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Equity Compensation Plans: Breaking down Dilution

July 24, 2015

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A well-designed equity compensation or performance incentive plan has potential to be a “win-win” for those with skin in the game, and corporate issuers have the opportunity to align their stakeholders’ interests by including equity pay in executive compensation packages. Shares granted under equity compensation and incentive plans can serve both to align executive behavior with creating shareholder value, and to retain and reward the key talent driving business growth.

When the SEC adopted mandatory shareholder approval of Equity Compensation Plans in 2003, crafting equity plans attractive to multiple stakeholders became even more relevant to plan designers. In the period since, both large institutional investors and proxy advisory firms have developed guidelines and methodologies for analyzing plans to arrive at voting decisions and recommendations. For example, ownership stakeholders typically analyze the dilutive effect of equity and incentive plans by benchmarking the target company’s overhang and run rate, ensuring dilution falls within a reasonable range compared to peers and relevant industry standards. A company’s overhang represents the shares outstanding and available for grant within a plan as a percentage of the company’s common shares outstanding. Run rate is the proportion of the plan shares granted from the available pool on a yearly basis. Shareholders and proxy advisors typically recommend requesting new shares every 3 to 4 years, which requires a balancing act on the part of corporate issuers.

Proxy advisors and shareholders also consider other plan features when formulating their voting decision. Most will vote against plans with evergreen provisions, or plans that allow for the increase in reserved shares without further shareholder approval. The same can be said for plans that allow the re-pricing of shares without shareholder approval.

A look at new share requests by S&P 500 companies in fiscal year 2014 provides a holistic view of equity and incentive plan dilution in the corporate universe. In a sample pool of 169 requests, which was chosen because shareholder voting results were disclosed, values ranged from 0.16% to 21.5% for overhang, -0.02% to 9.9% for run rate, and 67.9% to 100% for passing percentage. All in all, plans from this pool passed at high rates, even the least approved plan passed by two-thirds majority vote. By adhering to best practices and benchmarking dilution metrics, plan designers give their company’s plan a leg-up in the shareholder approval process.

Equilar Insight’s governance solutions include a dilution modeler that provides stakeholders access to this data. Learn more.