March 21. 2024

4 Pitfalls to Avoid In Equity Compensation

Delve into the complexities of equity compensation. Unearth the four prevalent missteps businesses make and arm yourself with strategies to avoid them.

In this article

A well-structured equity compensation agreement can have many positive effects for the company. There are also some possible unintended effects if the agreement is not adapted to the company’s needs and wishes. In this article, you'll find some things to keep in mind.

 

Dilution of the stock

As the options are exercised, the number of shares increases. This can potentially lower the value of the shares that current shareholders own. To counteract this dilution effect, some companies decide to buy back their own shares or utilize financial tools, such as total return swaps. However, if these companies decide to borrow money to fund these buybacks, they will incur interest costs, which can impact their financial results. 

Long-term and healthy perspective in decisions

Managers might focus on quick results rather than long-term growth if they can sell shares immediately after the options have been exercised. This happens if time aspects and goals have not been thought through. One solution is to order everyone to sit on the shares a few years after the option has been exercised. For the financial industry, there are separate regulations (Remuneration schemes in financial institutions, investment firms and management companies for mutual funds) that regulate this – something we will return to in a separate article.

 

Tax and employer’s contribution for illiquid shares in relation to expiration

Share salary instruments (as options) often give a high tax bill to the participant and employer’s tax bill to the company. In the event of a win, it is important that the liquidity of the participant and the company is considered. In the worst case, we have seen variants where options with a large “paper gain” have expired as it has simply not been possible for the participant to finance tax and redemption price. If the company is listed on the stock exchange and the share is liquid (there is a certain frequency in trades), some shares can be sold off to cover this capital requirement. So mainly this is a challenge where it is tricky to sell off a share of shares.

 

Unwanted high payouts

In some cases, stock pay programs (especially options) have yielded sky-high payouts. This is positive for participants, but not always desired by shareholders and this can also affect the company’s reputation. There are also mechanisms here that can counteract this. So-called Cap’s (roof) and Brakes (brakes) are effective mechanisms for removing the risk for the “front page of the financial newspaper” due to sky-high payments.

 

It has become more common to make a new price assessment when the options are ‘out of the money’, preferably to get top management to remain. Many believe that such a practice is unsustainable because it is a way of saying “done is done” that does not benefit ordinary shareholders who have bought and sat on the investment. It is often said that it is better to own a small share of Coca Cola than a large share of Jolly Cola. Used correctly, share pay can create organizations where all good forces are oriented in the same direction, for the company’s long-term and healthy development.

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