A Tale of Two Views: Opportunities and Challenges for Compensation in 2024

“It was the best of times, it was the worst of times.” Charles Dickens began his famous novel juxtaposing the lives of different characters during the French Revolution.[1] That may be a bit dramatic for the executive and equity compensation space, but 2024 is shaping up to be a split-screen year.

On the one hand, we began with a stock market at all-time highs. On the other, indices like the S&P 500 are weighted by market capitalization and driven by fewer than 10 stocks. Unemployment is low and job gains remain solid. At the same time, layoffs are rippling across industries, including companies reporting strong financial results. Economists continue to debate whether a recession is coming or has been averted.

Against that backdrop, companies face tough regulatory compliance hurdles for compensation, with pay vs. performance (PvP) entering its second year and Dodd-Frank clawback enforcements happening for the first time. However, we may see a reprieve in new SEC regulation while the FASB kicks into gear with standard-setting that shines a brighter light on compensation.

All this suggests we’re operating in a risk-averse climate filled with both opportunities and challenges. In this article, we’ll look at five areas of opportunity and five challenging areas that merit defensiveness or caution. We’ll wrap with some practical suggestions for setting priorities this year.

Opportunities:

Loosening Homogeneity in Award Design
More Equity
Improved Processes
Rising Interest in Valuation Leverage
The Mini-Moonshot

Challenges:

Traps for Managerial Opportunism
The Beginning of Clawbacks
Share Pool Conservation
Compensation-Related Litigation
Much Ado about ESG

Opportunities

Loosening Homogeneity in Award Design

There’s been a growing concern that long-term incentive design is becoming rote: Peers are benchmarked, existing practices are replicated. The problem, of course, is that even close peers face different circumstances and a particular type of award isn’t effective just because a company issues it. Recognizing these limitations, more companies are willing to experiment with novel award designs to address specific goals and concerns in incentive design.

Here are some approaches we think are interesting:

• Creative goal-setting to more explicitly embed uncertainty. There are many ways to do this, but the best really comes down to collaboration between two functions—financial planning and analysis (FP&A) and compensation. Together, they can set threshold and stretch performance levels that reflect risk better than either function can do on its own

• Shorter performance periods. Three-year absolute performance goals aren’t realistic for every organization. Creative twists include three one-year goals or growth percentage goals that tee off prior-year actuals. ISS may not like it, but they’re just one piece of the equation

• Alternative formulations of relative metrics. Relative metrics simplify goal-setting, but have their own drawbacks. We’re seeing more modifier designs, upside-only designs, and step function designs—all of which sprinkle in benefits of relative metrics in a thoughtful way

• Caps to make total shareholder return (TSR) awards more efficient. TSR awards have a natural premium that can be very high for some companies. Since the premium is driven by the long tail of upside possibilities, companies can rein it in materially by managing this tail (think capping the value delivery or limiting the payout to 150% instead of the traditional 200%)

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More Equity

Some companies are finding they can grant more equity without creating the sorts of problems they’d face if they boosted cash compensation. This surprising observation is showing up across sectors. We have clients in sectors like industrials and materials who have successfully broadened their equity usage, either by granting deeper in the organization or by granting more at key levels such as CEO minus three and four levels.[2]

This is a sensitive topic and hinges on understanding how granting practices compare to peers, how investors react to changes in stock compensation expense and dilution, and what the business case is for using equity more aggressively. Here are a few examples we’ve worked on most recently:

• Rolling out a market-competitive employee stock purchase plan (ESPP) to grow share ownership and differentiate from labor market competitors
• Deepening equity granting practices (measured by level eligibility and lowest dollar value equity grant)
• Benchmarking at a higher percentile, especially for the CEO minus two, three, and four levels[3] or for roles facing especially strong competition for talent
• Increasing participation rates within eligible bands or roles
• Issuing outperformance awards on top of the existing long-term incentive stack[4]

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Improved Processes

New accounting standards on income statement disaggregation. Investor interest in equity compensation expense and dilution. A ballooning proxy statement.

