The Almighty Dollar

Like so many small-town financial institutions, Lubbock National Bancorp’s image and personality have become intertwined with those of its chief executive. To be sure, the privately held bank’s ownersu00e2u20ac”mostly local businessmen from Lubbock, Texasu00e2u20ac”have been instrumental in drumming up business for the $206 million-asset bank. But when most folks think of Lubbock National, they think of its amiable CEO, David Seim. “David is well known around the state and this community,” says Roger Key, one of the company’s owners and directors. “He has a certain persona that is identified with the bank.”

So back in 1995, when a newly chartered bank in town sought to lure Seim away with a big chunk of equity, Lubbock National’s board sprang into action. Although Seim, who has been with the bank since 1980, earned a good base salary and some healthy cash bonuses for his efforts, he told directors that the chance to actually own a piece of the action sounded too good for a guy raising two kids to refuse. In response, Key, the compensation committee chairman, created a long-term incentive plan for Seim that gives him 0.5% of the company’s stock for each year that he meets a handful of performance goals.

“We were very pleased with David’s performance and had taken care of him from the standpoint of salary and bonus. We even had a salary continuation plan for his retirement,” recalls Key, whose family owns 49% of the bank. “But we needed to give him an incentive to stay with the bank on a long-term basis, and the one piece of the pie he didn’t have was equity.”

Today, Seim swears his undying allegiance to Lubbock National’s board, and why not? The three-office bank has performed well over the past two years, meaning that Seim already owns 1% of the banku00e2u20ac”valued at roughly $200,000. “To be honest with you, if we meet all these objectives over the next five years, I should be fixed for the rest of my life, financially,” he says.

Growing trend

Seim is far from alone. A recent survey by Pearl Meyer & Partners in New York found that equity awards granted to executives at 200 of the country’s largest firms represented 13.16% of all outstanding shares in those companies, up from 6.9% in 1989. With the stock market soaring, the value of those options increased by an astounding 55% in 1997 alone.

Bank boards have not only followed the trend; they’ve helped feed it. Only a decade ago, bank CEOs and their top lieutenants were among the most underpaid executives in corporate America. Most received modest base salaries and pensions, but little equity. Today, an explosion in stock option awards and other equity-based incentives have made bankers among the most richly rewarded executives on the planet.

In 1997, about 60% of all banks granted long-term incentives to their CEOsu00e2u20ac”up from 43% just five years earlier, according to Cole Financial, Inc., a Boston-based bank compensation consulting firm. Forty-eight percent of thrifts employed similar plans.

Virtually all large institutions now offer their top executives some sort of equity participation in return for good performance. But the real news is the trend’s acceleration at the smaller bank level. Over 55% of all banks with between $200 million and $500 million in assets last year offered equity-based incentivesu00e2u20ac”including stock options, phantom options, stock-appreciation rights, or restricted stock awardsu00e2u20ac”to their executives. (See sidebar.)

A complex set of dynamics is driving the shift to greater stock-based compensation. The industry’s consolidation wave, combined with greater profitability levels, has caused the average bank’s valuation to soar by more than 20% in each of the past few years. This makes owning equity more attractive to executivesu00e2u20ac”especially when most of their retirement nest egg is wrapped up in 401(k) and other defined contribution plans with government-ordained limits on how much employers can kick in.

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And as Lubbock National’s situation illustrates, competition for good people has never been so intense. Many banks and thrifts today are battling insurers, brokerages, and other financial services providers for customersu00e2u20ac”a game that requires hard work, brainpower, and creativity, not to mention stable relationships. Seim received several other job offers before the one that motivated his board to finally consider giving him an ownership stake. If the competitor down the street is willing to pony up equity, can your bank afford not to?

