EM’s Top Articles of 2021

As we look ahead to a busy year-end period and annual grant season, we like to reflect on the lessons of the year just passed. Often, the trends that begin to emerge can shed light on what to expect going forward. In that spirit, we delved through our Knowledge Center archives for the articles that were most popular among our clients and readers—and the ones we think might be most helpful to pause and revisit as we speed toward 2022.

1. Bold Predictions for Equity and Executive Compensation in the Next Four Years

The year 2020 brought us a new presidential administration with new regulatory agency leadership, along with a broad array of cultural, social, and political events making headlines. This seems to have made it a watershed year for corporate governance issues in general, and environmental, social, and governance (ESG) issues in particular.

What do those current trends mean for executive and equity compensation in the years to come? In this article from early 2021, we put our predictions on the board. Some highlights from our predictions by 2023:

• TSR prevalence reaches 70%
• ESG metric prevalence in LTIPs in the S&P 500 reaches 10%
• Say on Pay failures increase slightly in the 2021-22 proxy seasons
• The Dodd-Frank clawback rule is finalized
• The Dodd-Frank pay versus performance disclosure is finalized
• State pay equity laws shift to disclosure and reporting
• Investor pressure for voluntary pay equity disclosure results in disclosure from 25% of the S&P 500

Read more for our predictions about 2024 and beyond, including commentary on proxy advisor regulation, ESG metrics in the LTIP, climate disclosures, and updated human capital management disclosure rules.

2. Lessons From Year One Human Capital Management Disclosures

The SEC’s new human capital management (HCM) disclosure rules went into effect in late 2020, impacting the 10-K filings in 2021 for calendar-year companies. We collected S&P 500 company disclosures between September 2020 and March 2021 to analyze how companies approached the disclosure.

The themes we explored include:

• The most common HCM disclosure topics, from demographics to pay equity to Covid to corporate citizenship
• Disparate disclosure approaches, from minimalist to in-depth
• The use of both objective and subjective disclosure metrics
• Model disclosures that may form the basis of future practice
• How future SEC rule-making could change the nature of required disclosure

What should we expect now that year two is upon us? In the near term, we anticipate some convergence, at least at the minimalist end of the disclosure spectrum. Companies that took a wait-and-see approach have now waited and seen, so they may bring a disclosure that was bare-bones in year one into greater alignment with peer practices in year two.

Longer term, we expect that broader convergence will be top-down in some capacity. This is likely to come from a combination of institutional investor pressure, independent organizations setting standards (like the SASB, Sustainability Accounting Standards Board), and updates to the SEC’s own rules to become more prescriptive.

Read more for additional insights as you prepare for your next 10-K.

3. The Decision Points That Can Make or Break Equity Compensation at Pre-IPO Companies

Pre-IPO companies occupy a tricky middle ground. They’re mature enough that they need to compete with larger public companies for talent, but they don’t quite have the “ground floor” value proposition of a startup. Neither do they have the structural compensation advantages of a public company, like liquid stock to grant.

And yet, it’s critical for almost any pre-IPO company to rely on its equity as a differentiating compensation strategy. Because those disadvantages are equally advantages when flipped around. Pre-IPO companies aren’t as risky as a startup and typically have a clearer path to liquidity, yet they still have more upside potential than mature public companies.

What matters most is constructing an equity plan that will optimize for the positives and mitigate the negatives. While there’s no one-size-fits-all solution, there is a roadmap of decisions to weigh:

• Award type (incentive alignment, dilution, and peer practices)
• Calibrating grant sizes (percent ownership, fixed shares, or target value)
• Equity value for grant sizing (accounting value, economic value, or preferred value)
• Liquidity planning (none until a sale/IPO, regular liquidity windows, or in between; company-provided or secondary market)
• Vesting (time-based schedule, change-in-control requirements, or financial versus operational goals)

Read more for a deeper dive into these issues and more, including early exercise, post-termination exercise windows, and managing declines in equity prices. While certain aspects of this analysis focus on pre-IPO companies in particular, much is applicable to any type of private company.

