How to Tie Equity Compensation to Long‐Term Results

Abstract

Companies, investors, and regulators around the world are now seeking to tie executives' payoffs to long‐term results and avoid rewarding executives for short‐term gains. Focusing on equity‐based compensation, the primary component of top executives' pay, the authors analyze how such compensation should best be structured to provide executives with incentives to focus on long‐term value creation. To improve the link between equity compensation and long‐term results, the authors recommend that executives be prevented from unwinding their equity incentives for a significant time period after vesting. At the same time, however, the authors suggest that it would be counterproductive to require that executives hold their equity incentives until retirement, as some have proposed. Instead, the authors recommend that companies adopt a combination of “grant‐based” and “aggregate” limitations on the unwinding of equity incentives. Grant‐based limitations would allow executives to unwind the equity incentives associated with a particular grant only gradually after vesting, according to a fixed, pre‐specified schedule put in place at the time of the grant. Aggregate limitations on unwinding would prevent an executive from unloading more than a specified fraction of the executive's freely disposable equity incentives in any given year. Finally, the authors emphasize the need for effective limitations on executives' use of hedging and derivative transactions that would weaken the connection between executive payoffs and long‐term stock values that a well‐designed equity arrangement should produce.

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