“Today, you have to do it to be competitive,” says Richard Chapman, president of Bank Compensation Strategies, a Minneapolis-based consulting firm. CEOs “see what other CEOs are being paid, and they’re saying, ‘Why shouldn’t I get paid the same? I’m getting all the same performance measures thrust at me by my directors and stockholdersu00e2u20ac”growth, sales culture, noninterest income, shareholder valueu00e2u20ac”and my bank’s performing well. Now it’s my turn.’”

In this environment, many boards are concluding that they must up the ante to keep their most powerful asset: their leadership. But they’re also getting smarter about it, creating plans with lengthy vesting schedules that grant stocku00e2u20ac”or cash payments related to the stock’s performanceu00e2u20ac”only if specific performance objectives are met. This, advocates say, encourages good executives to stay put while shifting the added compensation burden from the income statement. At the same time, it aligns management’s interests with those of shareholders.

“Things are going up so fast that boards are asking, ‘What’s the quid pro quo? What’s the right number?’” explains Cole Financial President Ben Cole. “If you only get a salary, then what the hell do you care about investors? But if a good portion of your total compensation comes from stock optionsu00e2u20ac”if it’s tied to the same things that shareholders wantu00e2u20ac”then you begin pulling in a direction that benefits everyone.”

In the process, an important side benefit has emerged. As boards seek to tie those equity awards to performance, directors have been pushed to think harder about what they wish to see their institutions achieve. “Because of the compensation issue, boards are now getting more involved in setting the goals and direction for their institutionsu00e2u20ac”how fast they want to grow, what sort of returns they want,” Cole says. “The use of options has placed all these operational issues on the front burner.”

The notion of encouraging executives to think like shareholders is perhaps the most powerful appeal of equity-based incentives. Indeed, growing numbers of boards are using such plans proactively, as tools to prod executives into pursuing shareholder-friendly strategies.

Increasingly, experts say, the composition of the pay package carries an implicit message about the board’s expectations in terms of performance. A CEO might be the sharpest guy on earth. But if his or her compensation is oriented around short-term objectives, those are what the person will strive to achieve. Base part of that package on the ability to reach certain specified performance targetsu00e2u20ac”such as growth or return on equityu00e2u20ac”that benefit shareholders in the long run, and the executive himself begins to think like an owner.

This can be especially important in today’s acquisition-driven environment. It’s often said that there’s no better defense against takeover than strong performance. And if your goal is to eventually be part of a merger, then getting the CEO to think like an owner means he’ll be less concerned about job preservation and more likely to stay on afterwardu00e2u20ac”thus smoothing the transitionu00e2u20ac”if he has equity awards that have yet to be vested.

Key says Lubbock National isn’t thinking about selling. “But we wanted to make David an owner, so that when he analyzed the future of the bank, he’d do it with a shareholder’s eye.”

Seim is awarded his stock based on his ability to reach specified goals in the areas of asset growth, capital strength, returns on equity and assets, and asset quality. Last year’s highlights included an ROE of 15% and asset growth of 13%. “It’s somewhat of an intangible,” Key says. “But now he’s not just part of the management team, he’s an owner. And I think he’s focused more on the long-term issues that affect shareholder value.”

The brass ring

If this makes Seim sound more like Pavlov’s dog than a well-trained professional, he doesn’t seem too bothered. “In a perfect world, all of us would give it our all, regardless. But the reality is that in this system, we’re driven by money,” he says. “I can assure you, I think about my incentivesu00e2u20ac”if not every day, then at least every week.”

“Money motivates,” agrees Keith Patten, chairman and CEO of Camden National Bank, a $574 million-asset bank on the Maine coast that grants stock options to about 10 of its senior executives. “I hate to admit it, but it’s probably more true today than it ever was.”

Indeed, the use of performance-related incentives for bankers appears to be a match made in heaven. Few businesses embody the essence of capitalism more than banking, while few practices are more capitalistic than awarding equity for a job well done.

