the audit committee. One way to do that is to anticipate the compensation committee’s SBC-related priorities and address them in a proactive way. We suggest the following:

1. Get to know the compensation committee’s rhythms, beginning with the annual calendar and the purpose behind each meeting.
2. Play a hands-on role in financial goal-setting, if that’s not happening already. In particular, this means detailed involvement with setting threshold, target, and stretch goals for the relevant metrics and weighing in on which metrics make sense in the short-term plan versus the long-term plan.
3. Understand the proxy advisor landscape and the hot-button issues that affect say on pay and related proxy proposals.
4. Master the proxy—both its technical contents and the process behind its preparation.
5. To the extent possible, collaborate on succession planning procedures and frameworks. This is becoming an increasingly important topic at both the compensation committee and full board levels.
6. Participate in broader human capital oversight activities, such as the company’s annual pay equity assessments and reviews of diversity and representation statistics. Whether or not these activities fall under the formal compensation committee charter, the trend is clear that compensation committees are asking more workforce-related questions.  

The idea is to upskill your interactions so you can prepare for a future board appointment that may include a seat on the compensation committee as well as the audit committee.

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Incentive Design

Finance is often uniquely suited to further better decision-making and implement the compensation philosophy in the incentive design process, in partnership with the compensation function.

8. Are we over or under-granting?

As we mentioned, finance is usually closely involved with setting a top-down SBC budget, which is generally expressed in terms of dilution and financial statement expense.

Finance leaders assess SBC in different ways. In the high-growth technology sector, SBC as a fraction of revenue is an important metric. You’ll often hear that SBC expense shouldn’t exceed 10% of revenue, but this obviously depends on the context. As hyper-growth subsides, SBC as a fraction of net income becomes a more appropriate barometer.

How much is too much? First, study peer comparisons to gauge high, low, and average industry levels. These should be scaled for employee count, revenue, and market capitalization. They should also be determined for named executive officers in the proxy versus all other recipients.

Second, model internally the different ways investors model SBC in formulating valuations and price targets. As discussed earlier, investors vary in how much they burden an equity valuation with SBC usage, so it’s important to understand this range when deciding how much equity is too much.

Finally, listen to analyst questions and read analyst reports. These can be insightful when there’s a problem.

What happens when the evidence suggests SBC utilization does need to be curtailed? In that case, the CFO can work with the CHRO to pull levers like:

• Reduce grant eligibility 
• Emphasize an employee stock purchase plan over full-value awards 
• Adjust the benchmarking framework 
• Change global granting provisions 
• Revise award terms (e.g., vesting or retirement eligibility) 

For all the talk on dilution and excess burn rates, though, there’s surprisingly little focus on under-granting. Many companies could boost their SBC usage, not take a hit in their equity valuation, and unlock greater benefits in attracting and retaining top talent. As CFOs become more involved in operations and growth, we see them championing greater use of SBC when the data suggests there’s room for expansion.

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9. What should our role be in setting financial goals?

Nearly all companies grant performance-based awards, and most employ some combination of market and financial metrics. A market metric often takes the form of rTSR, where there’s no need to set an absolute future goal because performance is measured on a relative basis. Financial metrics, on the other hand, require setting future goals, often three years out.

Three goals need to be established for a typical performance award:

• The threshold at which some payout is earned 
• Target performance at which the middle (or close to) payout is earned 
• Stretch performance at which the maximum payout is earned 

The CFO should be immersed in this process. Getting involved is also a key way to add value to the compensation committee. Let’s unpack how.

First, establish what constitutes target performance. This should correspond to the board-approved financial plan, which the CFO takes a lead in developing, socializing, and having approved by the full board. Target performance should match the company’s best-guess expectation on the date of grant, which also ensures that reported pay in the proxy corresponds to a 100% payout and not a higher value that would suggest runaway pay.

Developing threshold and stretch performance goals is a tougher exercise. Some companies merely flex the budget to 90% and 110%. We’re skeptical of that approach. Finance leadership is best equipped to assess the variables impacting over and under-performance. As a general rule, stretch achievement should be about 10% to 20% likely and threshold achievement should be 80% to 90% likely.

The modeling used to develop the board-approved budget should be flexed to assess worst and best-case outcomes in the context of threshold and stretch levels. This might naturally correspond to the 90% to 110% construct, but it might not. When it doesn’t, it’s time to ask:

• Are the ranges too wide? During periods of high uncertainty, perhaps the modeling effort suggests a range around target of plus or minus 40%. Even if the model suggests that, the external optics may be untenable

• Do the upside and downside need to be symmetrical? For instance, could stretch performance be expressed as 110% of target and threshold as 80% of target? This can be done but will take explaining to justify, which is all the more reason finance needs to be heavily involved

Analyst estimates are a useful sanity check. But remember that analysts form their estimates using company guidance, so there’s circularity here.

Although compensation generally takes the lead in rTSR award design, finance should take the lead in goal-setting. At the same time, finance should know what compensation is trying to solve for and the dialogue taking place with the compensation committee. For instance, if there’s been a string of subpar payouts, perhaps compensation is after more achievable goals. Or they may be trying to set goals above the prior year in response to a common criticism from proxy advisors.

A firm like ours will work with both compensation and finance to test the effects of different peer groups, run back-testing, look for more efficient award structures, and so on. These exercises tend to be more quantitative and scenario-based since internal financial models have a relatively light effect on the design ideation.

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10. How can we make our LTI awards more cost efficient?

This is an extremely important but frequently overlooked area. It can be championed by finance leadership or even within compensation. The basic idea is that an efficient LTI design allows you to grant more equity for less cost. This is primarily done with market awards or stock options where a valuation model is used, but creative approaches are also available for financial metric awards.

The framework is this. A slight majority of companies calibrate the number of grants issued based on the accounting value. For example, if one performance stock unit costs $2 and the company intends to grant $100 in total value to their CEO, then 50 performance stock units would be granted. The accounting value often diverges from the face value of the stock, with many standard rTSR awards being valued at a premium (e.g., if the accounting value were $2, perhaps the face value of the stock would be $1.50).

Even if a company uses the face value to set grant quantities, a too-big difference from the accounting value will result in an outsized result on the face of the proxy, which investors won’t like.

The goal isn’t the lowest value. There’s no free lunch, so driving the value down means adding punitive features to the award. But there are levers that can reduce the value, allow more shares to be granted (or a lower proxy cost), increase the pay opportunity, and avoid tarnishing the underlying incentive goals of the award.[2]

When we run these analyses, we short-list multiple design scenarios and then model them both in terms of proxy cost and pay delivery potential. When modeling pay delivery, it’s worthwhile to see how the award behaves across performance states of nature. An award may pay out exceptionally only at levels of extremely high performance, thereby being too risky, not aligning with the incentive goals, and having a low perceived value.

While compensation can (and often does) take the lead on this analysis, we’ve worked closely with many CFOs who champion it because the analytical methods conform to what they’re already doing in different domains. Regardless of which function quarterbacks the effort, it’s important that it takes place because it bears directly on how competitive the LTI program is relative to its cost.

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[1] This topic has been covered extensively by practitioners and academics.An evergreen blog post by Aswath Damadoran offers a simple, down-to-earth discussion of how stock-based compensation affects valuation.

[2] These levers include but are not limited to: flexing the peer group, adjusting payout levels, adjusting percentiles linked to payouts, tweaking performance period conventions, introducing a holding period or payout cap, and altering the overall style of the metric (e.g., between being a modifier or standalone metric).