The-True-Cost-of-Equity-web

The True
Cost of Equity
The Hidden Cost
and Dangerous
Concentration Levels
JR Llewellyn

The True Cost of Equity - The Hidden Cost and Dangerous Concentration Levels | 4
restructure and improve your equity compensation
practices and create strategies that will bring greater
success to your bank.
Why Equity Compensation is
Commonly Used
What’s so wrong with equity compensation? Well,
equity itself is not necessarily the problem; relying
too heavily on it can be. As mentioned, there are
positives of equity compensation that have led to
its widespread use. The shareholder and executive
alignment created by equity gives your bank a good
story to tell investors by creating a “think like an
owner” mentality for those who have shares.
In addition, executives may be more likely to stay
with the bank because of the wealth accumulation
opportunity that equity creates, particularly in the
event of a sale.
Equity compensation
is used to attract and
retain executives because
it aligns shareholders
and executive interests,
and it provides a wealth
accumulation opportunity
for the executive.
The Role of Equity in Attracting
and Retaining the Right Talent
Competitive executive compensation is crucial for
attracting and retaining top executives, especially
in the current climate of the financial industry.
Executive talent is in high demand, and banks
have implemented various types of compensation
strategies to make their offers more attractive,
to be prudent, and to safeguard their employees
stay with the bank.
An important part of any compensation strategy
is that the compensation is valued by the
recipient; otherwise, it won’t be effective at all
for achieving the goal of recruiting and retaining
talent. Equity compensation has long been the
go-to strategy for creating a long-term incentive
for bank executives. To this day, equity continues
to be used because it can accomplish two main
objectives when used properly:
1. It aligns shareholder and executive
interests.
2. It provides a wealth accumulation
opportunity for the executives.
However, beyond its advantages, equity has
at times been a burden to the participants on
a number of levels. It has also often left the
shareholders in a difficult position to reconcile
the costs and dilution results from granting
shares versus the reward and retention value to
the executives. In this white paper, we are going
to discuss the hidden expense in equity plans
and the dangerous concentration levels many
executives experience in their personal portfolio
in bank stock. We will also discuss how you can

The shareholder and
executive alignment
created by equity gives
your bank a good story to
tell investors by creating
a “think like an owner”
mentality for those who
have shares.
Lastly, another major advantage of equity is that
it allows the fair market value (FMV) on date of
grant to be expensed rather than the end value. If
appreciation in the stock occurs, additional value
is received by the employee without an increase
in expense to the bank. Thus, there is a multiple
of value received over the related expense.
Equity will also continue to play an important role
within compensation packages. However, as we
move forward, we will begin to see the limitations
of equity and the importance of complementing
it with other forms of long term compensation
strategies.
Equity Usage: Considerations
for the Employee
Equity compensation will continue to play a
central role within compensation structures. However,
it is important to look at all aspects of equity
compensation, including the potential risks to the
employees and shareholders.
Equity has the potential to focus a substantial portion
of an executive’s wealth in the success of the bank.
This becomes problematic for a few reasons:
In a paradoxical shift, high concentrations of an
executive’s net worth can actually adversely affect
shareholder value. The executive’s interest can
become more closely aligned with ‘preservation’
of capital as opposed to growth of capital. This
undermines the very intent of issuing equity and
supporting the shareholder/employee alignment.
The assumption, which is highly accurate, is that
the shareholder is investing a ‘small’ portion of
assets into an organization, and thus, exposure
to economic cycles or complete failure can be
weathered. This directly opposes the thought that
if the majority of one’s assets are concentrated in
a single entity, the focus would be on stability and
preservation. Consequently, this may influence a
more conservative approach to building franchise
value.
Equity can put the executive in a difficult position to
liquidate shareholdings to “retire” if the stock is thinly
traded. In accordance with the theme described
above, equity earned inside a career represents a
significant piece of an individual’s net worth. If the
access to that net worth is limited (due to illiquidity
in the stock, for example), it can create challenges
post retirement for both the employee and bank. As
such, the value of the stock would then be reduced
(supply/demand), and the inability to sell stock in

