The NASPP Blog

It’s been a while since I’ve heard a new buzz word floating around the equity compensation circles. Today I’ve got one for you – “stress test”. Okay, technically that’s two words, but who’s counting? Anyhow, what’s a stress test? No, it’s not a mechanism to measure your personal level of bliss or distress in administering equity programs, or how a sudden acceleration of vesting is going to impact your blood pressure. This is about putting the payout structure for your equity plan design to the test – literally.  In today’s blog, I want to explore this concept that has existed in compensation circles, and seems to be expanding to include longer term equity incentives on a broader basis.

What is a Stress Test?

The idea behind stress testing is to look at a potential range of compensation outcomes for a plan or program, and then evaluate those compensation outcomes in conjunction with several risk/opportunity scenarios for the overall business. The goal? Determine where potential value imbalances, windfalls, and other sub optimal compensation outcomes may exist when the plan is evaluated in consideration of overall business factors and performance as a whole.  Companies want their performance (and other time based) payouts to be commensurate with the performance of the business and the value created for shareholders. For example, it’s not going to excite shareholders if executives received a huge windfall during a time when the company has stopped paying dividends. The goal of most performance programs is to align significant payouts with upward and profit creating (for shareholders) achievements in company performance. Yet, even with good intentions in plan design, the two don’t always match up when the value received by executives is compared to the value received by shareholders. Enter the stress test as a means to more thoroughly unearth any inconvenient truths that may have been overlooked or not considered in advance of implementing a particular award program.

An Art and a Science

The concept of stress testing pairs both art and science. It’s impossible to predict with 100% accuracy the true path of an equity award – both in terms of the company’s performance, stock price performance, an unforeseen factors.  This translates to an art involved in choosing the right scenarios to model as potential impacts to company performance and shareholder value. There are possibilities and probabilities and that’s the focus of stress testing. Evaluate multiple potential impacts and assess the probable end result on the equity compensation plan awards. How will a merger impact things? What happens if earnings targets are missed or overachieved? Once some scenarios are created, and the overall potential impact is assessed, a calculation is performed to determine the value that the executive would receive. The potential value to shareholders in these scenarios is also modeled and the two are compared. While not a guaranteed method of predicting the future, stress testing can provide more data and alternative scenarios for companies to consider before issuing performance and other equity awards.

One thing of note – stress testing is not limited solely to the performance component of the awards. Companies are looking at the impact of company risk/opportunity factors on the equity compensation package as a whole. For example, let’s say an executive has 50% of their shares in performance awards, and 50% in stock options. The company meets certain objectives and the performance awards pay out at the maximum level. The “stress test” that has been done to model this scenario in advance also considers the impact of those company/market conditions on the stock option portion of the executive’s equity compensation package as well. Is there a windfall on the horizon? The objective is to ensure that shareholders are getting paid first, and that the executive’s overall compensation potential does not exceed the value created for shareholders. If the cumulative “reward” to the executive for all of his awards is not aligned with shareholder value, then the company would likely modify the proposed payout structure to close the gap.

For More Information

I recently caught up with Scott Witz, VP of Compensation and Benefits for W.W. Grainger. During a brief podcast interview (part of our Equity Expert podcast series) he explained how Grainger approaches stress testing of their equity awards (along with other tips on administering performance awards). The nice thing about podcast interviews is that they are short! So check out Scott’s interview for some real information on how Grainger is approaching stress testing and their performance awards. Also, this concept will be addressed by Scott and other panelists in they Keynote session: Performance Awards: What Companies Need to Know Before Making Their Next Grant at our 22nd Annual Conference in Las Vegas later this month (September 29 – October 2nd). You won’t want to miss it!

Lastly, I note that the date of this blog is September 11th. Just like the bikers who stand on my street corner the morning of each September 11th waving their huge flag year after year in remembrance, we don’t and won’t forget.

-Jenn