Compensating for Dividends
Compensation in a texless dividend environment
The recent proposal by President Bush to eliminate double taxation on corporate dividends is a significant development in the world of economics. The affects of tax-free dividends in the stock market may be as such: 1) increased demand for certain dividend-paying stocks, 2) increased prices for these stocks as a result of the greater demand, 3) rise in companies declaring dividends due to their increased value in the marketplace, 4) less volatility in capital growth due to a steady cash-flow stream provided by the dividend payouts.
By taking one step further in this scenario, L&A can see the future affects of tax-free dividends on the design of compensation programs-specifically, long-term incentives.
With an increasing number of companies paying dividends to their shareholders, it will become even more important for key employees and executives to receive their piece of these payouts. Currently, the majority of long-term incentive packages are comprised of stock options-which receive no consideration for dividends paid and only gain on the basis of stock price growth. Going forward, since a large portion of retained earnings will be paid out, dividend-paying companies may not see the explosive growth in stock price that provided the motivation towards stock options in the first place. As a result, options may lose favor in the eyes of the executives (although, they may have already lost favor in the eyes of the company if FASB has their way on mandating a charge to earnings).
However, companies wishing to award their option holders with a piece of the dividend payouts (and thereby aligning shareholder interests more correctly with executives) can provide dividend equivalent rights as a part of their option program. These rights provide a cash payout to each option holder equivalent to dividends paid to shareholders.
More likely, other programs, such as restricted stock awards (RSA) will gain favor as a significant motivational tool. As an outright stock grant to the employee, the value of RSAs include any dividend payouts over the life of the stock-even before the restrictions have lapsed. Further, RSAs typically have voting rights as well, giving them another plus. Therefore, the employee participates in all shareholder returns-a true link between employee and shareholder interests.
Several characteristics of RSAs make them an equally attractive incentive program in the eyes of shareholders, board members, executives, the H/R department, and financial officers.
- Shareholders - Although it requires immediate dilution of EPS, the dilution is set at the grant date and does not vary as restrictions lapse. In addition, it takes a significantly fewer number of RSAs to motivate and/or be competitive over the long-term (usually a 1-4 ratio) than options which are dilutive when exercised.
- Board members - The long-term nature of these awards serves to align the goals of the executive with the long-term vision of the company.
- Executives - RSAs have an automatic value at grant with restrictions on sale or transfer until restrictions lapse over time; therefore, the executive immediately owns the stock, has voting rights with the stock, and is eligible to receive dividends .
- H/R department - RSAs have a high retention value due to forfeiture of the stock following an early departure.
- Financial officers - With a fixed charge to earnings at the time of grant, the open-ended variable accounting nightmares are behind them.
Interestingly, with the projected declining use of stock options as a result of the tax-free dividends, President Bush may have provided an indirect answer to the option accounting debate. Only time will tell as these possibilities pan out, so stay tuned.