During any period of business uncertainty, board and compensation committee members, executive management teams and human resources leaders will feel pressure to act quickly. A singular proven strategy underscored successful compensation decisions through both the 2008 financial crisis and the COVID-19 pandemic—zoom out far enough to see the full picture and act in a manner that is systematic and consistent with your organization’s broader philosophy (including your compensation philosophy) and mission.
As compensation-decision makers navigate this period of macroeconomic uncertainty, there are many considerations to keep in mind. Below, in no particular order, are a few that we see arise time and time again.
1. The Road to a 409A Issue is Paved with Good Intentions
An executive or other service provider may elect to forego current compensation to conserve free cash flow, for internal or external optics, or other reasons relevant to the company. Salary and perquisites tend to be the first looked to for adjustment, with bonuses and long-term compensation trailing. Regardless of the bucket of compensation reduced or eliminated, a service provider who agrees to a reduction may ask for a “make-whole” or similar commitment from the company.
This can raise the specter of Internal Revenue Code Section 409A in two key ways: (1) creating new deferred compensation, and (2) impermissibly deferring compensation from one year to the next. The former impacts how the compensation can be structured, can limit flexibility to amend or terminate the arrangement in the future, and can result in payroll tax being incurred in an earlier year than the compensation is delivered. Impermissibly deferring compensation from one year to the next can come with accelerated income inclusion, a hefty 20% additional tax to the service provider, and potential reporting and withholding consequences to the employer.
In any case where a service provider forgoes compensation otherwise promised, and especially if there is an element of a “make-whole” or similar commitment, this should be structured carefully and in coordination with counsel.
2. Sneaky Stock Price Surprises
In any volatile economic environment, shareholders, board members, executives, and employees may all be intently watching a company’s stock price. For purposes of compensation, it is important to not lose sight of how stock price can impact existing compensation programs as adjustments may need to be made to avoid unintended windfalls or unintended reductions in the value of employee awards.
Companies often approve equity grants based on a grant date value concept—in its simplest form, a dollar amount divided by a share price on a specific date. Where grant date value has been set over a period of lower volatility, a company may fall into a rhythm where grant date value benchmarking follows a steady trend based on the peer group or industry. In a highly volatile environment, however, using a grant date value that was determined based on benchmarking conducted months before the period of volatility began can result in delivering significantly more shares than originally anticipated to satisfy the intended grant date value. This can result in an unintended windfall to the employee (especially if the stock price subsequently rebounds) and in share management issues under the company’s equity incentive plan, which could force the company to ask shareholders to approve an increase in its equity incentive pool sooner than it may have expected and in the midst of share price volatility.
3. A Smooth In-Flight Experience
Lastly, the enticement to take swift action to modify in-flight short- and long-term incentive awards may be tempting whether it is driven by retention risk, the consistent repetition in public disclosure indicating that performance goals were not achieved (for public companies), or other reasons.
Immediate changes, however, can be a third rail with investors. Companies would be well-advised to take a measured approach that includes careful monitoring of external economic factors, especially ones that are specific to their industry.
On the other hand, a company in the process of establishing new compensation programs or setting new goals during periods of economic bumpiness can look towards adjusting altitude to smooth out the journey, rather than making in-flight changes. For example, splitting a full-year annual incentive plan into two six-month programs—where the second performance period builds off (and in so doing accounts for) events occurring during the first—can help keep employees engaged and motivated to achieve realistic performance goals. For long-term awards, we would expect relative performance metrics to continue as a mainstay in award design and some award design alternatives, like target performance ranges, shorter performance periods, and simpler performance targets with longer holding periods in the post-vesting period, to come to the forefront. In both cases, retaining discretion to allow for appropriate adjustments to performance metrics to account for unanticipated events is important.
At the end of the day, whether companies are facing economic uncertainty or economic stability, compensation decisions should be made thoughtfully and with the broader company in mind. This does not mean that companies, boards, compensation committees, or executive teams should sit back and wait. A learn-and-see model that involves consistent review of relevant data sets, coordinating with external advisers, and leaving aside one-size-fits-all programs in favor of understanding practices specific to the industry will serve best.