Appreciation in a company’s stock value can be one reason that executive compensation amounts appear to be so high.
Publicly-traded companies are required by the Securities and Exchange Commission ("SEC") to disclose how much their top executives were paid the prior year. Companies usually publish this data in the proxy that is sent to shareholders soon after year end. The Summary Compensation Table (“SCT”) breaks down compensation by person and by category. Categories include salary, bonus, non-equity, stock awards, option awards, and pension.
Some shareholders may notice how high the executives’ compensation amounts were and question why the company spent so much money this way. But the company may not have spent that much money after all. In fact, most of an executive’s pay may have come in various forms of equity rather than cash.
In the SCT, the stock awards category includes annual grant date fair value of full-value equity awards such as restricted stock awards and restricted stock units. Option awards includes the grant date fair value of contractual rights to purchase company stock at a fixed price. Therefore, for SEC purposes, the grant date value may be reported as compensation. The value of the company’s stock may increase significantly over a period of years. Then, once the executive exercises the options, the appreciation of the underlying stock may be reported as part of his or her compensation for tax purposes. Therefore, for tax reporting, the pay package may include substantial amounts that represent appreciation in the stock's value.
So, in their proxy filings, public companies follow the reporting requirements of the SEC. These requirements control both the timing and the determination of the amount reported as compensation. However, depending on various factors, the amount and timing may be different when the executive submits an income tax return. For that purpose, Internal Revenue Service (“IRS”) reporting requirements for compensation must be followed, and their requirements can vary considerably from the SEC's rules.
Private companies may also offer long-term incentives to their key employees. However, privately owned businesses are not subject to SEC reporting. Instead, private companies may follow generally accepted accounting principles ("GAAP") for their financial statements and IRS rules on their income tax returns.
There are also key differences within tax reporting rules. For example, qualified and non-qualified stock options receive different tax treatment. And options may be reported for income tax purposes when awarded in certain situations, such as when a voluntary section 83(b) election is made. Also, non-qualified deferred compensation ("NQDC") may be subject to payroll taxes when it vests but may not be subject to income tax until it is paid years later.
Therefore, when executive compensation amounts are collected in surveys, the timing and the amounts may vary considerably depending on where the data originates (i. e. SEC filings versus tax filings). And the reported amounts may include much more than just cash payments from the employer.
Let’s look at a simplistic example. A CEO is granted options to acquire 10,000 shares of her employer’s stock. The stock’s value on the grant date is $10 per share. That value ($10) becomes the strike price, which means the CEO will have to pay $10 to exercise each option. Eight years later, the stock value has increased to $50 per share. The CEO exercises the options, and the company issues her 10,000 shares of stock. Those shares are immediately sold on the market for $500,000. The company gets $100,000 of the sale proceeds (the strike price). The CEO gets the other $400,000 of cash. There are four important points to notice in this example:
1. This $400,000 was generated by appreciation of the stock, and the company’s other shareholders would have also enjoyed that appreciation during that time. (Also note that some dilution of the stock occurred, however, which would not have occurred if the options had not been exercised.)
2. The company did not pay the CEO in cash. In fact, the company received $100,000 of cash from the executive when the options were exercised.
3. The $400,000 was actually from options granted to the CEO eight years earlier.
4. The amount of her compensation that is reported to surveys may vary significantly depending on whether the survey collects data from SEC filings or tax filings. The type of options and certain other details, such as elections, determine when the CEO is taxed on the $400,000 and whether it is ordinary income or capital gain to her.
This is not to say that executives always deserve as much pay as they receive. Some earn every penny, others do not. But it is helpful to understand what is in the compensation amounts and how they may vary depending on the source of the numbers.