A Brief History of Equity Compensation

January 25, 2018 Shareworks Marketing

Equity compensation feels so commonplace in our work cultures that it’s hard to imagine it was ever something new. But it was. And not that long ago, either. Don’t believe us? Gather ’round the campfire and listen in as Shareworks by Morgan Stanley recounts the days of yore!

 

1950sish

Who did it first? You might think it was a technology company that awarded the first stock option, but it was actually the pharmaceutical giant Pfizer that first issued broad-based statutory stock options in 1952. But use of common stock to recruit, retain and reward employees was pretty unusual.

 

1980s

Stock options had begun an ascent in popularity in the late 1980s, particularly among technology companies that were on the verge of the dot.com boom, but also among well-known companies, such as Pepsi, Wendy’s, Bank of America and Citigroup. It was a simpler time. Stock-based compensation was so simple that it was possible to administer a plan using a calculator, WordPerfect and some Wite-Out. It wasn’t until the late 1980s that developers began creating software specifically for stock plan record-keeping. The emergence of the early DOS based floppy-disk versions of the purpose-built stock plan software we know today was timely. Broad-based stock option grants became more prevalent and the need for better, more scalable in-house administrative tools followed.

Perhaps more significantly, the availability of the new, unique record-keeping software provided the foundation for the stock-plan administration outsourcing business. Prior to a 1988 amendment to the U.S. Federal Reserve Board’s Regulation T, brokerage firms in the United States were prohibited from providing loans to employees to exercise stock options. But after the change in legislation, brokers jumped on the outsourcing bandwagon to capitalize on a new way of exercising stock options that became known as the cashless exercise. Initially, many brokers licensed software from early providers and worked with corporate clients to enable “co-sourced” cashless exercises. In this model, the company would share its stock plan data with a broker who used the same record-keeping platform. As cashless exercises became more popular, the co-sourced approach served to reduce some of the administrative burden for issuers and allowed them to maintain control over their data. The concept of full outsourcing followed, as industry players developed increasingly robust technology and comprehensive service offerings. Transfer agents and firms unaffiliated with the broker community got into the business, and a few brokerage firms invested more heavily and developed proprietary record-keeping platforms. Stock compensation grew in popularity around the world, and significant regulatory changes followed suit. To successfully administer a stock plan, you suddenly needed better knowledge and tools – requirements that fueled the growth of stock plan service providers.

 

1990s

Enter the tech boom of the 1990s. The talent-hungry industry used broad-based stock option programs as a recruitment and retention tool at a time when generous accounting rules made compensatory equity virtually free to give away. Ah, those were the days.

The regulatory front was relatively quiet during the 1990s. Section 16 rule changes adopted early in the decade gave corporate officers and directors more flexibility with respect to transactions in company stock and prescribed more detailed disclosure for officers’ and directors’ stock-based compensation. In 1992, the Financial Accounting Standards Board (FASB) had begun to consider whether to impose an earnings charge for stock options. But its Statement of Financial Accounting Standards no. 123 (FAS 123), issued in October 1995, was a compromise that gave companies a choice to either footnote disclosure of their stock-option expenses or to actually take an earnings charge using a fair-value approach based on grant date. (Companies that chose the footnote approach could continue to account for stock options under APB 25, which did not consider at-market stock options to be an expense; not so for discounted stock options, restricted stock, stock appreciation rights and other types of stock compensation.)

In those pre-FAS 123(r) days, companies experimented with broad-based plans because there was little reason not to. They didn’t have to record an expense for options in their financial statements. They were, however, required to record the intrinsic value of the options as an expense. And since the intrinsic value of an option is its market price less the strike price – and the two were often one in the same – many companies were able to reflect an intrinsic value of zero. On top of that, companies were often allowed to claim a tax deduction when an employee exercised. By issuing equity grants to employees, companies could essentially compensate employees at no cost to themselves, earn a tax benefit and conserve cash. It was the zenith of the equity movement.

