Long Term Incentive and the Black Box of Employee Stock options

Compensation of employees can broadly be divided into 3 buckets – Base Salary (fixed cash component of the salary including basic, HRA etc), Short term Incentive (aka Bonus, Variable pay, Performance driven pay), Long term Incentive (Restricted Stock/Restricted Stock Units, Stock Options). Total Rewards approach includes other elements like Benefits (Healthcare, Retirement etc) and Career development opportunities as a part of the total offering. Total Rewards is a big topic and merits separate discussion. In this article we shall focus more on Long Term Incentive (LTI) and specifically understand more about Employee Stock options. Long Term Incentive is more popular for compensating and rewarding Middle & Senior Management and Top Executives because their performance has a more direct impact on stockholder value creation. Infact, as a rule of thumb, more senior one grows in the organization, more will be the proportion of LTI in Total compensation package. The proportion of various elements also varies according to geography and culture besides the company philosophy towards compensation. As a general observation, for top executives of the company, LTI might be as high as 30%-40% of total compensation while for a middle manager, it might be around 12-15% of total compensation.

Stock Awards can be in the form of Restricted Stock or Restricted Stock Units depending on local regulations and company policy. There is a minor difference between Restricted Stock and Restricted Stock units. While grant of Restricted Stock means that the receiver holds actual stock of the company with a vesting period and restrictions applying for that vesting period (hence the name Restricted Stock), grant of Restricted Stock Units means a grant of promise by the company to award Stock at the end of vesting period. The receiver of units does not actually hold stock during the vesting period and hence may not receive any dividend and may not have any voting rights arising out of ownership in the company (depending upon the actual company plan). Taxation of LTI varies from country to country and is out of scope of this article.

Employee Stock Options are considered to be riskier than regular restricted stock/stock units. They give the receiver a right to buy stock of the company at a predetermined price (called grant or strike or exercise price) during a fixed time window. Employee Stock options are essentially ‘Call' options. 'Call' options have an upside potential linked to increase in stock price as against 'Put' options which have upside potential linked to fall in stock price. The aim of compensation is to incentivize managers to work in interests of stockholders hence the grant of 'Call' options. Usually Employee Stock options have a life of 10 years from the date of issue and can be exercised during this life once they are vested. Both Stock Award and Stock options can have cliff vesting (when entire grant vests after the specified vesting period) or graded vesting( when the grant vests in equal annual installments over vesting period). The Options can be tradable or non tradable. Usually the Employee Stock options are non tradable with some exceptions (Google and Novartis are 2 companies I know which grant Tradable Options). If stock price is lower than exercise price, options are said to be under water and if they are non tradable, they are worthless for the holder of options (even if vested). On the other hand Tradable options can be sold to a market maker (who perceives that share price might go up in future during lifetime of options) once they are vested. Hence tradable options might fetch some money to the holder despite being underwater. Tradable options are said to have intrinsic value ( difference between stock price and exercise price if positive, otherwise zero) as well as time value as against non tradable options which only have intrinsic value

There are various models that can be applied for valuation of options with the prominent ones being Trinomial model and Black Scholes model. There are various factors that impact the value of options. These are –
1) Grant/Strike/Exercise Price
2) Actual Stock Price
3) Option Life
4) Estimated future volatility of stock
5) Riskless Interest Rate
6) Dividend Yield Ratio

We shall not go into the mathematics of Black Scholes model but try to understand the impact of all these factors on value of Employee Stock options.
1) Grant/Strike/Exercise Price – As obvious, lower is the grant price, more will be the value of options

2) Actual Stock Price – Value of options increases with increase in exercise price. However, as mentioned earlier, in case of non tradable options, the value of options remains zero unless the stock price is more than exercise price.

3) Option Life – Option life is directly proportional to value of options. This derives from the fact that options give one flexibility to buy stock later in the lifetime of options. Holder of options can park the money in Riskless Instruments (such as Treasury bonds) during the life of options and earn interest on that. More is the life of options, more is the time available to defer buying the actual stock, greater is the opportunity to earn interest from riskless investments and hence more valuable options are.