But while most analysts, investors, and directors say such awards are helping to make banks more profitable, not everyone is sold on the idea of giving executives a piece of the equity pie. Indeed, the average $50 million-asset bank today offers no long-term incentives to its CEO, choosing instead to rely on traditional base salary and limited cash bonuses as the building blocks of the compensation package.

It’s not difficult to understand why. In many communities, the bank CEO is already the best-paid person in town. The suggestion of forking over even more money to that person can spark nasty whispers, if not outright outrage or resentment. This is especially true among some shareholders and directors who may earn only a fraction of what the CEO already makes. “It’s an extremely awkward thing for directors to address,” Cole affirms.

So it’s no surprise that the boards of many smaller banks have explored granting equity payouts, only to decide against it. “It’s the dynamics of the board,” Chapman says. “The type of directors we have in community banks include people with modest incomes. They say, ‘I never had [equity incentives] at my company, why should we do it for the bank president? He’s got an easier job than I ever had.’”

Return on investment?

This is a big frustration for the consultants who make their livings advising boards on the efficacy of such plans. But often, those directorsu00e2u20ac”and some investorsu00e2u20ac”raise legitimate points.

Do long-term incentives to executives really spur better shareholder returns? There’s no disputing that bank valuations have risen dramatically over the past few years, nor that earnings have risen steadily during the same time frame. While stronger, better managements certainly have been one of the factors behind that growth, it’s also true that the stock market seems to have taken on a life of its own. Might it not be that the cart is pulling the horse, rather than the other way around; that bank executives are merely benefiting from a massive equity giveaway fueled by forces beyond their control?

At Norwest Corp.’s annual meeting this spring, Denver-based investor Gerald Armstrong asserted that performance-based compensation “seems to be paid today for performance anticipated tomorrow. …Does it come with any guarantee that the performance is, in fact, performance?”

Many directors and small bank owners share such sentiments. If CEOs get a good salary, they ask, isn’t it reasonable to expect that they’ll give the job their best effort without extra incentives?

Not necessarily. “Sure, there are some boy scouts out there that will give 110% no matter how you pay them. But they’re in the minority,” says Claude Johnston, a Pearl Meyer managing director. “It would be foolhardy to operate your business under that assumption.”

The truth is, for every doubting director, there seems to be several others who testify that the promise of equity is the key to getting the most out of executives and producing better returns for shareholders.

“We set high goals for our people, and we feel they should be rewarded for it,” says John Forlines, Jr., chairman of Granite Falls, N.C.-based Granite Bank. The $529 million-asset institution has churned out some of the best returns in the industry, and Forlines credits the bank’s “plain vanilla” stock options, awarded to the top 15% of its employees, as a critical reason. “They would work hard anyway,” he says. “But they do just a little bit better with a little added incentive.”

Glacier Bancorp, a $580 million-asset holding company in Kalispell, Mont., has turned in an annual compounded return of 29.57% over the past decade. Chairman John MacMillan attributes that success directly to a program that provides option awards to any employee who has spent at least a year with the company. “You don’t have to be brilliant to run a bank. But you’ve got to work hard and have motivated people who are constantly looking at shareholder value,” MacMillan says.

Size matters

All in all, this is a trend whose time has clearly arrived. There’s no disputing that the sheer size of equity-based incentive awards in the banking industry have become mind-boggling by almost any measureu00e2u20ac”getting substantially more lucrative as an institution’s size increases.

Cole Financial has calculated the average CEO compensation package for banks at different size levels. It assumes that all options are exercised after five years and that stock values will increase by 10% annuallyu00e2u20ac”conservative figuring by recent standards. Those numbers then are adjusted for cost-of-living increases to achieve a value in current dollars.

In 1997, the CEO of the average $500 million-asset bank received a base salary of $216,900 and a 36% cash bonus, bringing the total short-term payout to $295,200. That same executive got 19% of base pay, or $40,500, in long-term incentives.

