Equity Compensation Problems and Solutions
Today I attended the NASPP Silicon Valley Chapter meeting to hear the presentation from Dr. John Hamman and Dr. Sebastian Goerg of Florida State University titled “Compensation Programs and their Behavioral Consequences”. They did a nice job addressing a complex subject before an audience of people who often think of employee behavior and equity compensation in terms of suboptimal exercise, forfeiture rates and lack of responses to grant notices.
They touched on some key premises of behavioral economics – people are irrational, risk averse, short-sighted, and generally poor decision-makers.
We addressed that five years (!) ago when I co-authored Behavioral Economics and Equity Compensation, which was subsequently presented in chapter meetings and webinars, yet there still is scant attention to what should be a core issue in equity compensation design: What are the behavioral consequences of stock options, RSUs, an ESPP offering? What do people do, or not do, in response? The answer, of course, is that people consistently make poor financial decisions and that has a huge impact on the effectiveness of equity compensation.
Are ESPPs a Problem or Solution?
There was a lot of discussion today about ESPP participation rates, and toward the end of the meeting the conversation seemed to focus on the ideas that “ESPP participation is good” and “we need to increase ESPP participation” – neither of which is necessarily true. The presenters have some interesting ideas for exploring these issues, by relating equity compensation behaviors (election to participate in ESPP programs) to other employee behaviors (individual performance, career progression, tenure).
I love to see academic professionals enter the discussion. Decades of effort have been spent trying to understand whether equity compensation is good, usually by parties that have an incentive to see more equity compensation in the economy (like those in the equity compensation business). At best, there are some positive correlations between granting equity compensation and positive outcomes (total return to shareholders, return on equity, employee satisfaction). At worst, as institutional investors and proxy advisors have concluded, equity compensation creates shareholder dilution and nothing more. Ugh.
Equity Compensation Research
I don’t want to be a buzz kill for the academics, but there are so many factors that suffer from multicollinearity that this is often a fruitless research venture. Defining a research project that is manageable requires excluding most of the relevant variables and then, when explaining correlational results, mentioning all of the variables that were excluded from the analysis. I have collected a library of these studies and it occurs to me that I should post them on our site.
Drs. Hamman and Goerg have expressed interest in additional discussions with our community, so I am putting this out to the community in hopes of triggering additional commentary that may help guide their research efforts.
To the ESPP participation question: Many financial planners will advise that until an employee has three (or six) months of savings in the bank, has no credit card balances (beyond current month charges) and is maxing out their contributions to their 401(k) plan that they have absolutely no business contributing to an ESPP. That narrows the potential population very quickly, particularly among the millennials. Even with the “guaranteed return” of an ESPP with a 15% discount and a lookback feature. We could debate that for an entire NASPP chapter meeting.
Next, consider that the most highly correlated variable with ESPP participation is cash compensation level – to a point. At $40,000 per year, an employee likely has no discretionary income for an ESPP. At $140,000 they may. At $240,000, they are likely receiving a large part of their total compensation in bonus and/or equity, and may already be overexposed to company performance. At the highest levels, executive stock ownership guidelines may prevent them from selling any equity grants as they vest making an ESPP contribution unlikely. If we could get all of that data, it might conform to a parabolic function. There’s a good research topic.
If the researchers could control for industry (ESPP more common in tech than in banking), company maturity and growth (equity compensation is more affordable and more valuable in a growth company), geography (ESPPs are still much loved in Silicon Valley), employer total compensation philosophy, individual employee total compensation mix, accumulated individual equity balances, accumulated liquidations of equity from current and past employers (i.e., how much money someone has in the bank from a previous lucrative equity situation), age, family wealth resulting from marrying well and/or inheritances, and dumb luck then we could probably predict who does and doesn’t participate in an ESPP. But I’m still not clear on why we would want to know that. What equity compensation problem are we trying to solve?
Particularly now that prevalent market practice has moved from stock options to RSUs – giving free stock to employees – we should ask why anyone would want to pay for more stock when they’re already getting it for free. The presenters today highlighted that the maximization assumption of classic economics is flawed, as demonstrated by taxi drivers and Swiss bicycle messengers. Enough, apparently, truly is enough. I have some free stock, now I’m going home.
This leads to questions about the stream of thinking I heard today – that we need to “educate” and “communicate” and then more people will contribute more money to ESPPs. That would be of great benefit to some companies who just happen to make more money when more of their clients’ employees buy and then sell stock. Beyond that, speculating that shareholders are benefitting from employee ownership through ESPPs is just that – speculation.
What Equity Compensation Problem Are We Trying to Solve?
After today’s presentation and discussion, I’m still not sure what problem we’re trying to solve, but I’m pretty sure that “low ESPP participation” is not much of a problem for anyone other than brokers and internal plan sponsors who sold the CEO and Board on the idea of an ESPP and then find that it’s costing more to have the plan (if they really tracked all of the hard dollar and soft dollar costs, which no one does) than is being delivered in compensation.
Personally, I believe that equity compensation changes behavior. I have direct experience with dozens of startups in our portfolio and I see it every day. But these are people who sometimes have worked for two years for no salary and no benefits for an equity stake, not employees with a salary, benefits, free lunch, free RSUs, and a free boat ride to work. ESPPs can be a nice way to deliver some low-risk short-term cash to those who can afford it but let’s not study ESPPs to the exclusion of the total compensation arrangement. It’s so much more complicated than that.
Drs. Hamman and Goerg, welcome to the difficult, and fun, world of equity compensation.