large blocks could have a negative impact on
the capability of an employee to retire, or if sold
without consideration to other shareholders, drive
the stock price down considerably.
Lastly, a key factor to equity grants is the
corresponding taxation for vested shares, or
exercise for options. If little attention is provided to
these details, it can leave the employee in a very
cash strained position. Most often, employees
will sell the shares to “pay the tax,” which dilutes
the very intent of the grant. Similarly, employees
with options may take out a loan to purchase
the shares, again stressing the finances of the
employee.
Past experiences, liquidity needs, retirement concerns,
and other factors can all influence what the participant
values. Prior to simply granting equity, explore the end
goals and objectives of both your employees and bank.
According to the Bank Director 2016 Compensation
Survey, 36% of executives rate equity as fully effective
for tying their interests to shareholder interests.
Another 17% view equity as ineffective in the short-
term, but ultimately effective in the long term. For
another 17% of employees, equity is considered
entirely ineffective, while 10% rate it as only effective
when used in conjunction with other benefits. A
sizeable portion of executives (20%) stated that they
were unsure of the effectiveness of equity.
Bank Director’s 2016 Compensation Survey revealed that equity is not
always effective for tying executive interests to shareholder interests, nor
is it always valued by participants.

Meanwhile, outside directors and chairmen stated
that executives value a cash bonus (74%) or a
retirement benefit (71%) over equity (which trails
in third place with 54%).
Clearly, while some participants do value equity
and feel that it ties their interests to those of
the shareholders, this is not the case for every
executive, so compensation plans should be
tailored accordingly. The more the type of
compensation is valued, the higher the probability
of retention and recruitment; thus, the bank must
design what is valued by the participants.
Bank Director’s 2016 Compensation Survey
revealed that equity is not always effective for
tying executive interests to shareholder interests,
nor is it always valued by participants.
What Is the True Cost of Equity?
The true cost of equity can be boiled down
to three main factors: the expense, the risk of
shareholder dilution, and the cash flow/tax burden
placed on executives. Boards need to understand
the true cost of the equity they grant beyond the
expense component.
Expense
As with any compensation structure, expense will
certainly play a factor in designing and creating
appropriate equity plans. The expense is fairly
simple to understand as the fair market value
(FMV) on date of grant must be ratably expensed
over the vesting period. Restricted shares are
valued by multiplying the share price times the
number of shares (ex. 100s x $10p = $1,000
worth of expense). Although stock options have a
valuation process that is slightly more complex, with
Black Scholes being the most common valuation
methodology, the premise is the same related to the
expensing of the FMV on date of grant.
As a side note for public companies, (and this is
primarily an optics consideration), FMV on date of
grant must be disclosed in that year’s proxy table.
This continues to cause some institutions concern
as the grant may vest over a long period of time (5, 7
or even 10 years), but the optics from the disclosure
standpoint play negatively to the general population.
There are advantages from an expensing and
retention standpoint to grant a large block; however,
this must be carefully weighed against the optics and
dilution considerations.
Dilution
From a value standpoint, the FMV of $10K could
be worth multiples beyond that in the event of
a change in control. This is where the true cost
of equity begins to erode at shareholder value.
There is a delicate balance between providing
upside opportunity to employees versus protecting
shareholders.
The end dilution impact is often overlooked from
an equity grant standpoint. Direct share dilution is
one consideration, but there is a multiple on the per
share dilution when considered from a shareholder
value standpoint. This is intuitive: as book value
multiples increase in an acquisition, the shareholder
value dilution is exponential. This begs the question
of what is the appropriate dollar value to give to
executives related to shareholder value dilution (as
opposed to direct share dilution).

Each bank has unique circumstances to
address; there is not necessarily a right or
a wrong decision. The purpose of walking
through a forecasted exercise to is identify
the potential dilution from both a direct share
and shareholder value standpoint, which will
provide a more complete understanding of the
compensation offered to executives under various
circumstances.
Liquidity/Tax Burden on Executives
Vesting of restricted shares results in the
executive being forced to pay the ordinary income
tax (assuming 83b election was not made). If not
properly planned, this can significantly impact an
executive’s cash flow. The exercise of options can
also cause liquidity pressures for executives. In
addition, if the options are nonqualified, any gain
will be immediately taxable as well.
In both instances, some executives will be
forced to sell the shares to meet some of the tax
obligation, which dilutes the very intent of stock
issuance. The added burden of cash flow for
certain employees may present complications that
are not easily addressed. In the spirit of putting
the employee’s interest first, companies should
monitor the cash flow burden carefully. Simple
design tweaks can greatly ease such burdens
without compromising the integrity of the plan
objectives.
While granting equity can be very beneficial
under the right circumstances, as revealed in
Bank Director’s survey, equity may be best paired
with additional forms of compensation such as
nonqualified deferred compensation arrangements.
We will examine those next.
Solution: Reallocating Some
Equity into a Retirement Benefit
If compensation expense, shareholder dilution,
and taxation/liquidity pressures are a concern,
then a shifting of expense away from equity is an
appropriate solution. Doing so can have dramatic
positive impacts on total share dilution/value and
ease the liquidity pressures on the executives.
However, the expense/dilution savings should be
significant enough to justify the reallocation, and if
any portion of equity is taken away, its value must be
replaced. Executives must be given another form of
compensation that is equally effective for retention.
The replacement plan should be a “guarantee,” such
Reallocation of equity is
the solution, but the value
of equity that is taken
away must be replaced
with another form of
compensation. Retirement
benefits are usually the
most successful.

