At large companies, options simply may no longer provide enough financial benefit for executives to justify the increasingly poor reputation they have among many big investors and governance advocates.ANDREW KELLY
Stock options – for years, the primary way companies tied executive pay to performance – are increasingly out of favour at Canada’s biggest corporations.
Do not, however, write their obituary: They’ll still have a place in many pay packages, particularly at smaller companies, compensation specialists say.
These conclusions are part of The Globe and Mail’s annual review, done in partnership with consulting firm Global Governance Advisors, of how, and how much, 100 of Canada’s biggest publicly traded companies are paying their chief executive officers. The median figure for total CEO pay among the Top 100 in 2023 was $8,583,258 in salary, bonus, stock awards and other compensation. That’s just a hair below the $8,598,141 in 2022.
The story, however, is what makes up the mix. The long-term decline in the use of stock options as a compensation tool seems to be accelerating, according to the numbers The Globe has tallied. Companies have been shifting to other forms of compensation, particularly stock awards that have performance requirements attached to them.
In 2018, options made up 33 per cent of the value of stock-based compensation for the typical executive in the Globe survey. That figure fell to 20 per cent in each of 2022 and 2023.
The number of companies in the Top 100 providing no stock options at all to their CEOs increased from 29 in 2018 to 43 in 2023. The number of companies that awarded a share package in which options made up at least half the value fell from 27 in 2018 to 15 in 2023. Only six companies awarded a share package in 2023 that was made up entirely of options.
And even as total pay is on an upward trend, the value of option grants is falling. The median CEO option award in 2023 was $714,160. In 2018, it was $900,000; in 2019, $1.13-million.
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The reason? At large companies, options simply may no longer provide enough financial benefit for executives to justify the increasingly poor reputation they have among many big investors and governance advocates.
“There definitely is a movement away from options,” said Peter Landers of Global Governance Advisors. Instead, larger companies are turning to other forms of stock awards “just because of the nature of the scrutiny they’re under by institutional shareholders, tax implications and the lack of ability to really grow and make those stock options worthwhile to the individuals … Where are you getting your most bang for your buck?”
It was not always so. Decades ago, salaries and cash bonuses made up the bulk of CEO compensation. Critics said the top dogs were making bank no matter how poorly a company’s shareholders fared.
The solution? The stock option. An option gives the holder the right to buy a share at a set price for a set period of time. Many executive stock options had terms ranging from five to 10 years. If the stock price went up, the value of the option went up – so, the theory went, a CEO’s interests were aligned with those of shareholders. The CEOs had “skin in the game.”
In an academic study on historical trends in executive compensation from 1936 to 2003, Carola Frydman and Raven Saks found that, as a share of total compensation, stock option grants grew in the United States in every decade from the 1950s to the 1990s and, by the year 2000, about half of executive pay was received in the form of options.
After the tech bubble of the 1990s, however, criticism of stock options increased. Executives whose companies’ shares had soared along with the broader tech market exercised their options, then quickly sold the shares and made millions. But after the bubble burst and stock prices plunged, executives who had cashed in before the collapse still had their millions.
“It’s a very imperfect vehicle,” said Catherine McCall, CEO of the Canadian Coalition for Good Governance, an alliance of large institutional investors. “The linkage it creates isn’t perfect because there is no downside to options. … It’s less of an alignment than full-value shares. When they go down, you feel the pain like shareholders do.”
Toronto money manager Mawer Investments typically votes no on say-on-pay proposals or the authorization of stock plans if the company can issue a number of stock options greater than 10 per cent of its shares outstanding or if the options have terms of longer than five years, said Jeff Mo, a small-cap stock portfolio manager for the company. As a result, he estimated, Mawer votes no at 70 per cent to 80 per cent of small-capitalization companies and roughly half the companies in its full portfolio.
“Options create an incentive for holders, especially if they are senior managers who have a high influence on strategy and decisions made by the company, to take on outsized risk, because it’s clear ‘heads I win big, tails I don’t lose anything,’” he said. “It’s not that we want corporate Canada to just move to cash compensation. We like the concept of equity-linked compensation, just not options, because of the asymmetric risk and reward.”