4) Estimated future volatility of Stocks – Options of more volatile shares are more valuable. Let us try to understand this. High estimated future volatility means high probability of stock price moving up or down from current level. Higher Stock Price in future creates more value for Option holder (which is virtually unlimited as it will keep increasing with increase in share price). On the other hand, if share price falls lower (to any level below or equal to exercise price), the value of options will still be zero. Employee Stock options have unlimited upward potential but limited downside (worst case – options are not utilized so zero value). Hence more volatility makes options more valueable.

5) Riskless Interest Rates – Value of Employee Stock options increases with increase in Riskless Interest Rates. As mentioned in ‘Option Life’, higher Riskless interest rates present greater opportunity to earn by holding options instead of actual stock hence the value of options goes up with riskless interest rates.

6) Dividend Yield Ratio – It means dividend granted to Stock holders as a proportion of Stock Price. This can also be seen as ROI of Stock. The value of options goes down with higher Dividend yield ratio. Increase in dividend yield ratio over say last year can mean 2 things – either dividend (numerator) has increased or Stock price (denominator) has decreased. Stock Price decrease will anyway pull the value of options down (see point 2 above). The option holder does not receive any dividend as against a Stock holder who does receive dividend. Therefore, by holding options instead of Stock, the holder is suffering a loss of dividends. Hence more is the dividend yield ratio, lesser is the value of options.

Some companies do offer a choice to its employees between choosing options or stock or a combination of both as LTI. Though understanding the Restricted Stock grant is straightforward, generally option valuation is a Black box for employees as well as HR (left mostly to Compensation). Educating employees about high risk involved with options and how they are valued can help employees make an informed choice about their LTI composition depending on individual appetite for risk. In addition, having a better understanding of how value of options is modeled can significantly lessen employee resentment if they see the value of their options going down. If understood and deployed properly (performance based shares, performance based vesting, performance based multipliers etc), LTI can be very effective tool in achieving its purpose of resolving principal agent conflict.

On the Chopping Block

A picture i found on the web while surfing - which shows clearly what happens to our salaries during recession time...
They get chopped off :-) !

Debate:: Have put this up for discussion

“Does what we do really have any impact on an organization? Can organizations still treat people like shit and make money?”

This is specially true in light of the present crisis, where we see layoffs, job losses and pay cuts become the order of the day. Are organizations still investing on people? When jobs dry up, where do people go? And, after organizations are done with the blood bath, and the economy recovers, where do organizations stand?

...Then the CEO went blogging!

continuing with the theme, companies are opening up more and more to web 2.0. A corporate blog is an amazing way to brand your workplace. There's nothing more magnetic than an open workplace, where employees are allowed to air their views.
It is the equivalent of Mass Media in a free nation.

Approaches a company can take towards the branding space includes;

1. Corporate journalists airing views and opinions of the employees on critical processes within the company. Yes it is an exercise with loud political overtones, but an amazing process for a young company to gather ideas and imbibe responsibility. Membership to the blog can be part of the induction process. Coupled with a "Best Suggestion" drive, this could serve as quick bouncing boards for ideas. Employee surveys are soon becoming passe.
   
2. CEO blogs to communicate strategic growth plans to the hundreds of employees. This removes the weekly email from his communication strategy. Ideally to project the employer brand to the outside world, this should be open to all. Why wait for the quarterly announcments to the press? Continuity!
3. Department blogs announcing plans to all employees.

In India, companies have been slower to adopt to Web 2.0. It's high time someone took the lead. The Learned Man lists some of the leading corporates who have risen to the challenge.

You know Gates!!!

Web 2.0 is turning the world on its head.

Five years back, my mom would accuse me of wasting time on the computer. Today, it's a different story. She just cant seem to get the perfect profile picture on Geni.com.

"What would Merlyammai think? Who took this lousy snap?"

Networking is the new 'in' thing. Get to know your family, your colleagues or some weird filipino who claims to have been your classmate in the 1st grade.