All of these call for better reporting processes. While improving external and internal reporting processes is challenging, it facilitates better decision-making, greater managerial engagement, and more effective compensation execution.

Our eyes are on both stock compensation accounting (managed by finance) and the proxy (managed by HR and legal). FASB’s income statement disaggregation standard, which will bring more transparency to employee compensation, is driven by investors specifically asking for more detail. They want to know how stock compensation is flowing through the financials.[5]

At the same time, quantitative disclosures like PvP and the Item 402(x) table have transformed the proxy from a marketing document to something more like a financial statement.

The interdependencies between finance and HR’s roles in preparing the financial statements and proxy are too many to count. Without open lines of collaboration, handoff errors and misunderstandings are all but inevitable.

Tightening scrutiny of external reporting raises the ante for best-in-class internal reporting. Always start with accuracy: Are internal processes reliable, timely, and precise? Next, consider whether they’re flexible and adaptable. Rigid processes collapse in the context of award design changes and struggle to keep up with ad hoc internal requests and modeling requirements.

A strong process is one that anticipates and comprehensively addresses internal forecasting, modeling, and what-if queries. Some examples of managerial reporting of this nature include:

• Developing quantitative proxy tables like the summary compensation table and PvP, which lean on accounting calculations
• Stock compensation expense and dilution impact from new award designs (e.g., new performance grant, vesting schedule change, etc.)
• Expense and dilution implications for future anticipated terminations
• Award modification impact analysis on financials and proxy (if associated with a named executive officer)
• Variance analysis at cost center and division levels
• Share pool and dilution forecast across stock price scenarios

Another opportunity is to streamline proxy reporting. From our surveying, over 70% of companies rely on manual spreadsheets in preparing their proxy tables. With new and complex disclosures like PvP, enhanced controls and automation become more important.

On the specific topic of PvP, our view is that it isn’t fading away. We’ve had a front-row seat to academic research on PvP data, which has made it clear that three years of historical data isn’t enough to draw meaningful conclusions—but five years probably will be. For this reason, we expect proxy advisors and large institutional investors will take their time to build and test grading frameworks using PvP data, but eventually they’ll come to market with such methodologies.[6]

Although PvP has its flaws, it’s arguably a better way to assess the pay-for-performance relationship than the summary compensation table data. The best action to take now is a focus on quality and understanding what’s driving PvP results. This will be our top priority as we serve clients via table automation and analytics.

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Rising Interest in Valuation Leverage

Does the accounting cost of an award matter to long-term incentive design? Yes, for market-based awards and options that require a valuation. Enter the concept of valuation leverage.

Leverage refers to the potential upside of a grant, which is driven substantially by the number of units granted for a fixed accounting value. For example, stock options are considered a more leveraged instrument than full value awards, because the larger number of options in an equivalent-sized grant means more upside if the price increases.

Of course, leverage can go too far—picture an award that vests only if the stock price increases 1,000%—but nobody is trying to maximize leverage for its own sake. Rather, the goal is efficiency. An efficient design delivers the most pay for the least cost while calibrating the realizable pay opportunity to the organization’s performance goals. Sometimes this means a lower-cost design, although that can come with undesirable tradeoffs.

More than ever, companies are interested in valuation leverage and efficiency as they try to balance constraints like limited shares and investor scrutiny with the need to retain and motivate key talent. Here’s what this looks like in practice:

• Test more TSR design formulations. This could include negative TSR caps, post-vest holding periods, challenge goals, peer groups, and payout levels

• Identify areas of potential valuation surprise and de-risking. Examples include lengthy stub periods between the performance start date and grant date, high volatility estimates, spring-loading risks, and off-cycle grant structures

• Revisit stock options. Don’t overlook exotic designs such as exercisability hurdles and premium options

• Add a TSR kicker. Use financial metrics that, when achieved, provide access to a TSR kicker with additional upside (the GO Award is one such example)

• Experiment with capped awards. These can cut extreme payouts while the greater number of target units results in higher payouts across the vast majority of high, moderate, and low scenarios for the same cost

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The Mini-Moonshot

When most people hear about moonshot awards, they think of mega grants like the popular 2018 Tesla grant (more on that later). But moonshot awards come in all shapes and sizes, and we’re very interested in what we call mini-moonshots.

