Executive Compensation and Stock Warrant Plans

by ERI Salary Surveys 30. April 2012 08:11

 

When Rob Johnson took the helm as CEO of JC Penney, his executive compensation package made headlines because he invested his own money in the company by purchasing a warrant valued at almost $50 million.  Warrants are financial instruments that are typically “wrapped” into debt arrangements like bonds, sold to investors to raise cash, and function similar to options.  So, how are warrants structured to be used as a compensation instrument?

CEO Johnson’s warrant has the following characteristics:

  • a 7.5 year term
  • vest date after June 13, 2017 
  • entitles him to acquire 7,256,894 shares
  • exercise price of $29.92 per share
  • vests only when market price is greater than $36.81

During ERI’s Q1 2012 data collection efforts for European executive compensation data, we identified a few Danish companies that have “broad-based” stock warrant plans in which both executive and non-executive employees are eligible. One such company is Lundbeck Group.  Their plan allows warrants to be issued up to a nominal value of DKK 8,750,000, equivalent to 1,750,000 shares of DKK 5 each. The awards have a 5-year vesting schedule that hybrid cliff and graded: no vesting in years one and two; 20% in three years; 30% in the fourth year; 50% in the fifth year, and otherwise lapse if not exercised before December 31, 2018.

Some stock warrants are “performance-based” where the grantee has to achieve target goals in order to actually own the warrant.  For example, in order for a warrant of 5,000 shares to vest, the grantee must sell $1,000,000 of product in the next 12 months with a cap of 50,000 shares.  

When a warrant is issued as a compensation instrument, how similar is it to employee stock options?  Let’s start with a side-by-side comparison to understand the similarities:

Warrant

Employee Stock Options*

Right to buy company shares at a future date and at a pre-agreed price

Same

Do not have to be tied to employment (or board membership)

Same for non-qualified plan

Can have a term longer than 10 years

Same for non-qualified plan

Are dilutive and affect stock values

Same

Underlying stock is equal to the exercise price, plus any increase in value

Same

Disclosed in proxy statement  in option awards column

Same

Not taxable upon grant or issue

Same

Upon exercise difference between exercise price and the stock’s value is taxed at ordinary income tax rate

Same for non-qualified plan

*Same = both qualified and non-qualified employee stock option plans unless otherwise noted

 

So are warrants “synonymous” with non-qualified stock options?  Technically, the answer is “no.”  In addition to raising funds, companies also issue warrants to control dilution by issuing the warrants to a targeted group of shareholders who may elect to invest more money or lose ownership percentage. When warrants are issued to raise money or control dilution, they are transferable in the open market and do not have restrictions like not vesting or performance triggers.  As a compensation tool, warrants appear to be more versatile and can serve dual purposes, depending on the needs of the organization, whereas employee stock options have more specific requirements.

For more information, analytics, and tools related to executive compensation, visit www.erieri.com.