I happened to chance upon this video on how its affects the world of employer branding and recruitment.

I guess the message is clear for the rest of us. Network. Get the word
around. Web 2.0 has just created a parallel universe. Some of us have
missed the bus. There is a lot of catching up to do.

Financial Crisis - Don't Worry, Greed will Prevail

Note: I had posted this article on only my personal Blog since this was an HR only dashboard but i feel this topic transcends all domains, hence i am posting the blog here also. All comments are welcome.

Global financial meltdown - Three words that in all likelihood conjures up the most frightening monster the world has known. This monster is taking away all the things that we cherish, directly or indirectly. First there is a pay freeze, then there is a pay cut and if that was not enough there goes our job. With that goes our 'discretionary' spending capacity, our willingness to buy things that makes our miserable lives slightly bearable, our self esteem. The factories close down, industries vanish and social unrest begins. In the midst of all this, nations along with their policy makers are left scratching their heads. Question: Our goose is cooked...right?.....Wrong!!!

I have a simple solution to this. Forget about it...Dont worry, cause this is not going to last long.

I am sane enough to believe that these so called experts who are telling you that the financial world - thus in every sense the real economy - has come to an end are lying or to put it more subtly, not telling you the whole truth. Being a layman, i will try to tell exactly why i believe that this crisis is infact going to turn around very quickly.

Let me start with simple process flow. I go to work everyday and earn a salary every month. Some part of this salary goes to buy necessary and other products, some goes into savings like Cash, equity (shares, bonds, MF's), Commodities etc, mostly to a bank. Now the place where i am working makes a product and sells it to the consumer to generate revenue and hopefully profits. Again this money is split into buying important raw materials etc, paying bonuses; dividends and saving it in a bank. The bank gets this money and pays interest to the consumer or the corporate who has deposited the money. If my company is doing well, it takes a lon from the bank and carries out expansion plans - increase manpower, get more machines, etc - and from its increased profit pays off the debt. Since the bank needs to make money too, it charges an interest higher than what it has paid for the money and this becomes the profit (after overheads). This way the cycle keeps moving.

Now for some economics. Demand and Supply. Classical theory of economics states that if the demand goes up - the supply remaining constant - prices go up too. This is true for Oil, most precious metals, etc. For other goods, if the prices are higher, then the consumer might shift to substitutes so organizations in an effort to make more profit do not increase the prices. Instead, they increase their capacity to produce goods at almost the same rate as the demand moves up. This creates new expansion plans, new jobs, and hence again the above mentioned cycle continues.

Now to make the explanation clearer lets figure some connections:
If the companies/ individuals do not earn money they have less to saveIf the banks get less money, they give out less money and hence make less moneyIf there is less money for people to spend, they either buy cheaper substitutes or not buy at allIf the consumer does not buy, the companies do not make money and expansions go for a tossIf expansions do not happen/ new companies do not come up, the industry slows downIf the industry slows down, the governments have less taxes to collect and lesser budgetsIf budgets are lesser, social spending decreasesIf social spending decreases, the unrest begins

Now the impact for the stakeholders:
Since banks are making losses/ 'not enough' profit, shareholders get angry; CEO has to goSince other organizations are making losses/ 'not enough' profit, shareholders get angry; CEO has to go. Above corollary is that shareholders are also losing money. Since countries are not making money and hence people are suffering, governments will lose their votebanksInfact due to the extreme lowering of oil prices, terrorists are also not going to have much money since their masters purse strings might just be running on emptyand hence due to all the above except one....the individual loses
Hopefully, you get my drift. This is just not going to happen. Rich individuals/ corporations/ governments can take the fallout for sometime but sooner or later they will realise that there is just no other way to come out of this but to make profits.

Also since the world today is extremely connected (take the example of terrorists - US does not buy oil due to recession and terrorists have lesser money for spreading hate) and mind you this is an extremely delicate connection, making profits is not easy unless the entire global machinery is greased. This grease comes from banking organizations and consumers who will spend the money thay they generate. And banks will spend once they are aware that if they dont, they are the ones who lose the most. They own the money and they need to pay the interest.