Data from The Globe’s compensation survey suggests companies are, in fact, not substituting cash for options. At $5.06-million, the median figure for total stock-based compensation crossed the $5-million mark for the first time in 2023. In 2018, it was $3.64-million.
That means companies are moving to some kind of mix of stock, not options. One kind is restricted stock, which vests over a period of years so long as the recipient stays employed. Another is performance shares, which an executive only gets if the company hits some financial target, like the stock outperforming those of peers, or increasing revenue or profits by specific amounts.
Mr. Landers of Global Governance Advisors believes many companies have been using a rough formula of 50 per cent performance shares, 25 per cent restricted stock and 25 per cent stock options. But many institutional shareholders and governance advocates criticize restricted stock for its lack of performance requirements. So Mr. Landers says he’s seeing some companies making performance shares 60 per cent or more of their mix.
But others are not moving in that direction. Ryan Resch of compensation consultant Southlea Group says his firm is seeing the value of restricted shares going up over time. “They have no performance conditions and they typically pay out in cash. I’m not sure from a shareholder perspective that that is a better deal than options.”
He said options “have a role to play” as part of a compensation package. “Some portfolio managers may like to see you have relative performance, but I think there’s a lot of shareholders and owners that really would want to see absolute growth and absolute returns.”
The Globe’s annual compensation study looks at the 100 most valuable companies in the S&P/TSX Composite Index. Most are mature, their years of big share-price growth in the rear-view mirror – which makes outsized gains from stock options less likely. At the same time, the companies’ size makes them appealing to a wide range of established institutional investors inside and outside Canada – the kind of investors most likely to have a robust governance wish-list.
That’s the one-two punch that helps explain the declining numbers in The Globe’s study. That also means smaller, high-growth and cash-poor Canadian companies are where options not only survive but flourish.
“If your share price is already at a level where you’re not seeing double-digit growth any more, which you would see at a smaller company, stock options aren’t as lucrative,” said Christopher Chen of Compensation Governance Partners. “You’re just not going to see the upsides.”
Victor Li, who runs his own consultancy, Victor ESG Inc., said a decline in options is “generally the trend among larger companies, but in the smaller companies, I don’t think it has moved at all. They still rely heavily on options.”
An additional factor in the decline of options is changes in Canadian tax law. The increase to the capital-gains tax inclusion rate, set to go into effect this week, will ding top executives and make options mildly less attractive in 2025. But the big hit came in 2021, when the federal government set a $200,000-per-year cap on stock deemed “qualified,” or eligible for preferential stock treatment. The typical CEO’s options package is far more valuable than that.
“It’ll be interesting to see two years from now when we’re looking at 2025 compensation,” Mr. Landers said. “I think that’s where we might see more of a shift, because then the full tax rules and the effect of those tax rules will come into play.”
While options use declines broadly among large companies, some industries may be an exception. Technology companies, perpetually in growth mode – even when large and valuable – still rely on options. Shopify Inc. is one of the six companies in the Globe study to use options for 100 per cent of its stock-award package in 2023, the fifth consecutive year it has done so. However, in February, the company switched it up and gave CEO Tobi Lütke a US$150-million stock package in which restricted stock made up 25 per cent of the value.
The large companies in Canada’s precious-metals mining sector have largely moved away from options after facing pressure from shareholder activists who argued that their share prices largely rose and fell with commodity prices. Just two of the seven in the S&P/TSX 60 Index used any options in their CEO pay packages in 2023.
Canada’s energy sector, which also relies on commodity prices for its fortunes, has a different perspective: Six of the eight in the S&P/TSX 60 use options in their CEO pay packages. One of those companies, Tourmaline Oil, used options exclusively in its CEO share package from 2018 to 2021.
In 2022, the company explained to shareholders that it believed it had “transitioned to a large, senior producer with a focus on free cash flow generation.” As a result, Tourmaline management and the board’s compensation committee “determined that stock options alone were no longer the most desirable and effective form of long-term compensation.” It began using restricted shares as part of the mix, Tourmaline said, because they “better reflected the nature of the company’s stage of maturity.”