Coca Cola’s Reduced Options

Posted by Marc Hodak on October 2, 2014 under Executive compensation, Governance | Read the First Comment

Yesterday, Coca Cola caved in to the bad press regarding the equity plan they proposed last April–and passed by nearly 90 percent of voted shares–by altering their equity award guidelines.  It’s fun to speculate about the various forces arrayed for or against the Coke equity plan, and what Warren Buffet thinks, and how the press has reported the issues at stake.  But I’ll sidestep all the juicy speculation and bright fireworks and go straight to the only thing that matters, or ought to matter, to shareholders:  Is the new Coke policy better than the old Coke policy?

Let’s start with the policy change itself, which has three parts:

1.  Coke will be providing more transparency about the rate at which equity is being awarded (burn rate, dilution, and overhang)

2.  Coke will be using equity more sparingly in “long-term plan” awards, instead favoring cash

3.  Coke will be awarding far fewer options from their equity pool than before relative to performance-based stock

The effect of the latter two policies will be to significantly reduce the number of shares used to compensate management.  What they are NOT changing is just as important as what they are changing.

–  They are not changing the target value of “long-term plan” awards to management.  If an executive had a $1 million target long-term award, they will continue to have a $1 million long-term award; it will simply be paid more in cash than in equity.

–  They are not changing eligibility for awards.  They continue to believe that equity awards should be broad-based within the company.

So, what have the shareholders gotten out of these changes?  Well, management and the board will finally be able to step out of an unwanted limelight over pay.  Shareholders benefit from managers and directors being able to focus on business with one less distraction.  As for the economic benefits to the shareholders, that’s pretty easy to estimate, too:  Nothing.  The change in policy yields no economic benefits because, at the end of the day, there were no changes to the expected value of future awards to management.

To understand how little difference there is between the new and old Coke policies, consider something Warren Buffet, Coke’s largest shareholder, once said.  Let’s call it the Original Buffet Rule:  The goal of any company should be to get back more than $1 for every dollar it spends.  That rule should presumably hold for compensation expense.  And it should hold whether they are paying $1 or $1 million.

So,  let’s say that the board decides that they want to pay an executive $1 million.  Using the Original Buffet Rule, shareholders can question whether this person is worth $1 million dollars, or whether their achievement is worth $1 million, or whether any agreement or plan that resulted in this $1 million payout was a good one.  These are all legitimate economic concerns.  If they can’t get past these concerns, and they decide that $1 million is too much, then it doesn’t matter what pay instrument would be used to award that amount, e.g., whether it is awarded in cash or stock or stock options.  If it’s too much, it’s too much.  Only if it is not too much does it make sense to the talk about the award instrument.

Now, some of the plan’s critics, including Mr. Buffet, were in fact concerned about what Coke’s equity plan implied about the future total pay of its management.  I think that’s what Buffet meant when he called the plan “excessive.”  But, in the end, that is not the issue that the Coke board addressed and, therefore, presumably, not the issue that most concerned the investors that Coke’s board made such point of hearing out.  Instead, these investors seemed to be concerned that future equity awards would simply create too much dilution.

What difference should that make?  Suppose that shareholders agree that $1 million is the right amount to pay to an executive.  If so, then we can move on to the question of instrument; do we pay it cash, or in equity, or some mix of the two?  What would be the relevant considerations in such a decision?  They would include:

–  The company’s cash usage situation:  Do they have enough cash?  If they do, are they better off using cash for a compensation payment than for other purposes?

–  The company’s equity situation:  Do they have enough shares in their account to make the award?  If they don’t, would it be prudent (or possible) to buy back some shares in order to make that award?

–  Retention and alignment:  Would the company prefer that the executive have some or all of that amount in restricted stock?  Or in vested stock with holding restrictions?

Note that if the company has plenty of cash and plenty of shares and no particular concern about the executive’s existing exposure to the stock price, then whether they pay in cash or equity makes not one bit of difference from the shareholder’s perspective.

But isn’t awarding shares all dilutive!?  Yes, it is.  But so is paying out cash.  Both types of awards dilute equity exactly the same; they just dilute it from different parts of the balance sheet.  In other words, if you’re fine with the overall level of the award, and the company is not strapped for cash or stock, then the instrument of compensation is of no economic consequence.  Furthermore, if the company is not strapped for cash or stock, and you are not fine with the level of the award, then the instrument of compensation is irrelevant.

In other words, the net effect of Coke’s new equity policy is to provide more transparency about something that does not make any difference to the shareholders as long as Coke is a solvent company.  The net effect of Coke’s commitment to reduce the number of shares being awarded, and especially options on those shares, is to artificially constrain the instruments available to the board in making awards and, potentially, to reduce the amount of alignment between Coke’s managers and shareholders.  So, I have to take back the statement that this policy would have no economic effect.  It may have a slightly negative economic effect.  New Coke might be subtly worse than old Coke.  Who knows how much a subtle difference can make?

If one recognizes that, for a company as solvent as Coke, dilution per se is an irrelevant conversation, then one might reasonably ask what all of the standards around dilution and burn rate and overhang have to do with shareholder value in your typical Fortune 500 company.  That is a good question with a surprisingly easy answer, but I will leave that to another day.