I can tell you this and much more in complicated jargon but it all boils down to this. Yes, for a short time (my bet is 6-12 months) things are going to be nasty. But this is just a blip. This can never be the great depression part 2 since the economies are not isolated and global linkages will play its own hand. We have probably seen the worst and things will - hopefully - seem better very very soon. It was greed that got us here and it will be Greed that will get us out of here...

Ritesh Sharan

HR analytics

Reproducing an interesting article (this is not mine) I found on a yahoogroup- though its actually an advertisement for an HR analytics tool, it puts forth some interesting points on using HR analytics.

Making Their Numbers by Tom Starner[Human Resource Executive Online October 2, 2008]

Some HR executives are turning to workforce analytics as a way to demonstrate their department's strategic value. For analytics to be meaningful, HR needs to understand not just the 'what,' but also the 'why,' say experts.To Lou Manzi, the use of workforce analytics boils down to a fairly simple concept:

"If you aren't keeping score, you're just practicing," says the vice president of global recruitment at GlaxoSmithKline, the global pharmaceutical giant that has its U.S. headquarters in Philadelphia.

Manzi's choice of words may not be original (it's an old saying), but, based on his experience so far, it's a very apt way to characterize how workforce analytics can work within HR. He also believes that, after years of promise, workforce analytics is finally coming of age in the HR arena.As testament to that, Manzi's staff recently moved from the practice squad to scorekeeping.

"We'd been doing some limited metrics, but we eventually realized we could not get the data quickly enough to meet today's fast-changing recruiting environment," he says.

Additionally, the data HR was producing simply didn't add enough business value, while at the same time, users were asking HR for data they should have been able to get on their own.

"We were chasing our tails," he says. "We needed to step the process up to a higher level, and drive business results."

According to a 2007 research report from Ventana Research entitled Workforce Analytics Business Intelligence: Best Practices Education, about 63 percent of respondents from benchmark research conducted by the firm have made improving workforce analytics a priority. However, only half the organizations surveyed have the skills required to do so, and 57 percent are not satisfied with their existing approaches. That's no surprise, considering that 69 percent report using spreadsheets as a way of doing workforce analytics, while only 29 percent use dashboards.

"Spreadsheets and silos of data have ruined the reputation of HR and hampered the business," says Mark Smith, CEO and executive vice president at Ventana, a benchmark research and advisory services firm in Pleasanton, Calif. "Yes, HR is finally getting it. But only in the most mature HR groups."

1. Last Bastion of Inefficiency

"We've been talking about metrics for a long time, but when you delve into it on a buyer basis, most still have relatively rudimentary analytics they rely on," says Lisa Rowan, program director for HR and talent-management services at IDC in Framingham, Mass.

Some HR leaders have a good handle on quantitative metrics -- time-to-fill a position, for example -- but lack a firm grasp of the qualitative ones, such as quality of hire, she says.

"For analytics to be meaningful, you need both," says Rowan. "It's not just about the 'what,' but also the 'why.' The 'why' is much harder to get at and requires time and patience."

Larry Hutchison, CEO of DoubleStar, a talent-management vendor based in West Chester, Pa., points to an online poll conducted by his company last spring in which 61 percent of the 400 respondents said they're assessing, selecting or implementing workforce analytics software this year, with more than 40 percent citing the need for talent-management data as "critical."Hutchison adds that he sees a difference when meeting with potential customers these days.

"Today, we're meeting with the senior HR people right away, instead of meeting with the IT folks first, which is what we traditionally did," he says. "I think HR leaders are realizing that it's been hard to get that proverbial seat at the table because they didn't have numbers to bring with them."

He also believes the interest in workforce analytics is occurring partly because more people are coming into HR from more numbers-focused areas such as finance and marketing. Then there are the HR executives who understand that driving business results should be their main objective, he adds.

"It all starts with a basic premise that HR is the last bastion of operating inefficiency out there," Hutchison says. "From a services standpoint, 65 percent of the operating costs for an organization are tied up in people, so you need to optimize your data and correlate performance back to that spend."

