Is there any place for executive equity “mega” grants?
12/08/2019
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“Mega” means big. Hence we do not tend to see it associated with AGM resolutions for a CEO’s equity grant, given connotations that it could also mean overly generous. Nevertheless, this is the generic term used for the lumping together of several future years’ annual equity grants into one large opportunity. No further grants will be made for several years. So on an annualised basis they are not generous, and the annualised accounting expense is about the same as the alternative of annual grants.

Annual grants of overlapping long term incentive awards have become the norm in most large listed Australian companies.

The reasons for implementing this­­ structure are sound – it rewards continuous improvement over time. However, this is not the only structure that works: indeed it is suboptimal in some situations.

A front-loaded incentive, otherwise known as a “mega grant” (where the executive is granted a significant amount of equity equivalent to multiple years’ worth of traditional annual grants and covering an equivalent time period) can be more effective.

Such grants are normally contingent on what would be considered “mission critical” objectives: these goals are “make or break” for the company.

For technology companies in particular, where success is reliant on scaling quickly by securing users before the competitor does, front-loaded incentives based on a 4 or 5 year objective for customer growth, revenues or profitability can make more sense than the traditional overlapping annual incentives based on TSR and/or EPS growth. The point in time focus is more akin to private equity than publicly listed companies. However, the increase in smaller technology company IPOs of companies that on another continent may access capital from private sources means that such incentive frameworks may make sense, and have been seen more often in the Australian public market.

The simplicity of the goals and size of the carrot being offered serves as to focus the executive team’s efforts on what really matters. Executives must “go hard or go home”.

Once initial scale and/or profitability goals have been achieved, then the company can transition to the traditional incentive model.

The use of this framework extends beyond technology companies, however. Consider the following scenarios.

Commercialising a product licence

A front-loaded equity grant might be based on milestones such as setting up manufacturing infrastructure, reaching production levels and achieving sales.

Achieving regulatory approval

A biotech company may base a significant incentive on achieving approval in various jurisdictions for its product or completing clinical trials. A technology company developing a new product may base the same on acquiring necessary patents.

Significant project completions

Resources or energy companies may focus on achieving initial mine production levels or completing solar or wind farm construction.

Post crisis strategy

Following a crisis involving significant destruction of shareholder value, temporary replacement of annual incentive grants with one front loaded incentive can focus attention on a new strategic plan’s objectives.

New product introduction

Front-loaded incentives for leadership of a new business unit working on a significant new opportunity outside traditional operations might also benefit from front-loaded incentives.

Beware the risks

While front loaded grants can be effective, they also carry considerable risks:

  • The block style of grant presents a clear exit point for an executive who might be considering a move out of the company. Overlapping grants ensure there is always money left on the table should the executive contemplate exit.
  • If performance does not follow the proposed plan, or strategy needs to respond to external contingencies, front loaded grants may become unachievable. With no prospect of further incentives in sight, executives may become demotivated and call for a replacement incentive. Boards looking to make changes to incentives will likely face resistance from shareholders.
  • At times it can be difficult to identify “the metric” or metrics that will be required for the front-loaded grant. If the board changes its mind, a swap to another metric can be difficult.
  • These awards by nature of their size and their focus on select key metrics can lead to executives taking on additional risk or gaming the system. Following 2009 GFC and the recent Hayne Royal Commission, there is particular scrutiny of executive plans that encourage excessive risk taking.
  • Many of these plans involve cliff vesting with a binary outcome, where all or none of the incentive vests based at a certain date. Mitigation of this may involve measuring outcomes over a longer time period at the end of the performance cycle or having graduated vesting where some equity vests for partial achievement of objectives. (Not always possible, for example if a patent is either granted or not, or a clinical trial is successful or not.)
  • This type of plan is often frowned upon by external stakeholders, often due to the magnitude of grants and the risks. If such plans are to be implemented, communication and justification of plans is important.

Once the need for the front loaded plan has passed, the company may consider a transition to a more traditional overlapping grant structure as it evolves.

© Guerdon Associates 2021
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