Beyond The Paycheck: Compensating For Growth

All but three of America's 100 fastest-growing public companies offer long-term incentive compensation to executives. Stock options are the norm, with a few twists that include "junior" stock, discount options, and restricted stock purchases.

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What are the current long-term incentive pay practices among smaller growth companies? Are tax-favored incentive stock options (ISOs) widely used? What alternative approaches are used to obtain favorable capital gains tax treatment or to achieve other company objectives?

To answer these questions, we analyzed long-term incentive practices for the 1983 INC. 100 -- INC.'s list of the fastest-growing publicly held companies in the United States (see INC., May, page 51). We then compared them with fortune's Top 200 industrials for a look at the differences between emerging growth companies and mature corporate giants. Information for the analyses was drawn from proxy statements, annual reports, and telephone interviews with company executives. While the research focused only on public companies, certain practices -- including ISOs and restricted stock arrangments -- can be adapted easily to private companies.

Stock options offer several attractive characteristics to growth companies, so it isn't surprising that 95 of the INC. 100 make options available to their top managers. First, payouts are potentially unlimited -- a significant point for entrepreneurs who don't respond well to circumscribed pay arrangements. As the chief executive officer of one company explains, "With annual incentives, all I can tell my top people is that they'll get 25% of salary for making plan and maybe 50% if they have a great year; with options, it can go from zero to the moon." Second, under current accounting rules, options granted at 100% of market value have no impact on the income statement. In other words, companies can deliver compensation through options without charges to earnings. The significance of this point to companies striving for earnings growth is obvious. And third, ISOs give executives an opportunity for capital gains tax treatment.

ISOs are part of the executive pay package in 83 of the 100 companies, including 45 with provisions for ISOs and nonqualified options and 38 with provisions for ISOs alone. Twelve companies have only nonqualified option provisions. Among companies that offer both types, the nonqualified options are generally used to make individual grants above the ISO limit of $100,000 (plus unused carryovers) per calendar year. Also, these companies can make nonqualified grants if stock prices fall and later ISOs are "blocked" because of the sequential-exercise rule.

This rule provides for ISOs to lie blocked if they were granted at $25 a share in Year 1 and at $20 a share in Year 2, when employees would be required to exercise the earlier, higher-priced options before the later, more attractive, lower-priced options. In this case, a company with both types of options might decide in Year 2 to grant nonqualified options that could be exercised regardless of other grants outstanding. Note, however, that if the grant were less than 100% of market value, there would be impact on the income statement.

The fact that some companies grant both ISOs and nonqualified options while some grant only one or the other reflects the controversy over trade-offs between the two types of stock options. On one hand with ISOs, executives have an opportunity for tax deferral when the option is exercised, and all appreciation above the initial grant price is treated as a long-term capital gain when shares are ultimately sold. On the other hand, with nonqualified options, executives realize taxable income at exercise for any value above the initial grant price and potential capital gains only on any incremental appreciation between exercise and sale.

With nonqualified options, however, a company can deduct an amount equal to the income recognized by executives at exercise, while there is no company deduction with ISOs. This produces an equation favoring the Internal Revenue Service: A company would be foregoing up to a 46% tax deduction (any state tax deduction would be additional) to improve the executives' tax position by as much as 30% (the difference between the maximum individual income tax rate and the maximum capital gains rate; a slightly higher percentage would result if any applicable state taxes were considered).

Assume, for example, that corporate and individual income tax rates are both 50%. A company could grant twice as many nonqualified options as ISOs without increasing its costs, because the tax savings would be available to repurchase half of the shares represented by the option gain. At the same time, a company could provide equivalent aftertax benefits to executives without increasing its costs, by granting only 60% more nonqualified options than ISOs. The decision to grant ISOs is not based entirely on employee tax or company cost considerations. Other factors include the highly competitive market for outstanding executives in growth industries, where the use of ISOs is prevalent, and the greater likelihood of long-term stock ownership that comes from eliminating the need for executives to sell shares to pay taxes at exercise.

ISOs may also be used by private companies, with the option price equal to market value, which may be closely approximated by book value per share or a formula price, e.g., a multiple of earnings. There is a rule that ISOs may not be given to anyone owning more than 10% of the company. Otherwise, the only difference from ISOs in public companies is that shares normally must be resold to the company. Executives at private companies are entitled to the same favorable capital gains treatment at the time such resale occurs.

Beyond the standard stock options, analysis of the INC. 100 reveals a new wrinkle in executive pay plans commonly called "junior" stock. In 1982, only three of the companies offered it. However, look for greater use of this long-term incentive, particularly among growth companies that have created wealth for founders and seek to offer capital gains opportunities to second-generation executives.

Under this arrangement, a company creates a new class of stock to be sold or granted only to its employees, with voting, dividend, and liquidation rights subordinate to those of its primary common stock. Such junior stock is valued below the common, based on an investment banker's determination of an appropriate discount. The amount of the discount reflects a number of factors, including the likelihood of subsequent conversion to common stock; dividends, if any, compared to those paid on common stock; the company's creditworthiness; and the volatility of the company's common stock price.

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