as an executive retirement plan that will provide
retirement income.
Although these types of arrangements are
inherently performance-based, additional
performance criteria can be built into the
plans to mirror existing equity plan structures.
Furthermore, the designs of such plans today no
longer carry the unknown liability burdens that
caused many banks to deviate from them over
the past decade. If designed properly, executive
retirement plans deliver substantial value to the
bank, shareholders, and the participants.
Example: Successful
Reallocation of Equity for an
East Coast Bank
The best way to understand how reallocation of
equity can be successful is to look at an example.
We worked with a East Coast bank that had
exactly the equity problems we’ve just described.
We helped them reallocate that equity into an
executive retirement plan.
The Client: East Coast Bank
The East Coast Bank maintained a robust long
term incentive (LTI) equity plan in addition to
an employee stock ownership plan (ESOP).
Between the two plans, certain employees had
the opportunity to receive 60%+ of their salary in
equity.
The Problem: Excessive Equity Grants and
Underwhelming Retirement Benefits
With a goal to be a top performer within their
market, the bank made a strategic decision to
tie the executives with the shareholders through
performance-based equity grants. As the plan
matured, it became quickly evident that the multiples
of equity to salary were quickly escalating to levels
from 6 to in excess of 15 times final pay.
Beyond the basic consideration of share and
value dilution to shareholders, there became an
unreasonable concentration in bank stock for the
executives between both the ESOP and LTI plan.
In addition, the aging executive population was
becoming concerned over their ability to liquidate
shares for retirement purposes. Consequently, due
to the similarity of its executives’ ages, the bank was
alarmed as to the potential impact that stock sales
would have to their share price if these executives
needed cash.
Upon further review, there was significant overweight
in equity relative to peers, but cash-based executive
retirement benefits were non-existent within the
compensation structure at the bank.
The Answer: Diversifying into Other Types
of Compensation
The solution we provided to the East Coast Bank,
although simple, had a profound impact on the lives
of the executives and a tremendous positive impact
for the shareholders. By reducing the upside wealth
accumulation for the participants (as they themselves
were concerned over their concentration in bank
stock), we reallocated a portion of the ‘expense
savings’ to a guaranteed lifetime retirement benefit
through our LINQS+ methodology, a supplemental
executive retirement plan (SERP) strategy.
This retirement benefit was greatly appreciated

and valued by the participants. The net result
accomplished the following:
• Reduced 280G exposure
• Gave executives a known retirement
benefit
• Provided savings on the expense total
expense accrual (aggregating the
redirected equity expense and the new LTI
equity plan structure) and
• Provided approximately 20% savings in the
shareholder value dilution when
considering an acquisition at a 1.5 multiple
of book
The Result: Value Creation, Reduced Tax
Burdens, Reduced Risk, and
Satisfied Executives
The results of our work with the bank were
resoundingly positive for everyone involved,
executives and shareholders alike. Employees
received a guaranteed retirement plan, and the bank
saved costs for the shareholders by reallocating
equity and redesigning compensation. The
compensation plan structure created significant
value, and the executives diversified their reliance on
excessive equity. Annual tax burdens were reduced,
and projected 280G exposure declined to zero over
a 5-year period.
If you’ve relied too heavily on equity, there are ways
to modify your compensation strategies so you have
the best executive compensation plans in place for
the shareholders and executives. An institutional
advisor can assist you with devising strategies that
position your bank for success.
If you’ve relied too heavily
on equity, there are ways
to re-strategize your
compensation strategies
so you have the best
executive compensation
plans for shareholders and
executives.

About Compensation Advisors
Compensation Advisors possesses over 20 years of compensation experience with financial institutions.
We leverage that experience to design and implement relevant, innovative solutions that relate to current
regulatory environments. Having worked with over 600 financial institutions, the firm has the knowledge
and expertise to navigate the obstacles associated with compensation practices. Our primary goal is
helping our clients attract and retain key executives and top performers. Compensation Advisors is a
member of the Meyer-Chatfield Group.
Contact us today to get started.
(866) 796-6222
compensationadvisors.com

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