By the late 1990s, stock compensation had become more burdensome for companies that took a broad-based and global approach, due to the sheer size and scope of their stock programs. The impact of the technology sector at this time can’t be overemphasized. The talent-hungry industry used broad-based stock option programs as a recruitment and retention tool at a time when generous accounting rules made compensatory equity virtually free to give away. Yet by 2000, the stock market had begun to wane, and stock options and employee stock purchase plans fell out of favor. The high-tech bubble had burst. In the wake of scandals such as Enron, Tyco and WorldCom, the Sarbanes-Oxley Act was passed in 2002. Section 404 of the act required issuers to disclose the scope and adequacy of their procedures and internal control structure for financial reporting, and stock compensation was a specific concern. Suddenly, stock plan administration became a highly visible function with a level of regulatory oversight previously unheard of.

The NASPP: A nascent profession and community

In the United States, the National Association of Stock Plan Professionals was founded in 1992, primarily to bring together people involved in all aspects of stock compensation, from design to delivery. Stock plan professionals needed a community where they could network, exchange ideas and information, engage in constant learning, and keep abreast of regulatory developments and best practices. The NASPP helped to give the administrative community a voice, and it began centralizing the substantive knowledge required to successfully administer a stock plan. At the time, software designed for stock plan administration was in its infancy, and regulators focused on disclosures and stock plan transactions by corporate officers and directors.

 

2000s

At the end of 2004, FASB released FAS 123(r), now known as ASC 718, which finally required companies to book an expense for stock options. This action leveled the playing field among equity types. Previously, stock options had been the vehicle of choice because of their favorable accounting treatment (i.e., no expense), but the amendment allowed companies to consider other types of stock awards that might be more effective in attracting and retaining talent. Soon, restricted stock units, which before had typically been reserved for higher levels of management, were being granted to all levels of employees around the world. Stock-settled stock appreciation rights became a popular way to deliver the same value as stock options by using fewer plan shares. The new accounting rules also challenged third-party providers and triggered the development of even more complex record-keeping systems. Also as a result of FAS 123(r), companies looked at their equity plans more closely and became more creative. The resulting diversity in equity types made stock plan administration much more challenging.

New oversight and accounting rules meant that stock compensation had become the focus of regulatory action, not only in the United States but abroad as well. As stock compensation grew in popularity around the globe, tax authorities began to revisit related tax policy and legislation. Tax laws and rules were adopted where before there had been none; some countries, such as France, and the UK, introduced tax benefits for stock awards with certain features.

Employees who moved from one country to another became the targets of increased scrutiny by national tax authorities looking to receive their share. Beyond the United States, securities laws and currency exchange also evolved as stock compensation became more prevalent. The complexities of stock plan administration and, now, global compliance kept growing.

 

A frenetic future

And it shows no signs of stopping. Tax rules alone continue to evolve everywhere. FASB and the International Accounting Standards Board are still are working together toward the convergence of IFRS and U.S. GAAP. Web-based record-keeping platforms are the norm, and companies are now exploring social media tools such as Facebook and Twitter for stock plan communications.

Over the past two decades, we’ve seen incredible changes in stock compensation, and the function of administering equity compensation has grown from a clerical position to a true profession. Though stock compensation will no doubt remain an integral way of attracting, motivating and retaining talent, it’s sure to continue evolving at a rapid pace.

Previous Article
Form 3921 – Who Needs to File, When to Do it, and How to Do it
Form 3921 – Who Needs to File, When to Do it, and How to Do it

You need to file IRS Form 3921 if your employees exercised stock options last year. Get the rundown on how ...

Next Article
10 Ways to Revive a Lagging ESPP – Strategies for US Plans
10 Ways to Revive a Lagging ESPP – Strategies for US Plans

When your company launched its ESPP, it likely did so to recruit, retain and reward employees on a broad b...