Mini-moonshots aren’t so large that they crowd out normal annual granting. Neither are the targets so aggressive that they require swinging for the fences. Instead, mini-moonshot grants may be issued every couple of years and they stack on top of the existing long-term incentive structure. They’re often issued to the CEO and one to two levels down, and typically contain stretch market-based (e.g., absolute TSR) goals that yield generous payouts if the company executes against its long-run strategic objectives.

Transformative goals tend to be rigorous, two-to-five-year strategic priorities that could turn the organization into a different type of company. These strategic priorities can be linked to valuation, e.g., “If we transform our software company into a subscription-based business with over $1 billion in annual recurring revenue, then the market capitalization should leap from $10 billion to $30 billion.”

Baseline design considerations for mini-moonshots include:

• Metric: absolute TSR growth
• Hurdle rigor: more than x% of current stock price, but linked to FP&A planning
• Performance period: at least three years but ideally five
• Measurement frequency: leaning toward discrete versus continuous
• Quantum: one-half to all of the annual long-term incentive

Two examples that we’re particularly fond of are those used by Cadence Design and Pure Storage.

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Challenges

Traps for Managerial Opportunism

In compensation, the principal-agent problem describes how shareholders (the principals) hire managers (the agents) to operate on their behalf but lose degrees of control and oversight in doing so. The interests of the agent may not align perfectly with those of the principal, leading to potential conflicts of interest and monitoring costs.

The SEC has been specifically focused on information asymmetries possessed by managers and how they could use these opportunistically. There are three[7] new rules specifically focused on opportunism:

• Rule 10b5-1 revisions. These were released in 2022 and became effective on February 27, 2023. In summary, the rules require a lengthier cooling off period, prevent overlapping plans, limit trading patterns, and require more disclosure

• Item 402(x) disclosure. This is a new proxy table required as part of the 10b5-1 rule. The table must list all grants made four days prior to and one day after the release of material nonpublic information (MNPI). The table must be disclosed in the first filing covering the first full fiscal year period beginning after April 1, 2023 (meaning it will initially appear in calendar year filers’ proxies issued in 2025 for fiscal year 2024, but as early as summer 2024 for off-calendar filers)

• SAB 120. Effective immediately upon its release in late 2021, this accounting guidance clarifies that stock compensation awards issued shortly prior to the disclosure of positive MNPI should be revalued to incorporate the effect of such MNPI

Item 402(x) and SAB 120 address cousins of stock option back-dating: awards that are spring-loaded (granted right before the release of good news) and bullet-dodging (granted right after the release of bad news). Eastman Kodak was involved with a well-known case of spring-loading.

It’s easy to trigger SAB 120 and Item 402(x) without meaning to. The triggers are similar but not identical. For example, Item 402(x) sets a bright line around negative four to plus one business days of releasing MNPI, whereas SAB 120 doesn’t have a bright line.

The solution is to revisit your granting policies, especially off-cycle and ad hoc grants. Remember that MNPI usually comes from an earnings release or investor day presentation, but it doesn’t have to be financial information. For instance, an 8-K announcing a new product launch or joint venture also qualifies as the release of MNPI. We worked with White & Case on a handy guide to support reviews of grant policies in light of the new SEC guidance.

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The Beginning of Clawbacks

The SEC’s clawback rule was released in late 2022 and went live in late 2023. Shortly afterward, we were already working on two clawback cases.

We hope that no one reading this ever has to go through a clawback (restatement) situation. But if it happens, it helps to keep a few things top of mind.