At a $5 billion-asset institution, the CEO’s base salary rose to $448,900, with a cash bonus equal to about 64% of that base, for total cash of about $735,900. But that same executive received 159% of his base salary, or $712,700, in long-term incentives. “On a conservative basis, he makes $1,448,600 in total compensation,” Cole says.

And if those numbers are head-shakers, consider what the CEO of the average $50 billion-asset bank made. Base salary rose somewhat modestly compared to the smaller banks, at $784,600, and the cash bonus rose to 153% of base. But the long-term incentive package ballooned, worth an eye-popping 502% of base salary, or $3.94 millionu00e2u20ac”and that’s merely the average.

Throw in an acquisition or some other momentous event, and the totals can soar. Last August, for instance, the former First Bank System, Inc. closed its acquisition of Portland, Ore.-based U.S. Bancorp and took its name. In the deal’s wake, the Minneapolis-based company’s CEO John Grundhofer alone garnered $17.86 million in stock option gains and long-term incentive payments last year, while Chairman Gerry Cameron, who plans to retire this year after selling his bank to Grundhofer, garnered $13.4 million.

Such figuresu00e2u20ac”especially in an age of rapidly rising valuationsu00e2u20ac”can sound downright obscene and spark questions about the efficacy of awarding equity to executives. But experts say that well-designed incentive plans guard against managers taking advantage of simple market conditions while ensuring that officers only get a big payout if shareholders do wellu00e2u20ac”a factor that can make a raise easier to justify to skeptical investors.

In this light, the executive payouts in the U.S. Bancorp deal may not look so bad. At a price of $69.19 per share, Cameron’s $10.6 billion deal paid investors in the old U.S. Bancorp a 54% premium over the bank’s valuation at the beginning of 1997. Investors in the old First Bank got a nice payout, too: Their shares jumped in value by 64% last year. Usually, Cole says, such “golden parachutes” are “peanuts compared to what shareholders get” in an acquisition.

Long-term planning

Directors pondering placing equity in the hands of employees must first think hard about what they hope to achieve. Such plans take on myriad forms and structures, largely dependent on an individual bank’s strategic and tax situations.

Some touch only the CEO, while othersu00e2u20ac”such as Glacier Bancorp’su00e2u20ac”include everyone from the directors themselves down to the rank of teller. Many plans include straight-out equity or stock option awards, while many offer cash payments that are tied directly to a stock’s accretion. Vesting schedules vary widely, but often are vital if your goal is to keep employees in place. And while most options are granted only after a bank meets a predetermined set of performance goals, others are given out beforehand, in the hopes that merely holding shares will inspire managers to think about the future.

At $574 million-asset Camden National Corp., senior officers get periodic nonqualified option awards, regardless of the bank’s performance. “We feel it’s better [than performance-based awards], because if you’ve already got 1,000 shares, you’re incented to make the value of those shares grow from the beginning,” Patten says. And you can’t argue with success: A block of Camden National stock worth $38,400 in 1977 is now valued at about $1.6 million. “The better the bank does, the more value those executives’ stock has,” Patten adds.

What planu00e2u20ac”if anyu00e2u20ac”is right for your bank? It depends on everything from your bank’s competitive environment to the value you place on present management. “How important is that executive, and what is the downside if you lose him?” asks Lubbock National’s Key. If you conclude your CEO isn’t very effective, you might well wonder why he’s still there. “If he’s good, realize that you’re going to lose some of your customers and credibility if he leaves.”

Chapman recommends that boards first get a firm handle on how their key executives’ salary and bonus packages compare with peers. State banking associations often are a good source of such information. “If you’re in the bottom quartile, you’d better have some very attractive supplemental plans, or you’ll lose that person,” he says. “On the other hand, if you’re near the top in terms of cash compensation, perhaps you should be giving them an opportunity to defer some of that income.”

Step number two is determining that quid pro quo: If you’re going to offer a long-term equity award, it’s only reasonable to demand some enhanced performance in return. Indeed, for many boards, this is the primary reason for starting incentive plans in the first place.

