Proxy Advisors and Pay Calculations

Charlie Pontrelli is Research Manager at Equilar, Inc. This post is based on his Equilar memorandum. Related research from the Program on Corporate Governance includes Paying for Long-Term Performance by Lucian Bebchuk and Jesse Fried (discussed on the Forum here).

Realizable pay is often cited in the governance community as an excellent gauge of pay for performance alignment. Ideally, if a company is performing well, realizable pay will be greater than disclosed pay. And if a company is performing poorly, realizable pay will be lower than disclosed pay.

Realizable pay calculations are typically made as of a company’s most recent fiscal year end and includes compensation granted during the preceding three- to five-year period (the “evaluation period”). It is similar to disclosed pay in that it includes salary, bonuses and other compensation actually paid during the period.

The difference between the two calculations is the way equity is valued. Disclosed equity values are made as of the grant date and realizable values are made as of the company’s most recent fiscal year end (the end of the evaluation period). Additionally, disclosed pay typically values performance awards at their target level and realizable pay may value performance awards upon actual payout if the performance period has ended.

The transformation from disclosed to realizable pay can be summarized as follows: disclosed equity awards will have appreciated or depreciated in value depending on stock price movements and company performance by the time they are measured on a realizable basis. The remainder of this study looks at how crucial it is to ensure that disclosed and realizable equity valuations are performed on an apples-to-apples basis to ensure accurate conclusions can be drawn from a comparison of these calculations.

Double Trouble

This phenomenon recently hit the spotlight in a Wall Street Journal article which used data from Institutional Shareholder Services (ISS) to highlight the intricacy of modern day pay structures. More specifically, it looked at how compensation can increase or decrease over time depending on stock price performance and the achievement of performance goals.

One executive that stood out was Mark Hurd at Oracle, whose realizable pay of $534.6 million increased 181% over his disclosed pay of $190.2 million, despite only a 7.4% stock price increase from May 31, 2015 to May 31, 2018. So what was the driving force behind this increase if not stock price performance?

According to Equilar’s ISS simulator, which is based on ISS’s realizable pay calculation described in more detail in their FAQ, Mr. Hurd’s realizable pay is estimated to be $269.4 million. This is 49.6% less than the $534.6 million reported in the article.

What happened? It is likely that the figure reported in The Journal includes compensation granted to both of Oracle’s co-CEOs, so we will consider the smaller valuation containing only Mr. Hurd’s pay. However, even this valuation is 41.6% larger than disclosed pay value which is hard to explain with such a modest stock price increase. The full disclosed and ISS Simulated pay calculations can be found in table 1 below.

It turns out that this change was a result of differing option valuation models between the disclosed pay and realizable pay values used in the study. Two commonly used models are the Black-Scholes option pricing model and the Monte Carlo simulation, both of which use a series of underlying assumptions to calculate the value an executive can expect to earn from an option grant. Changes in these assumptions can have significant impacts on the value of an option. In the case of performance-based awards, the Monte Carlo simulation also takes performance considerations into account in order to come to a fair value based on the probable payout of the award. When more rigorous performance goals are set, a Monte Carlo simulation will produce a lower fair value.

Stock Price Down 9%, Options Worth 60% More?

Oracle originally determined the grant date value of Mr. Hurd’s largest option award during the evaluation period using a Monte Carlo simulation and valued the grant at $103.7 million. This is the disclosed value that was used in the study. Because a Monte Carlo simulation was used, it factored in the likelihood of achieving the rigorous performance goals placed on the option. These performance goals include an $80 stock price target (56.5% growth), a $100 billion increase in market cap (48.3% growth) and six operational goals which must be achieved within five years in order for the award to fully vest. The realizable pay value calculated by Equilar’s ISS Simulator, based on ISS’s Black-Scholes model, yields a $165.6 million realizable value at the end of the evaluation period. This is $61.9 million higher than the Monte Carlo simulation result on the grant date because it does not factor the likelihood of performance outcomes into the valuation. The underlying option assumptions used in each model are shown in table 2 below.

In the months following the grant, Oracle’s stock price fell from $51.13 to $46.72, an 8.6% decline. As a result, these options were all underwater at the end of the evaluation period and no value could have been realized by Mr. Hurd at that time given that these are illiquid. However, even though his options were underwater, the different option valuation model made it look like the award increased by 59.7% due to the exclusion of performance criteria. Given the decline in stock price, one would expect a realizable value lower than the disclosed value.

When looking at what is realizable, a more reasonable approach is to focus on the intrinsic value of the option:

(Stock Price – Exercise Price) x Number of Options Granted

This calculation is easily interpreted as the exact amount an executive could realize if he or she exercised their options at that point in time. If Mr. Hurd’s options had been valued intrinsically, his realizable pay over the three-year period would have been $87.4 million, a decrease of 54.0% from disclosed pay, because this option grant would have been valued at $0 since it was underwater. The full intrinsic realizable pay calculation is shown in table 1 below.

While intrinsic valuations are accurate to the value an executive can actually realize, they do present a significant challenge when comparing executives who were granted options against others who were granted only shares or units. This is because of how sensitive intrinsic valuations are to stock price movements. Given a 10% decline in stock price from the grant date, an option holder would see a 100% decline in their equity value because their options would be underwater while a unit holder would only see a 10% decline. When comparing the two it would always appear that the option holder’s pay package is more aligned with company performance. An option valuation model becomes a suitable alternative here because it attributes an expected value to the option grant even though it is currently worthless. While realizable pay can be a valuable metric, it is important to carefully consider the details of the calculation in order to avoid misleading conclusions.

Table 1

Pay Definition Year Salary Stock Options NEIP Other Total
Disclosed Pay 2018 $950,000 $103,700,000 $3,612,553 $32,470 $108,295,023
2017 $950,000 $22,190,625 $16,863,075 $705,464 $123,115 $40,832,279
2016 $950,000 $21,870,000 $18,103,275 $198,621 $41,121,896
Total $2,850,000 $44,060,625 $138,666,350 $4,318,017 $354,206 $190,249,198
Equilar ISS Simulator 2018 $950,000 $165,648,998 $3,612,553 $32,470 $170,244,021
2017 $950,000 $26,280,000 $22,721,963 $705,464 $123,115 $50,780,542
2016 $950,000 $26,280,000 $20,908,724 $198,621 $48,337,345
Total $2,850,000 $52,560,000 $209,279,685 $4,318,017 $354,206 $269,361,908
Intrinsic Realizable Pay 2018 $950,000 $3,612,553 $32,470 $4,595,023
2017 $950,000 $26,280,000 $13,027,500 $705,464 $123,115 $41,086,079
2016 $950,000 $26,280,000 $14,310,000 $198,621 $41,738,621
Total $2,850,000 $52,560,000 $27,337,500 $4,318,017 $354,206 $87,419,723

Table 2

Assumptions Disclosed ISS Simulator
Model Monte Carlo Black-Scholes
Exercise Price $51.13 $51.13
Stock Price $51.13 $46.72
Risk Free Rate 2.1% 2.8%
Expected Life 7 7.1
Volatility 22.4% 21.2%
Dividend Yield 1.5% 1.5%
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