4. Why Your TSR Award Value Is Unexpectedly High—and What You Can Do About It

With the pandemic and surrounding events hitting different industries in wildly different ways, the 2021 granting season created plenty of surprises. Fair values for TSR-based performance awards were no exception. When surprises arrived in the form of high fair values, companies were in a bind—those high values mean either higher expense and greater disclosed compensation in the proxy, or fewer shares issued to executives for the same target cost.

With many similar dynamics still in play, this issue remains very relevant for 2022 grants. In this article, we sought first to help companies understand the most common reasons their values may be higher:

• Realized performance. If a company is outperforming its peers during the stub period between the beginning average measurement and the grant date, the average expected payout will be higher than if they were underperforming, all else equal. This is simply because they have a head start over most peers toward those higher payout levels. In turn, this higher expected payout leads to a higher fair value. This is typically the largest driver of year-to-year fluctuations in TSR award value.
• High volatility. Many people are familiar with the Black-Scholes formula for stock options, where higher volatility means a higher value. While it’s not so simple with Monte Carlo models for TSR awards—there are literally thousands of moving parts that can swamp the effect—a higher volatility often means a higher value for reasons similar to Black-Scholes. This is especially pertinent given the volatility spike in 2020 that is still unavoidably part of companies’ lookback for computing historical volatility.
• Low correlation with peers. The effect of correlation is usually smaller than the other effects above. But in an extreme year, companies with broad-market peer lists like the S&P 500 saw radical divergences reflected in the correlations—think technology sector versus energy sector in 2020. Combined with high volatility, this can have a magnifying effect on value swings.

But company management still can control their fate. They can refine award designs to mitigate extreme outcomes, such as aligning measurement windows to the grant date and selecting peers within your sector. And regardless of design, you can always avoid surprises by being better informed about the range of possibilities and edge cases to keep an eye on. Read more for details on how to diagnose and mitigate these risks in your LTI program.

5. Executive Mega Grants: Navigating Pitfalls in Design, Valuation, and Accounting

A mega grant is what the name implies: an equity award that’s extraordinarily large, and notably one-time rather than recurring. Mega grants strongly align incentives at a time when win-win incentives are critical and aggressive shareholder value creation is necessary. They also provide powerful retention hooks for executives via high realizable pay over a long period.

But there are reasons mega grants are used only in exceptional cases. Shareholder advisor groups view them very negatively, and they involve putting many eggs in one basket with limited ability to adjust later. Also, the costs can be high and the administration and accounting can be tricky.

In this article, we draw from our experience with these grants to offer tips on getting them right:

• Design: tying recipient outcomes directly to shareholder outcomes via shareholder value creation (stock price or market cap hurdles) and other strategies for mitigating potentially negative shareholder or proxy advisor reactions
• Valuation: granular valuation modeling is critical early in the process to reflect the design decisions that can be very sensitive (e.g., hurdle, performance period, how performance is measured), and those that are counterintuitively less sensitive (e.g., RSUs vs. options, making extreme hurdles more extreme)
• Accounting: vetting key assumptions and methodologies with your audit team and their specialists early, avoiding material cheap stock risks if pre-IPO, and properly incorporating tranche-level derived service periods into your expense amortization models and controls

Read more for additional detail on these issues and the pitfalls you should look to avoid as you set out to implement a mega grant.

Parting Thoughts and Additional Resources

If you prefer audio and video over written articles, please also review our webcast replays from 2021:

• January: Granting an Award with an rTSR Metric? Here’s Your Pre-Flight Checklist
• February: 2021 State of the Union in Equity Compensation
• May: The 5 Ingredients of a Successful Pay Equity Study
• June: Effective ESPPs: Mastering the Design, Implementation, and Accounting
• September: Equity Compensation Reporting for Multinational Companies
• September: Human Capital Management Disclosure: Looking Back and Ahead
• December: Incentive Design Trends and Predictions for 2022

We wish you well as we head into the holidays and year-end, and we look forward to what 2022 holds for all of us. We hope that all of our clients and friends find these materials useful. Please peruse our Knowledge Center for more thought leadership on demand. And as always, we would love to hear from you.