The cost exemption. A clawback is required from active and former employees who were Section 16 insiders during the covered period. Chasing down former employees, some of whom may be retired and not even living in the country, will be costly and complex. For many companies, the cost to recover will exceed the recoverable monies, bringing the cost exemption within reach.

Before invoking the exemption, consider two questions. First, would it look bad to shareholders? Second, have you made the obligatory “reasonable effort” toward recovery? It’s better to get the money back, so act fast and forcefully with multiple credible overtures to all covered executives. Carefully document your efforts in case the exemption does become necessary.

Disclosure requirements. Before a restatement, the only required disclosure is of the clawback policy itself (as an exhibit to the 10-K) along with a checkbox on the cover of the 10-K indicating whether any values are restated and subject to a recovery analysis. After a restatement, up to nine discrete disclosures become necessary. The disclosures pertain to the proxy or listing exchange directly, with some required only when invoking one of the allowable exemptions. None of the disclosures are particularly difficult, just make sure you don’t miss any of them.

Stock price metrics. When stock price metrics exist, the company must determine what the stock price would have been had the correct numbers been reported all along. This is usually determined via an event study, which is a common tool in stock drop litigation cases but will likely be an entirely new concept to the board and executives involved. There may be other appropriate techniques available as well, depending on the context. We’ve found that considerable education is needed when a board finds itself in this situation.

Discretionary clawback policy. The Department of Justice has made overtures that companies should adopt clawback policies that reach further than a Dodd-Frank clawback by addressing other forms of misconduct. Institutional investors like BlackRock have also suggested the same.

Obtain consent. To simplify the enforcement process, be sure to get executives subject to the clawback to acknowledge and agree to comply with the clawback as a condition for receiving equity.

We’ve published extensively on the topic of clawbacks. Please see our resources center to keep track of our latest content.

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Share Pool Conservation

Share pool problems come in two flavors. The first is a company that’s running out of shares because its share price is falling, potentially preventing it from fulfilling its annual grant needs. The second is a company with adequate shares (perhaps because they’re still benefiting from an evergreen provision) but the CFO or compensation committee wants to rein in granting because they believe the high burn rate is suppressing valuation. The playbook for solving each of these begins with the least punitive approach and progresses to the most punitive.

• Optimize share utilization in your plan terms. Aside from design changes, consider allowing for “liberal share recycling” of shares withheld for taxes in a net settlement. Although this costs points on ISS’s equity plan scorecard (EPSC), the additional shares unlocked usually outweigh the reduction in the number of shares that can be requested

• Optimize the share request. Take actions to improve the number of shares that can be requested. For example, consider implementing a minimum vesting requirement of one year and ensuring that executive granting practices check the boxes in the EPSC. License ISS’s EPSC tool to run scenarios and enable cost-benefit analyses

• Make grants in the present, but condition them on an upcoming share request. While the accounting grant date is deferred, this at least locks in the quantity

• Grant from an inducement pool. This strategy is available when onboarding new executives, and works especially well for larger sign-on awards

• Issue cash-settled awards to non-executives. Preserve the flexibility to modify the awards later on to settle in equity, either at company discretion or automatically upon approval of a new share plan

• Implement other design changes. This one’s debatable. For example, restricted stock units are often considered less dilutive than options and performance units that scale up to 200%. We take issue with this logic since a performance award should only pay out richly when the stock price has rebounded and it becomes cheaper to replenish shares into the pool

• Reduce equity eligibility. If this is too punitive, consider launching (or improving, if already present) an ESPP to match the take with a give

• Calibrate grant sizes using a hypothetical rebound price. For example, if the stock price is $2 but the 52-week high was $15, consider using a price between $2 and $15

Companies under pressure to reduce dilution tend to concentrate on strategies six or seven, whereas companies running up against raw share pool limitations focus on doing whatever it takes to replenish the pool and keep the business going.

