Equity Incentive Plans in times of Uncertainty For Private circulation only

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Equity Incentive Plans in times of Uncertainty

For most Indian companies, the equity grants come at the end of the fiscal year after the annual performance of the organisation and evaluation of the executives. With challenges posed by COVID-19 along with other factors, such as oil prices (oil prices have come down by approximately 66 percent in past one year1) and depreciation of rupee, stock prices across industry clusters have reacted sharply to the uncertainty. The key indices are down by 15 percent to 50 percent from April 2019 levels.

In these circumstances, how should the Nomination and Remuneration Committees (NRC) approach equity grants? This note provides select potential alternatives, which can be considered with their respective pros and cons. The applicability of these alternatives obviously will vary from one company to another given its own situation with respect to business and talent imperatives.

There are broadly two types of grant structures that exist viz. companies that make the grant on an annual basis and companies that have a grant cycle of more than one year (companies with one-time grants or companies that have frequency of grants of more than one-year, e.g., grants happen once in three years). Given the present situation, these grant cycles might have to be treated somewhat differently.

Index Performance

1 Source: Nasdaq NMX

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Equity Incentive Plans in times of Uncertainty

This perhaps can be used if the assessment is that the industry and the company will revive in near term, i.e., 3–6 months and concern that executives may be overtly rewarded in the case of recovery. For companies that use stock options, the exercise price could be average of past 3–6 months (premium priced options). For companies that use full value instruments, such as Restricted Stock Units (RSUs), the number of RSUs granted could be calculated based on 3–6 month average share price. If the recovery doesn’t happen, appropriate add-ons can be considered.

• Strong messaging to shareholders and conviction that management will be able to turn around things as external environment improves

• For grants of full value instruments (RSUs), the accounting impact will be lower and fewer shares will be required

• The fair value of premium priced options will go down and hence, to deliver the same economic value, more number of shares will be required resulting in quicker depletion of the pool

• The stock options may remain underwater if the recovery takes time. With the retention value of options already granted going down, there could be a retention challenge

Pros Cons

Use three-six month average share price

Deviate from the normal cycle of grants and make the grants later in the year. If things improve, the grant size should not get impacted materially. If the environment doesn’t improve, the approach discussed above can be considered. To make up for the delay, the vesting schedule can be slightly accelerated, e.g., if the vesting schedule is 30-30-40, it could be 33-33-34 for this particular grant.

Do nothing - Wait and watch

• Good messaging – company is not taking advantage of down-cycle and providing an opportunity to executives to earn a windfall

• The share usage will be contained in the case of stock price recovery resulting in the available pool lasting longer

• Reduces the performance orientation in overall compensation structure

• With the retention value of options (already granted) going down, there could be a retention challenge

Pros Cons

If the companies have an annual grant structure and the cycle is coming up, the following are some of the select alternatives to evaluate:

Annual grant structures

If the equity compensation plan has been implemented to ensure that executives swim with shareholders, the shareholders should be okay with honoring the compensation commitment made to executives.

Grant as planned

• The retention value of grants already made has gone down due to depressed prices. Grants at current prices will help retention and somewhat make up for the lost value when the situation stabilises

• With depressed share prices, more number of shares would be required to deliver the same economic value and hence, the share pool will be depleted faster

• The governance around executive compensation can be questioned if there is a quick v-shaped recovery

Pros Cons

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Equity Incentive Plans in times of Uncertainty

If the grants are recent, irrespective of the nature of instrument (options, RSUs, performance shares) the wait-and-watch approach is probably the best. For historical grants, especially where the vesting was subject to performance and the performance period is approaching an end, there could be a challenge. If the performance conditions were based on aspects such as total shareholder return or market capitalisation/share price increase, the NRC can potentially revisit the averaging period at the end of performance period and use an average based on longer period, i.e., for companies already using a 3-month average of closing price, a 6-month average can be used. For those companies with no averaging, a 3–6 month average can be considered. If the performance conditions were internal (related to P&L, balance sheet, cash flow, etc.), the committee may have to consider applying discretion. Alternatives such as extending the performance measurement period itself, adjusting the past quarter performance, extrapolating the past three-quarter performance with suitable adjustments can be considered.

One-time grant structures

Should you be looking at re-pricing?Re-pricing stock options is generally not acceptable to shareholders. These are unprecedented times and in our opinion, the repricing may be considered only if there has been a sharp decline in share price, which in committee’s view is, largely, beyond the control of management and the expiry period of options is approaching (e.g., 3–6 months left for options to expire). If the options have life to go, the committee could follow a wait-and-watch approach and see if the recovery happens over the next few quarters.

A fine balance has to be achieved to ensure that larger stakeholder community views the compensation practices in a positive manner, and at the same time the purpose of having equity-based plan is met. Given the fact that the current situation is not just limited to India, the recovery in the share prices may vary by industry and company based on how quickly the situation stabilises worldwide.

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