“These results validate our belief that the stronger the link between executive pay and company performance, the more likely the company will be to outperform the competition,” said DC&P President Jack Dolmat-Connell.
DC&P’s study of executive compensation and long-term incentive usage in the 100 largest high-tech companies in the U.S. found that high-performing companies were 65% more likely than low-performing companies to grant stock options to their CEOs as the only long-term incentive and were 39% less likely to grant restricted stock.
Conversely, low-performing companies were 32% less likely than high-performing companies to grant only stock options, but 63% more likely to grant restricted stock.
“There are two possible explanations for these findings,” Dolmat-Connell said. “Either stock options are a superior incentive compared to restricted stock, or executives and boards at high-performing companies are more likely to grant stock options because of their better linkage to company performance. Either way, the results are significant.”
To avoid or reduce the burden of new accounting rules requiring that stock options be expensed, many companies now offer restricted stock instead of stock options.
Dolmat-Connell cautions that, while restricted stock often should be included in a company’s total rewards portfolio, decision makers should carefully examine the performance implications of a radical change to their long-term incentive programs before shifting from options to restricted stock.
“Accounting costs should be one factor in choosing a long-term incentive instrument,” he said, “but they shouldn’t be the only factor.”
Dolmat-Connell believes stock options link pay to performance more closely than restricted stock does, because executives benefit from stock options only if they can boost the stock price after the options are granted. If they can’t improve performance, the options are worthless. Those who hold restricted stock benefit when the company’s share price increases; however, they can also cash out and make money even if the stock drops in value.
“While restricted stock does not have the negative accounting implications associated with stock options,” Dolmat-Connell added, “company decision makers should ask themselves what the real cost of their long-term incentive plan is, once they have factored in the ability of their incentives to drive performance.”
DC&P’s study reviewed the use of long-term incentives for CEOs, which was also generally representative of long-term incentive trends for CEOs, COOs, CFOs, heads of sales and general counsel. Data was accumulated from proxy statements filed as of May 12, 2005, collected by Equilar, Inc.
While DC&P’s survey found a dramatic shift from stock options to restricted stock and performance-based long-term incentive plans (LTIPs), most companies continue to offer stock options, but in combination with other incentives.
DC&P found that technology companies are generally doing a good job linking pay to performance. Cash compensation increases were, overall, in line with revenue and net income growth. While bonuses grew significantly, growth is likely a result of companies paying out higher bonuses based on above-target performance. That’s a reasonable assumption, according to Dolmat-Connell, considering the significant increases in performance in 2004, compared to 2003 (at the median). Revenue climbed 15% in 2004 vs. 9% in 2003, while net income growth continued to far outstrip revenue growth, posting a 38% increase in 2004 vs. a 28% rise in 2003.
The median total shareholder return of 15% in 2004 was strong, even though it was only a third of the 46% returns companies delivered in 2003, the first year of a solid rebound in technology. A majority (56%) of unprofitable firms did not pay CEO bonuses in 2004, an additional signal that firms are linking pay to performance.
“We have reached a point where how people are paid matters as much as how much they are paid,” according to Dolmat-Connell. “Companies need to develop incentive plans that are designed to achieve strategic objectives. Firms that do this almost always outperform those that do not.”
Study results are available on request by contacting DC&P at info[at]DCandPartners.com or 617-663-4984.
DolmatConnell and Partners, Inc. is the compensation and benefits consulting arm of The Odyssey Companies, Inc., which also includes The Patriot Financial Group LLC, the benefits plan financing and financial/estate planning arm of the firm. The Odyssey Companies believes that integrating these services enables companies to provide executives and employees with The Right Pay (with amounts tightly linked to performance), The Right Protection (comprehensive, cost-effective benefits) and The Right Planning (financial and estate planning to meet long-term goals).