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Compensation-Related Litigation

On January 30, a Delaware judge voided a $56 billion pay package for Elon Musk, siding with plaintiffs in a suit brought against the Tesla CEO and certain board members. But this topic is much broader than shareholders objecting to an outsized moonshot grant. Let’s look at some ways compensation-related litigation could unfold this year and in the years ahead.

Department of Justice focus on incentive metrics and clawbacks. In speeches at the March 2023 ABA White Collar National Institute conference, members of the Department of Justice reinforced points that Deputy Attorney General Lisa Monaco laid out in a memo from September 2022.

One of those points is the agency’s desire to see compensation structures that encourage compliance and deter misconduct. This supports the use of balanced scorecard components in annual incentive plans (in contrast to the typical proxy advisor preference for objective metrics only). Beyond that, goals could clash with the tone of the Justice Department’s analysis if they’re so ambitious that they create an incentive to take risks.

Justice Department representatives also emphasized the importance of “compensation systems” that penalize misconduct, specifically highlighting clawback provisions. This is one of many forces that’s likely to nudge companies to adopt clawback rules even broader than those mandated by Dodd-Frank.

Moonshot and transformation grant risks. The Tesla case involved sums that are categorically excessive for most boards. Still, the judgment means new risk for outsized grants even if the amount is much more modest.

The reason is that the court abandoned the business judgment rule for the entire fairness standard. Whereas the former defers to the board of directors in making sound judgments, the latter flips the burden of proof to the board, requiring the board to show (in an undefined way) how its decisions are entirely fair. The entire fairness standard was adopted because the court concluded that Tesla board members were not independent, despite Tesla board members meeting Nasdaq listing standards for independence.

Proving that performance goals are rigorous and “fair sharing” in a larger grant may not be sufficient in the wake of the Tesla decision. Consider taking the following steps:

• Assess board independence as critically as possible and address any concerns through a genuinely arms-length, even adversarial, negotiation process
• Document contemporaneous evidence of the negotiation process’s objectivity along the way
• Use PvP analyses in determining whether the award is rigorous and justified
• Benchmark the award, even if custom analysis is needed due to unique circumstances
• Use custom analyses for benchmarking that focus on the risk of pay, sharing ratio, nature of the executive, and other variables that may not be part of an add-water-and-stir summary compensation table benchmarking exercise

Proxy misrepresentations. Litigation against Apple caught our eye because it involved a plaintiff alleging a misrepresentation in the proxy over a deeply technical matter. Apple uses the face value of the stock instead of the accounting value to calibrate grant quantities. This led to an approximate $20 wedge between the “target value” intended for CEO Tim Cook and the value disclosed in the summary compensation table.

Apple easily prevailed in the case because the proxy rules don’t require a particular method for calibrating grant quantities and Apple’s disclosure of its process was clear and transparent.

The takeaway is that plaintiffs’ litigators are reading proxies for what may appear to be misrepresentations. As the proxy becomes more complex, dense, and quantitative, risks of omission or inadvertent misrepresentation go up. So clarity is extremely important.

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Much Ado about ESG

Remember the journey of milk? In the mid-20th century, milk consumption was actively touted as essential for the young and elderly alike. Then it came under fire from health experts. Today, the data is mixed and you’ll meet people on both sides of the aisle, but hopefully consumers know how to test their own boundaries and needs.

We hope this is how the environmental, social, and governance (ESG) debate evolves, with companies arriving at their own conclusions about ESG’s importance given their business strategy.

ESG intersects with compensation in two places. One is the impact that the company has on how workers are compensated, with pay equity being a common measure. The other is the decision to use an ESG metric in the annual or long-term incentive plan.

We’re seeing trepidation about pay equity following the Supreme Court ruling on affirmative action. Many companies that haven’t formally embarked on pay equity analyses are worried about blowback from their boards or internally if they do an analysis and it uncovers problems. But pay equity studies, done right, are entirely consistent with evolving legal frameworks. Studies are privileged and not open to outside examination. Moreover, pay equity is a journey, not a one-time exercise. That makes education of the board and C-suite leaders essential to gain the right perspective on results.

