Page 529 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

Chapter 8. Long-Term Incentives 515

COMBINATION PLANS
The various plans described may be used in combination with each other. Indeed, it is
commonplace for companies to use two or more of the plans for their executives.
While many company plans provide two or more forms of long-term incentives, all
eligible employees may not use all plans, and some plans may not be used by anyone. Those
that are used may be separated by organization levels (e.g., performance-unit plan for the
top 20 executives and stock options for the next 100 key people).
By developing combination plans, it is possible to neutralize some of the individual plan
disadvantages. A good example of this is the development of the performance-unit plan with
an attached stock option, which neutralized the impact of the unknown stock price of
the classic performance-share plan. A stock award coupled with sufficient cash to cover tax
liabilities makes sense, especially to those with short-swing-profit problems. In addition,
putting the executive at risk with company stock can be coupled with a nonmarket plan to
provide some protection. The most typical combination is a stock option plan and a stock-
award or cash plan. The stock option is the more highly leveraged of the two, typically
because about three options are equated to one share of full-value stock using Black-Scholes
or other present-value methods. However, the option is worthless if market value does not
go above option price. A stock award, on the other hand, has value even though the stock
price declines, assuming it does not go all the way to zero. Stock awards in such combina-
tions may be performance based, time based, or a combination. Cash plans, of course, are
unaffected by stock market changes.
Plans may be either independent (self-standing) or dependent (tandem). Independent
plan combinations are, as the word suggests, independent of each other. What happens with
one has no effect on the other plan. Under the dependent plan, the action taken with one
plan will typically reduce benefits under the other plan.
Under an independent plan, if the executive receives 18,000 options and 6,000 awards,
he or she would be entitled to both. However, if the person were given the same in the form
of a dependent plan, the choice to exercise 6,000 stock options would result in the forfeit of
2,000 restricted stock awards. Dependent plans need to be carefully structured to avoid both
constructive receipt and economic benefit, as described in Chapter 3.

Market Value Combination

For years, stock options were essentially the only form of long-term incentive compensation
for many companies. Executives found that when price-earnings multiples increased, the
levels of compensation were significant—creating more than one multimillionaire.
Conversely, when the multiples dropped, increases in EPS were meaningless in terms of
stock prices, as many options went underwater. This volatility caused many companies in the
early 1970s to cut back on the use of options and introduce an additional form of compensa-
tion such as the performance-share or performance-unit plan (which is not affected by the
market price of stock).
It is possible to compare and contrast the degree of downside risk with upside growth
potential for each type of plan. Figure 8-8 shows a comparison of 10,000 shares under a stock
option of $50 a share, a performance-share plan of 5,000 shares at $100 a share, and a
performance-unit plan of $500,000. Note that all three will generate $500,000 if the stock
price rises to $100 share—not an unrealistic assumption about seven years out, assuming no