Director Equity Compensation: Designing Appropriate Performance Incentives

Service on the board of directors of a public company can involve a substantial time commitment along with potential liability risks. Directors must also comply with strict independence standards. In light of these demands, public company directors are generally compensated for their efforts. According to the executive search firm Spencer Stuart, in 2023 average total director compensation for S&P 500 directors was $316,000.

Companies must put careful thought into how they structure short-term and long-term performance incentives for directors. They should use their business judgment to strike the appropriate balance between fixed (e.g., annual base salary) and variable (e.g., short-term and long-term performance incentives) compensation in order to encourage directors to stay focused on long-term value creation. The appropriate mix between fixed and variable compensation can also be influenced by factors such industry, company size, and board size.

Various types of equity compensation awards may be allocated to directors including stock options, stock appreciation rights (SARs), restricted stock, and restricted stock units (RSUs). Different forms of equity compensation come with different economic, tax, and accounting implications.

Stock Options

Stock options provide directors with the opportunity to buy a specific number of shares of company stock at a predetermined price during a specified period of time. The predetermined price is known as the exercise price or strike price. The exercise price is equal to the fair market value of the company’s stock on the grant date.

Once the stock options vest, the director is allowed to exercise their options and purchase the company’s stock. The vesting conditions can be performance-based or based on serving as a director for a specified period of time. Performance-accelerated stock options may also be awarded in certain circumstances, which may result in vesting at an earlier date.

Granting stock options to directors can be beneficial to companies from a tax perspective because stock options are generally not subject to Section 409A of the Internal Revenue Code. Section 409A outlines the rules for the taxation of deferred compensation. Stock options are excluded from the definition of “tax-deferred compensation” under Section 409A if they meet certain conditions.

Another advantage of granting stock options relates to calculating earnings per share (EPS). The EPS calculation involves dividing a company’s net income by its total outstanding shares of common stock. Since stock options are not considered outstanding shares until they are exercised, they are not included in the denominator of the EPS formula.

Stock Appreciation Rights

Stock appreciation rights (SARs) benefit the company’s directors as the price of the company’s stock increases in value, making them similar to stock options in that regard. SARs provide directors with the opportunity to receive compensation equivalent to an increase in the company’s stock price over a set period of time. Unlike stock options, SARs are often settled in cash.

SARs that the company pays out in cash, instead of stock, offer a variety of benefits. One major benefit is that they do not cause equity dilution. Additionally, SARs that are settled in cash are not deemed to be equity compensation under the stock exchange rules. The implication is that shareholder approval is not required for equity plans that solely grant directors SARs. One downside of SARs is that companies must have enough cash reserves available in order to be able to make cash payouts to directors who exercise their SARs.

Restricted Stock

Restricted stock grants involve awarding shares of the company’s stock to directors once certain conditions are satisfied. Restricted stock provides the holder with voting rights and the right to receive dividends. Compared with stock options, restricted stock may feel like a more tangible benefit to the holder.

Restricted Stock Units

Restricted stock units, or RSUs, are a form of compensation that grants the holder the right to receive a specific number of shares of the company’s stock subject to a vesting schedule. Depending on the vesting requirements, RSUs can be time-based, performance-based, or event-based.

Retirement Plans and Programs

In addition to the different forms of equity compensation described above, executives may be offered the opportunity to participate in certain retirement programs. There are two broad categories of retirement plans—defined contribution plans (e.g., 401(k) plans) and defined benefit plans (e.g., pension plans that tie the benefits to years of service). There are also “qualified plans” and “nonqualified plans.” Qualified plans are subject to complex rules under ERISA and are generally available to a larger employee population while nonqualified plans may be limited to senior executives and are not subject to ERISA limitations.