Ian Gordon, director of product marketing at IBM Cognos Analytic Applications in Ottawa, Canada, agrees that HR's interest in workforce analytics is on the rise.

"It's safe to say we've seen an uptick in the last six months to a year, as HR continues to try and find ways to be more strategic," Gordon says, adding that for the first time, HR is using data not just in a responsive mode -- as in, for example, when an employer loses five key employees and needs to find out what's going on."You have to manage human capital as much as you do cash, so you need some way of understanding and deploying that resource," he says.

2. Analyzing, Not Just Gathering
GlaxoSmithKline's Manzi falls within the second group Hutchison mentions -- the HR executive who needs to deliver more strategic clout by driving business results. He's certain workforce analytics can help him do it because it's already happening.GSK needed a workforce analytics vendor that understood recruiting, and whose technology is "system-agnostic," says Manzi.

"Prior to last year, we were spending much of our time gathering data, but we had the 80-20 thing backwards," he says. "We spent 80 percent of the time gathering, and 20 percent of the time analyzing. That wasn't working."

By implementing workforce analytics via a pilot project (GSK is a DoubleStar customer, using the latter's Workforce Insight On-Demand application) , Manzi says HR hopes to learn how it can become a more powerful business partner."We could no longer just gather data; we had to analyze it so we could drive what was valued by our line managers," he says. "We said, 'We'll do the heavy lifting. Here's what the data says; here's what you can do with it.' They responded very positively, so the validation is on the right track."Manzi cites a simple example of how workforce analytics has begun to drive business results. As he explains it, GSK's job-sourcing process delivered a bona fide job candidate within about 32 days, on average. Yet, by analyzing data via workforce analytics, HR discovered it was taking another 60 days to get that person hired and onboarded.

"Somewhere along the line, it was taking too long to finalize a hire," he says. "It wasn't the recruiters, it was the process."

Manzi explains that if the delay in hiring is within the sales force, for example, and every day that a sales professional isn't working costs the company $5,000 (a hypothetical number), that delay in landing the candidate is obviously very expensive.

"That situation has direct business-driver impact," he says. "If you fill the job in 20 days versus 50 days, that's $150,000 in real money."

Going a step further, Manzi says, there's no reason why workforce analytics can't dramatically reduce critical processes such as time-to-hire. In his view, if it takes four months to fill a certain job, the data can show how to anticipate that need and greatly shorten that cycle -- to the point where candidates are already lined up when certain jobs open up.

"We used to rely on gut feelings, to some extent, but now we rely on data," he says. "The tough part is that when you're ready to collect and truly analyze data, you must be prepared to see something you didn't want to see and hear something that you didn't want to hear."

Manzi says workforce analytics outcomes are improving all the time. While they may not be a strategic best practice within GSK quite yet, the results from recruiting are starting to pull in the non-believers.

"When they see it doesn't need to take 90 days to fill a job, that it can be done in 30, that shows HR is contributing to the bottom line," he says.

3. Turning Up the Heat
Pamela Wilfong, vice president of HR operations and compliance at Arthur J. Gallagher Co., the large insurance brokerage firm based in Itasca, Ill., agrees with Manzi that HR's use of analytics should drive business results. Like any fast-growing global company, Gallagher places a very high priority on driving top-line results, she says, adding that HR's focus is on helping the company do just that while reducing expenses to improve operating margins.One way to get there, says Wilfong, is to give managers ready access to strategic information and professional- development tools that will support growth throughout the organization.

"We must step up and provide [our managers] with the tools, data and analytical capabilities they need to identify trends early on and make informed decisions," she says. "This type of analysis requires robust employee data and analytical tools."

Gallagher's workforce-analytics application, from IBM Cognos, will go live during the firm's third or fourth quarter this year, she says.When it comes to the vendor selection process and other pre-implementation processes, Wilfong says, the key is to clearly define goals and requirements for the tool and related processes up front, in "painstaking" detail.

