Why is it So Difficult to Get Equity Amounts Right?

May 12, 2016

Let me start this by saying that there is little new in this post. If you have been a senior compensation professional during a market downturn, this should sound familiar. If you have not had this exciting and seldom pleasant experience, buckle up and let’s go!

The main selling point of equity compensation is that it provides unequaled compensatory upside through its extreme variability, while allowing a predictable and fixed compensation expense. This can be frustrating when things don’t go as planned.

Compensation professionals prefer to be confident in the values they give management for approval. They also like to provide employees with easy to understand communications that describe things in black and white. Lastly, they like to use round numbers and simple growth rates whenever possible. With equity compensation, you can either be confident, easy to understand and use simple numbers, or you can be right.

Let’s start with a simple table that will be the basis for arguments among long-term compensation professionals. This table is a basic reference. The numbers are wide-ranging. Many people will disagree with it.

Equity comp chart 1

There are many ways to look at the value of equity compensation. These reason equity is so hard to value is that all of the methods provide inaccurate results at some point. Given the uncertainty in the markets, it’s probably a good idea to discuss some of the ways people assign value to equity.

The Black-Scholes Merton (BSM) model: This is the most common tool for companies to determine stock option value. It’s a mathematical formula created by people far smarter than me. They were even awarded a Nobel Prize for it. It is also always wrong.

The model usually values each stock option share at between 30% and 50% of the underlying stock price. Shorter or longer grant lives can change these numbers a bit. A volatile stock price is also a major driver of additional value. Volatility and value can be confusing, as shown below. The Growth Stock obviously provides more value to anyone holding stock options, but it has far lower volatility and therefore a lower BSM value.

So, how do you deal with Black Scholes? First, don’t try to explain it. You know how people always say their job “isn’t rocket science?” In this case, it is. The BSM model uses math created to determine the trajectory of rockets to help determine the trajectory of potential values. Just tell people that the BSM generally ranges from 30% to 50% of the stock price and you will let them know if they fall outside this range.equity comp chart 2

Second, understand its purpose in compensation. Models like BSM are used to ensure that some level of expense (Fair Value for ASC 718) is included for shareholder consideration. It is not a predictor of your future stock price.

Realized and Realizable Value: These are the actual amount paid (realized) and current intrinsic value of vested and unvested equity not yet transacted. Realized pay can only be determined when the value is finalized. It is sometimes reported in public company filings, but not in survey data. Remember that your survey data doesn’t tell you what equity will really be worth in the future, but we often treat it like it does.

Risk Adjusted Return: This is a method for comparing the potential return of your awards by looking at a stable resource and factoring in the riskiness of your company. Sounds great, huh?  But, the trick is finding a suitable predictable source to use as the basis of the comparison. I haven’t found that this method works consistently enough for employee equity to give you any traction.

Perceived Value: This is the most important value up to the moment someone does a transaction. It is also both very tricky and deceptively easy to find out. If you want to know how much value your executives or employees feel their equity is giving them, simply ask. But, you need to be prepared to hear two kinds of values. The first, some super crazy inflated value that is unlikely to ever become real. The second is nothing. Absolutely nothing. The first usually occurs when the market and your stock price is hot. The second occurs when things turn sour.

Luckily, perceived value is the one thing you can impact in a positive way. Education programs and great data sources can help modulate individual perceived values into ranges that you find more acceptable. Without a reasonable perceived value, your equity program will never meet its objectives.