Aligning management performance with shareholders’ interests through unrestricted share structures creates greater accountability leading to better returns for all.
Covid-19 has not only propelled companies of all sizes to embrace new ways of doing business, but it also offered a unique opportunity to reposition age-old management fads like restricted share-incentives. Various initiatives are allowing for greater transparency in pay gaps across organisation in all industries, and therefore the opportunity to implement new innovative structures at executive level is now a real possibility.
With the pandemic shedding thousands of jobs in an already tough market riddled with high unemployment and rising pay gaps in the labour market, finding innovative ways to align executives with shareholders has become increasingly important. This issue has been repeatedly disclosed in our mainstream media, yet there are very few solutions being proposed.
Despite South Africa being quick to follow developed markets in matters such as corporate governance codes, we have lacked the courage to innovate in the most important part of corporate governance: executive remuneration. Our long-term incentives are the same as those used in the 1990’s. Not much else has remained the same, so it is high time to rethink how executives are incentivised.
All the share scheme options available in South Africa are restrictive in nature and covered by Section 8C of the SA Income Tax Act, this requires any incentive subject to vesting restrictions to be taxed at one’s marginal tax rates. For high earning executives, this is 45%. This creates the perverse situation that executives need to liquidate their share-based payments in order to pay the tax thereon, rather than become long-term shareholders in the company’s that they manage.
Current restricted share scheme structures are linked to the share price, we know that the share price performance is not linked to employee performance. Executives are either fortuitous or very unlucky, in that if their structures coincide with the growth of the share price, they can do very well, but if there are external shocks – like Covid or macro shocks in the US – these schemes often lose out terribly resulting in unhappiness.
Unrestricted shares are the best mechanism for aligning management with shareholders as this gives management a meaningful stake in the company’s they manage. Unrestricted shares vest immediately, meaning the executive is expected to act like a shareholder from Day 1, not one day in the future if they are lucky. They become part of the same team as the shareholders whom they serve.
Unrestricted shares are also a good incentive tool because management don’t receive them for services rendered but subscribe for them as any shareholder would. This helps achieve shareholder and management alignment through improve management performance and therefore growth in share value. Unrestricted share-structures allow management to buy into the business they manage. The terms are preferential, allowing management to invest a meaningful stake in the business they manage, hence, any debt that is taken to purchase the shares is readily repaid. Existing shareholders are only diluted if there is growth.
The returns are directly dependent on company performance and can be cash-flow neutral under certain circumstances. Furthermore, these incentives are easier to design, implement and manage, reducing the costs and by implication the headache that companies currently face. The compliance, tax treatment and reporting are also much simpler than current structures. It also has excellent succession benefits whereby management can over a period of time take a greater equity stake in the business as they prove their worth. Hence it is a highly efficient and we consider a real long-term incentive as opposed to the current structures which vest over a 1 to 3-year period, which is certainly not long-term. These structures are suitable for both listed and private companies.
When considering executive remuneration, it is important to consider all three dimensions when designing the structure to ensure that one constituent is not losing out at the expense of the other. It is time to start thinking about the new ‘Triple Bottom Line’: The Company, Existing Shareholders and Participants of the Incentives. Every constituent should benefit from these structures. At present no one is benefiting.
Boards are ultimately the custodian of corporate governance at companies are now starting to design structures that result in executives becoming shareholders – instead of merely selling their incentives as soon as they vest! We are starting to see mandated minimum shareholding requirements for executives. Voting by shareholders on remuneration structures has also become popular and activist shareholders, specifically asset managers, pension funds and community organisations are starting to exert influence on companies to make positive changes regarding corporate governance concerns. We applaud their efforts, but action needs to follow intent.
Ultimately, any executive incentive strategy requires a high level of integrity on the part of management, the company and particularly the board. No structure is immune from manipulation, but we maintain that unrestricted share incentives are the best mechanism for aligning interests of company, its shareholders and management.