"That will give you much more confidence when you ultimately propose a solution," she says. "It's imperative to seek multiple perspectives and feedback in establishing your precise requirements before you begin looking at tools."

Wilfong adds that HR's definition of a requirement may not match those of an organization's CFO, CTO or line managers. For example, the finance department might seek to interface certain employment data with its own financial-planning systems, or marry specific employment data with cost analytics from its own applications.Once the requirements are defined, she says, the next step is to research the best-in-class tools. This includes asking a lot of questions and seeking demonstrations from the top contenders. If possible, it's especially beneficial to have a select group of employees test drive the proposed tool to see how well it responds to their specific needs, she says.

"We want our professionals to remain focused on producing new business and servicing existing customers, so our objective is to minimize the amount of time they spend navigating complex tools and processes or engaging in redundant or repetitive activities," she says. "Therefore, our top requirement is efficiency and ease of use. We also look for systems that are quick, easy to maintain and expand, and cost-effective."

She adds that the expense and time necessary for building a robust global data warehouse from scratch meant "turning up the heat" on HR itself in finding a solution that would provide more existing capabilities up front.As for determining the end-user population, Wilfong says, giving everyone access to a reporting tool without educating them as to what they are using or what the data means is worse than not sharing information at all.

"There is too much potential for a casual user to use the wrong data or draw incorrect conclusions," she says.

Wilfong predicts that corporate and field HR staff; other corporate departments, such as finance; and line and executive managers will use the application once it's fully implemented. Gallagher HR also intends to provide managers or other more casual users with several established reports incorporating meaningful analytics, dashboards and core data that they can access and refresh easily, as needed.

"We will be providing some of those reports up front and will expand that suite or capabilities as needs change," she says, adding that for more extensive or ad-hoc reporting requests or analysis needs, HR will designate a smaller team of subject-matter experts within the function to help satisfy those requests with accuracy and speed.

4. "A-ha" Moments
When it comes to the data itself, Wilfong outlines what she believes to be the most effective steps HR can go through to provide data that actually matters to other executives and line managers.First, she says, it's critical to define needs up front by aligning your objectives with the company's business goals, a fairly standard approach for most HR technology implementations. Next, it's a good idea to seek multiple cross-functional perspectives as to what defines success or constitutes a "red flag" in a particular area. Then, discuss the formulas or data elements you might use to define success or identify problems, and any rationale as to why specific data elements are more relevant than others. Finally, provide reports that are driven by those data elements.

"This may sound a little simplistic, but the process and reports need to be simple to be successful and repeatable," she says.

IBM Cognos' Gordon says the most common experience he's seen for new customers is that workforce analytics provide them with insight they couldn't get before. For example, with IBM Cognos 8 Workforce Performance, an average HR person could -- in just minutes -- investigate the demographic workforce distribution (to understand the age of the workforce at a company, location and department level) without involving IT or requiring an analyst to use a bunch of text-based reports from the HRMS and then build a model in Excel using the data from the reports -- not once but three times.After that, if they wanted to see how they have been doing at recruiting into the company, by age range, and again, by department or location, the information is available quickly without requiring an analyst and IT to spend a whole bunch of time working in Excel.

Finally, they can present the information in easy-to-read, simple reports.

"The biggest 'a-ha' moment for customers is when they see the breadth of data they can get right out of the box," he says. "They say, 'I can now know what's going on in the way I want to see it.'"

DoubleStar's Hutchison says the major objective with the company's workforce analytics applications also was to make it simpler and highly configurable.

"Our application offers 17 dashboards from eight to 12 different views," he says. "When you add it up, there are 150 metrics we've defined, and within that, the customer can drag and drop, access a number of views, etc."

GSK's Manzi is confident that workforce analytics will get increasing traction now that vendors are delivering easy-to-use, robust applications.

"When the CEO says to me, 'What's the No. 1 challenge in recruitment?' I now have the data to back up what I say," Manzi says. "With these tools, you can actually get to the performance data that can directly lead to how you can chagne behaviour in positive ways