A New Replacement For Incentive Stock Options (ISO)
By David Grace (DavidGraceAuthor.com)

We’re all familiar with the typical employee Incentive Stock Option (ISO). The standard one vests 25% after twelve months. Then, monthly over the next three years until it is fully vested after 48 months. The unexercised portion expires upon the employee’s termination.

There are also ISO options granted to executives. This often vests in a much shorter time frame which can be from vesting immediately to vesting after twelve months. Once vested, stock options incentivize the recipient to make those business decisions that will raise the stock price the most in the shortest period of time.

If a course of action will raise the price $5/share in the next month. But, will lower the stock price two or three years down the road, the executive’s choice is easy . Get that price up now. Exercise the option ASAP. Don’t worry about where the stock will be three years from now. I would argue that this method of short-term compensation is one of the major forces driving quarter-to-quarter management and creating a situation where, to a greater or lesser extent, every major corporate decision is weighted and designed to gain Wall Street’s approval.

One school of thought…

If you’re paid $10,000, $20,000, or more per week, that should be enough to encourage the executive to perform well. What if that’s not enough money to get their best efforts? Then they shouldn’t be working for you in the first place. That is clearly not the prevailing opinion in American business and boards of directors of publicly held companies seem to think that their executives require millions of dollars in additional compensation in order to motivate them to do their best work.

Assuming those boards are right does not mean incentive compensation must be in the form of a stock option.

Let’s consider a different incentive mechanism that would discourage short-term planning and encourage long-term planning.

Let the CPAs come up with a standardized formula for massaging gross sales into a number that bears some semblance of a relationship to profitability, some refinement of EBIDTA. Call it Pseudo Profit or Sort Of Profit (SOP) or whatever you like.

Next, determine what the company’s maximum annual incentive fund will be, e.g. .1%, .5%, 1% of SOP —- whatever percentage the Board elects. Let’s say the Board adopts an Executive Compensation Plan. This then specifies the Incentive Compensation Pool (ICP) will not exceed 1% of annual SOP. That ICP will be divided into let’s say 1,000,000 Profit Incentive Units (PIUs). So, if an executive is granted 50,000 PIUs, they will be entitled to a payment equal to 5% (50,000/1,000,000) of the Incentive Compensation Pool. The Board could issue less than 1,000,000 PIUs in any given year, but never more than 1,000,000 PIUs in any one year.

How is this different from an ISO?

It’s different because the relevant ICP would be based on a fiscal year of four years in the future.

If Jane Brown is granted 50,000 PIUs at any time between January 1, 2015, and December 31, 2015, that means that she will be entitled to 5% of the ICP that is 5% X 1% (or whatever percentage the board chose) of the SOP for the fiscal year (if the fiscal year is a calendar year) ending four years later — December 31, 2019. This means that Jane has to care about how well the company will be doing four years from now instead of what the stock price will be six months from now.

If for any reason including death Jane’s employment with the Company terminates before December 31, 2019, Jane’s incentive compensation would be prorated based on: number-of-months-worked-after-grant/48 (but never to exceed 100%). So, if Jane’s employment terminated two years after the PIU was granted then she would receive 24/48 = 50% X 50,000 PIUs or 2.5% X 1% of the SOP for the fiscal year ending 12/31/19.

Because we would not want to deplete the company’s cash reserves Jane would not be paid in cash. Instead, Jane would receive Company shares equal to the calculated dollar value of the PIUs based on the market price on January 2, 2020, or on some other set date. For example, the last date that the company’s tax return for the fiscal year 2019 was due.

In such a plan:

1) The shareholders would know in advance the maximum annual percentage of SOP that could be paid to all executives as an incentive compensation pool.

2) Payments would be made in stock, not cash

3) Executives would be given an incentive to grow the company’s profits over the long term, and, consequently

4) Executives would be given an incentive not to focus on short-term stock prices or even care about short term stock prices

5) And, executives would be given an incentive to remain with the Company for the long term. That is, the sooner you leave after the time of the grant the smaller share of the SOP you’ll receive.

Whether the company grants stock options or PIUs it will still dilute its shares in order to give executives incentive compensation but a switch from ISPs to PIUs would give executives an incentive to focus on the Company’s long-term profitability instead of its short-term stock price. PIUs would also give the executives a strong incentive to do what they need to do in order to stay with the company instead of using their current employment as a bargaining chip in a game of musical executive chairs.

What’s the downside to switching to PIUs? No, seriously, what do you think is the downside in comparison to the existing executive stock option mechanism?

By David Grace (DavidGraceAuthor.com)

About Vola:

Vola Finance can advance you up to $300 at NO INTEREST. Vola Finance can make sure your bank balance does not get too low. The Vola app alerts you before it does so that you don’t pay overdraft or NSF fees. Vola Finance breaks down your spending pattern to help you budget your upcoming expenses. The Vola App finds ways for you to save.

Also, Vola supports over 6000 banks and credit unions. Vola uses one of the nation’s largest bank connection providers to securely establish a link to your account.

Vola is transparent. There are NO HIDDEN FEES Vola operates by charging a subscription fee, there are no other charges. If the features offered by Vola are not compatible with your bank or phone, Vola will refund you.

Keep reading