As for executive compensation, most companies (70% to 90%) incorporate an ESG metric in their annual plan while fewer than 10% do so in their long-term plan.[8] However, each company handles ESG incentives differently. A few questions to consider include:

• Is there an ESG metric so tied to the corporate strategy that it would be odd to not include it when setting compensation goals?

• Is the ESG goal incremental, making the annual plan a good fit? Or is it a large, audacious, strategic goal that belongs in the long-term plan?

• How should the goal be incorporated (say, as one goal in a broader balanced scorecard or as a stand-alone metric)?

• What weight should the goal have in the overall stack of metrics and incentives?

• Is there legal risk associated with using a non-financial goal of this nature, especially if it’s related to diversity and inclusion?

We think boards and management teams are going to think much more critically about these topics in 2024. That’s not to say they’ll pull back on ESG, but rather put it up for more nuanced debate and discussion.

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Wrap-Up

We’ll close with five suggestions as 2024 gets underway:

1. Open up lines of communication between accounting, HR, and legal. There are too many critical intersection points to ignore

2. Invest in internal and external process upgrades. As stock compensation comes under the magnifying glass, process agility, precision, and flexibility will win the day

3. Develop an internal dashboard of strategic executive compensation topics. With so much new reporting and regulatory-linked activities, it’s easy for every waking minute to get consumed by compliance. Be sure to maintain a living dashboard of strategic priorities as well

4. Data-driven, analytically-oriented functions command greater executive presence. This is true in both accounting and total rewards. Executive management is hungry for visualization, modeling, and crisp, data-based storytelling

5. Consider creative long-term incentive design strategies while dosing them with professional skepticism. That’s to say we think there’s a lot of promise in considering out-of-the-box strategies in terms of award features, granting practices, etc. At the same time, novelty needs to be intimately tethered to strategic priorities and never simply be for its own sake.

One thing not mentioned anywhere here is the impact AI will have on the compensation landscape. The jury is still out on what that will be. Accounting models are closed form in nature, meaning they’re equations with exact answers (i.e., there’s no room for hallucination). Executive compensation design is similarly model-linked but the sweet spot is fusing analytical modeling with context-specific ideation. Certainly, AI will impact the data harvesting and curation space, and this may be the first place in which it begins adding value. In any case, we’re keeping an eye on developments in this space.

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[1] For those interested in one of the most famous openings in a novel, Dickens writes: “It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to Heaven, we were all going direct the other way…”

[2] CEO minus three is usually the VP level and CEO minus four the senior director level.

[3] CEO minus two is usually the senior vice president level. But again, there’s no set rule and the right level to focus on could be CEO minus four or further down.

[4] Outperformance awards can be structured very differently, but they share the quality of delivering high pay at a high level of risk or uncertainty. They aren’t meant to replace the “safer” stack of long-term incentive awards, but to supplement it by offering favorable accounting treatment and meaningful upside only in an outperformance situation.

[5] Investors approach stock compensation differently. Some are of the opinion that stock compensation is a valid expense and should be included with non-GAAP results. We call this a numerator focus. Others are more focused on the denominator of EPS and how dilution is modeled in the context of stock compensation granting and expense patterns.

[6] For example, a common robustness test of a model is to calibrate it using one time period of data and then see how those results hold up over a different time period. This arguably requires at least four years of data, and ideally the full five years, in order to be done meaningfully.

[7] Technically, there should be a fourth. The SEC released new rules on share repurchase disclosure in May 2023, but in late 2023, the US Court of Appeals for the Fifth Circuit ruled that the SEC violated the Administrative Procedure Act. After some back and forth, the court vacated the new rule and issuers must comply with the previously existing rule on share repurchase disclosure. The new rule would have required considerably more frequent and granular disclosure of repurchase activity.

[8] We give a percentage range because different firms define an ESG metric differently. For example, we don’t consider a metric like safety to be an ESG metric (to us, it’s an operating metric) whereas others might.