The cleanest compensation fuel – restricted stock

The cleanest compensation fuel – restricted stock

Brent Longnecker and Chris Crawford, Longnecker & Associates, Houston

The emerging talent gap within energy companies across the US has become one of the most serious concerns keeping senior management and board members awake at night. In a recent survey of utility industry human resource executives, conducted by Carnegie Mellon University's Electricity Industry Center, the retiring workforce is listed as the number one concern.

The talent gap has been building for decades. It initially started in the 1970s as the "boom to bust" cycle of oil and gas created volatility and ultimately job losses. Many engineers were forced out of the business in the 1980s, which fostered an underlying mistrust of the entire industry among potential college students.

An article in Fortune magazine reported that in the 1970s, 40 US colleges and universities offered degrees in petroleum engineering. By 1984, these 40 schools awarded approximately 1,500 undergraduate degrees in petroleum engineering. By the 2000s, only 20 remaining colleges were awarding around 800 petroleum engineering degrees.

In addition to the drop in petroleum engineering degrees, roughly 35 million Generation X and Y employees are available to replace the nearly 70 million baby boomers that will hit retirement age between 2005 and 2020. A 2007 survey of international and regional energy executives conducted by IHS CERA anticipates that more than 50% of current engineers will be retired by 2015, triggering a significant talent shortage throughout the energy industry.

If the talent shortage isn't enough, try adding to the equation the projected increase in oil, gas, and coal demand. The world economy has entered a new phase in global industrialization, led by China and India. US industrialization involved 150 to 200 million people over a century. In the next decade in China and India alone, around one billion people will be moving from a rural to an urban way of life. This will result in a dramatic increase in energy consumption to provide light, heat, and mobility. Andy Inglis of BP Exploration & Products noted, "The really big strategic issue for all oil and gas companies is matching the Earth's resource endowment on one hand, with the capability – technology, skill, and know-how – required to bring those resources to market on the other."

Brent Longnecker, chairman and CEO of Longnecker & Associates   Brent Longnecker, chairman and CEO of Longnecker & Associates

According to the International Energy Agency, by 2030, world energy demand will be 50% higher than today, and non-OECD countries are expected to contribute 85% of the total world energy demand growth between 2005 and 2030. Of particular note, those resources reside in some of the harshest environments of the world: the deep oceans of the Gulf of Mexico, Brazil and Africa, the deserts of Africa and the Middle East, and near the Arctic Circle.

Further, shale plays in the United States are making matters even more complicated. New applications of hydraulic fracturing technology and horizontal drilling have led to a significant increase in US natural gas, gas liquids, and crude oil reserves. However, technology must have talent. All of this points to higher demand for talented and skilled professionals that are already undersupplied.

Therefore, it's not hard to see why energy companies are struggling with how to attract and retain a growing scarcity of talent. Whether you're at a public, private, or international company, we have discovered one of the cleanest forms of compensation fuel – restricted stock.

How restricted stock works

One of the great things about restricted stock is its simplicity. In its purest form, restricted stock is a grant of shares that vests over time (the restriction). For example, if an employee is with a public company, and the stock price is $15.00 on the date of grant, and the employee receives 5,000 shares that vest in three years, the employee would be the owner of those 5,000 shares at the end of the three years. Because the employee gets all of the shares at the then stock price it's often called a full-value award. The ultimate value received by the employee is 5,000 x the price on the date of sale, less any taxes. If the stock price went up to $25.00 at the end of the three years and the employee then sold the shares, the employee would receive $125,000.

Naturally, a recipient perceives value on the grant date. Studies indicate that participants typically perceive the value of the award at the stock price on the date of grant. In the example above, the participant would perceive at least $75,000. This perceived value creates a natural handcuff to the company and at the very least forces a competitor to come out of pocket at least the value of the perceived handcuff to attract the employee. In addition, if the employee leaves, the unvested, full value of the award is still there to attract his/her replacement, thus making this type of award a good vehicle to attract, retain, and motivate.

Companies typically award restricted stock on an annual basis, thereby creating a rolling handcuff that makes it hard for the employee to leave a company. The most common vesting period for a grant of restricted stock in an energy company is three years.

Why the CFO likes restricted stock

Not only does an employee like the simplicity and perceived value in restricted stock, the CFO is typically a proponent. The following key benefits explain why restricted stock is a preferred compensation tool.

Charge to earnings

The charge to earnings for restricted stock and restricted stock units (settled in stock only) are fixed and budgeted at the time of grant. For example, if the company grants 100,000 shares at $15.00 with three-year vesting, the charge to earnings is $500,000 per year for three years, in spite of any increase in stock price. The upside is that the stock price may go up to $30.00, and the employees would receive $3mm in value vs. the $1.5mm charged to earnings. And the company gets a tax deduction for the full value realized at $3mm ($1mm in tax deduction at 33%), which almost offsets the charge to earnings of $1.5mm. However, it is key to note that if the company uses cash-settled RSUs, the company does not receive fixed accounting under ASC 718. Rather, it uses liability accounting, and the fixed charge to earnings benefits described above does not apply.

Dilution

In a public company, restricted stock utilizes fewer shares than any other equity vehicles such as stock options, stock appreciation rights, etc. In comparison, it takes approximately three to four stock options to have the same equivalent value as one restricted share, and may never deliver any value to the employee, thus becoming much more dilutive than restricted stock. In the current environment where the use of shares for management awards is increasingly scrutinized, utilizing fewer shares for greater value has a real premium.

