Designing the Right Equity Compensation Plan for Your Bank

Designing the Right Equity Compensation Plan for Your Bank

Equity plans are an attractive form of compensation for banks that want to attract and retain top executives. While equity plans are beneficial, it’s important that your bank remain sensitive to what is valued by the participants, what the bank has authority to grant, and dilution to be experienced by the shareholders. The three most common types of equity granted are restricted stock, stock options, and synthetic equity. Synthetic equity plans include phantom stock, restricted stock units, and stock appreciation rights. Directors and bankers alike ask the question: Which is best? Here’s what you need to know about equity compensation for banks.

Choosing the right equity compensation plan allocation

The right type of equity plan for your bank depends on a number of factors. Before deciding on a plan, it’s important to consider:

  • Dilution impact: Always a concern to existing shareholders, a prudent structure and allocation of equity must be a foremost thought in plan design.
  • Upside potential: This will help dictate what type of equity to grant.  Options are typically reserved for ‘high growth’ potential or to incentivize high growth, with restricted shares being more associated with retention grants, as there is intrinsic value in the grant.
  • Liquidity opportunity: This is the most significant consideration when allocating equity. Without the ease to liquidate the shares, the value of the grant is significantly diluted to the participants.
  • What is valued by the participants: What is is the culture of your bank? Who has an owner mentality? Does anyone? If shares are going to be sold at the earliest possible time, it undermines the very intent of stock and option awards.
  • Cash need considerations: Whether exercising shares or dealing with the tax impact, are your participants ready and capable of addressing and handling those issues?
  • The strategic objectives of the bank: The direction and goals of the bank will determine whether equity is a prudent form of compensation.

Now, let’s explore the three types of equity plans: restricted stock, stock options, and synthetic equity plans.

Restricted Stock Equity Plans

The term restricted stock refers to stock of a company that is non-transferable until predetermined conditions, (vesting schedules and performance criteria, for example), have been satisfied. Upon satisfaction of those conditions, the stock is transferred to the participant holding the restricted stock award allocation, and there is no purchase necessary. The participant will owe tax once the risk of forfeiture lapses (assuming the 83b election was not exercised), and this can put significant pressures on the grantee when the stock vests. To avoid a potential tax burden, careful attention should be given to the design process.

Still, there will always be a retention aspect to restricted stock as long as awards are unvested. This is because of the intrinsic value of stock, provided that it’s at a reasonable price. Plus, the accounting treatment of restricted stock is extremely simple to understand and administer.

After a specified time, stock options are provided to the grantee to purchase shares at a specified price (the exercise price). Unlike restricted stock, stock options have zero intrinsic value. Any value derived is from the increase over the exercise price.  If the stock options are nonqualified, the optionee will owe tax upon exercising the stock. It typically takes 3 or 4 options to equal the value of one share of restricted stock under “normal” earning conditions.  Consequently, if your bank is concerned about dilution, options may not be the best tool. Look into stock appreciation rights (SARs), which may be a better fit.

Because stock options have no intrinsic value, there are drawbacks. Your bank could potentially expense thousands—if not hundreds of thousands—of dollars and receive zero value related to retention. Also, industries tend to rise and fall cyclically, so even if your back performs well during a downturn, your stock could be swept up in market segment pressures, affecting the value of your options.

Assuming a cashless exercise is not embedded in the equity plan, stock options must be purchased, leaving many stock option grantees unable to do so if they lack the cash. When they do, “flipping” the stock is common to get the cash to either pay the taxes or repay a loan for the initial option purchase. This dilutes the very intent of issuing the stock in the first place, so it’s important to have the right strategies in place to help mitigate this type of concern.

Synthetic Stock Equity Plans

Synthetic equity mirrors that of true equity, but it is settled in cash as opposed to equity. In some instances, such as with restricted stock units (RSUs), a participant may be given a choice to settle in part cash, part equity.

The three primary types of synthetic equity are the following:

  • Phantom stock, which is similar to restricted shares.
  • Stock appreciation rights, which is similar to stock options
  • RSUs, in which an individual receives a number of “units” that can be settled at a future date.

Valuation of synthetic equity can be a challenging process if this is not already a practice at the bank, and the expense can be less attractive when compared to true equity. Thus, synthetic equity is best used in conjunction with true equity plans to give a participant cash to either pay tax on restricted shares or exercise and pay taxes on options.

How banks should grant and vest equity compensation awards

There are two primary types of grants: retention grants and performance grants. Retention grants are typically done on a recurring schedule and allocated to key performers to keep them from leaving. Performance grants are made upon achieving a predetermined goal of the bank/individual.

In today’s environment, both types of grants have valid business reasons to explore, but with the continued pressures to provide competitive executive compensation, experts highly recommend the use of performance-based share awards.

From a vesting perspective, both graded and cliff vesting has a place.  Graded vesting would imply a percentage vests over a three year period; for example, a 3-year vesting schedule would vest one third each year.  However, for maximum retention, cliff vesting tends to be favored. A 3-year cliff vesting schedule provides 0% vesting from year 1 to year 3, and 100% vesting in year 4. As annual grants build, the participants will build up an account balance that will remain ‘at risk’ should termination occur.

The ideal equity compensation plan depends on a number of factors

Regardless of the equity decision, it’s important to first explore all compensation vehicles and ensure they will accomplish your goals. Banks can no longer afford to implement compensation strategies because a competitor does or because “we’ve always done it this way.”  Be intentional about why you are granting equity, or any compensation strategy, and the projected end results. It is imperative the bank think through the process with regards to liquidating shares, the taxation to participants, and the perceived value of equity by the employees. Working with outside consultants helps to ensure you are getting the most out of your compensation plans and efficiency of every dollar you spend in today’s competitive landscape.