NOTE: Beware of two potential downsides: (1) Institutional Shareholder Services (ISS) counts restricted stock like two shares for every one share awarded when approving shares for management awards. (2) There is an effect on earnings per share (EPS). Because restricted stock is an outright grant of shares, it requires a reduction of shares from treasury stock, an increase of shares issued, but not an increase in shares outstanding. Shareholders sometimes take issue with this because it results in potential dilution (the decrease in the ownership percentage of current owners when additional shares of stock are issued). However, because the number of shares used is significantly smaller than the number used with stock options, dilution should be less of an issue to shareholders. This is particularly true when companies take the time to communicate and discuss this with their key shareholders.

Tax considerations

Many Americans are still fuming over their new paycheck in 2013 post "fiscal cliff" tax hikes, but there is some good news in taxes owed for restricted stock.

  1. Taxes are not owed until the restricted stock vests (the restrictions lapse), thus giving a deferral of sorts.
  2. Companies are increasingly adopting tax withholding rights which allow the employee to receive the net shares or proceeds less taxes, and the company settles the tax liability with the employee shares withheld.
  3. Employees can get capital gains treatment on restricted stock via an 83(b) election. If the employee makes an 83(b) election within 30 days of the grant, he/she can recognize income in the year the restricted stock was granted based on the fair market value at grant (no discount is allowed for the restrictions on the stock). The advantage of accelerating the income is that any future appreciation in the stock is taxed as capital gains when the stock is sold.

Performance-accelerated restricted stock

A twist to the traditional time-vested restricted stock award is its performance-vesting counterpart, a performance-accelerated restricted stock award plan (PARSAP). Under this type of plan, the restriction can be stretched over a longer period of time than usual (six years instead of three). This adds retention value, spreads out the charge to earnings, and provides an additional motivational feature of the ability to accelerate or lift restrictions if certain predetermined performance criteria are met.

PARSAPs offer two main benefits. The first is the accounting and tax anomaly. The amortized charge to earnings for a PARSAP is spread over a longer time period than the charge for a traditional RSA. For example, 50,000 RSAs awarded at $15.00 with typical vesting of three years equals a $250,000 annual charge to earnings. However, if the PARSAP is spread over a seven-year period, the annual charge to earnings is $107,000. If the performance requirements are met prior to the seven years, vesting is accelerated. At such time, the accelerated portion of the award is taken as an accelerated charge to earnings.

Chris Crawford is the COO, executive director and co-founder of Longnecker & Associates   Chris Crawford is the COO, executive director and co-founder of Longnecker & Associates

The second benefit is that this simple "twist" boosts the retention and motivational aspects over a traditional RSA significantly. Boards, shareholders, and HR executives tend to favor the additional performance wrinkle to quiet critics of restricted stock for so-called "payment for breathing." Combine the added retention and motivation with the better accounting consequences and the PARSAP may prove beneficial in a company's long-term incentive program.

Private and international company versions

Many people at private and international companies believe that restricted stock only applies to public companies that operate in the US and are thereby disadvantaged in their competitiveness for key talent. However, private and international companies can use restricted stock in actual form or via restricted stock units – whichever best suits them.

Restricted stock in a private company mirrors restricted stock in a public company, except that when the restrictions lapse, there is not a readily available market in which to sell the stock, thus creating a liquidity decision the owners of the company will have to make, which can be easily built into the plan.

Restricted stock units (RSUs) offer a unique twist in that it is a full-value award like restricted stock, but is a cash-based plan like phantom stock. A company may establish a restricted stock plan that simply gives a percentage of the company expressed in units, similar to shares. For example, a company may establish 10 million units equal to 100% of the company's market value and then award units on this basis.

The units are easy to understand and have meaningful value. Designed by Microsoft when options began to lose their competitive value, the RSU version is attractive and prevalent with private and international companies since the employee can simply receive cash for the value of the shares once the restrictions have lapsed.

Summary

As energy companies continue to scrap and fight for the same scarce talent, getting the most value for the compensation expensed buck is at an all-time premium. Considering the many distinct advantages of restricted stock: the perceived value to the employee; the potential realization of upside stock price appreciation while protecting against stock price volatility common to the energy market; accounting, tax, and dilution advantages; potential for performance accelerators; and the application to private and international companies, we recommend companies give serious consideration to utilizing one of the cleanest compensation fuels around – restricted stock.

About the authors

Brent Longnecker, chairman and CEO of Longnecker & Associates, has over 26 years of experience in the analysis, design, and implementation of innovative performance, productivity-enhancement, and cost-savings programs. He was selected by Consulting Magazine as one of the top 25 consultants in the US and is the first executive compensation consultant to receive this honor. Longnecker's consulting engagements with numerous CEOs, boards of directors, investment bankers, attorneys, and certified public accountants for all major industries have embraced a wide range of operational, organizational, strategic, and ethical business issues.

Chris Crawford is the COO, executive director and co-founder of Longnecker & Associates. He has more than two decades of human resource management and consulting experience in private and public organizations with an emphasis on the design and analysis of executive and director compensation programs. He currently serves as an advisory board member, technical reviewer, and faculty member for WorldatWork teaching the certification course on variable pay. In addition, Crawford is a member of National Association of Corporate Directors (NACD), WorldatWork (formerly American Compensation Association), the Society for Human Resources Management (SHRM), and National Association of Stock Plan Professionals (NASPP).

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