For CEOs, Cole often advises broader, general goals, such as a combination of growth in both ROE and assets. “Those two things pull against each other,” he notes. “So if you can achieve both, then the guy probably deserves what he gets.” For lower-line executives, the targets might be more specific, such as reducing nonperforming assets or the efficiency ratio. The opportunities are limitless, Chapman says.

Los Angeles-based GBC Bancorp rewards the top 15% of its staff with stock options. Parts of those awards are based on the $1.5 billion-asset business bank’s overall performance. But employees also have their own job-specific goals to achieve. “On one hand, we like to have heroes. On the other, we like to encourage teamwork,” explains Chairman and CEO Li-Pei Wu.

At Glacier, all employees are rewarded annually on two basic criteria: the bank’s ROE and specific job responsibilities. The result is a matrix that spells out how many options each employee will receive if the bank attains a certain return. “Everyone has copies of that, and I go to each of our offices every year with a slide show to make sure they understand the bank’s performance and what it takes to get a higher return on equity,” MacMillan says.

Imbedded in Glacier’s approach is the third crucial step: deciding ahead of time just how much equityu00e2u20ac”and in what formu00e2u20ac”the board is willing to grant. Chapman recommends setting a specific base earnings level you wish to achieve: “Once we get beyond that level, we’re willing to share a percentage of that added value with our executives,” he says. “Maybe it’s 10%, 15%, or 20% to management, and 80% to shareholders. Then you create an award formula around that basis to create the specifics.”

Think hard about how many people you wish to include in the planu00e2u20ac”usually it’s only the CEO or a handful of top executivesu00e2u20ac”and whether giving away real equity seems feasible. Many smaller banks, fearing the dilution of equity awards, opt for phantom stock options or stock appreciation rights, which provide cash payments that mimic the stock’s performance. So, too, do mutual thrifts, which have no stock to offer.

Such promises of future cash usually must be reflected on the balance sheet as liabilities, similar to a loan-loss reserve. (Stock options are off-balance-sheet affairs.) This gives the bank an opportunity to claim the payments as a tax deductionu00e2u20ac”an advantage standard stock options don’t allow.

Of course, the payments, when they do come, will be taxable as ordinary income for the executiveu00e2u20ac”eliminating the tax-deferment that some managers find attractive about such plans. But with the capital gains tax rate now at only 20% for individuals, boards may conclude that it’s simply smarter to dodge the 35% federal corporate tax that most companies now pay.

Above all, beware. These plans are usually far more complicated than meets the eye. Pearl Meyer’s Johnston, for instance, advises caution with stock appreciation rightsu00e2u20ac”nonqualified awards that pay executives the amount a stock’s value climbs over a given time period. While those rights look and feel a lot like a stock option, they also present a tough accounting challenge and “create uncapped, unknowable charges to earnings over the foreseeable future, based solely on the performance of your stock.”

And don’t forget about vesting. If your executives are good enough to offer long-term incentives to, you probably want to keep them. Once awarded, options and rights are typically exercisable only after an employee has spent a predetermined timeu00e2u20ac”usually between two and seven yearsu00e2u20ac”with the bank. “If you’re going to offer awards, you want them to be handcuffs, so you’ve got to put in a good vesting schedule that leaves a pot out for them if they stay,” Chapman says.

This all might sound pretty basic. But the devil, as they say, is in the details. Chapman tells of an Iowa thrift that established a plan to give its CEO 90% of his compensation in retirement income. “They vested him too quickly, and he left at age 34, with $90,000 a year promised to him for the next 20 years,” he recalls. “They really screwed up.”

There have been no such fumbles or regrets in Lubbock. Indeed, Key says that Seim’s stock plan has produced such good results that the board is now weighing setting up similar plans for several other executives. “We’ve concluded that in order to attract and keep good talent today, you have to provide more than just salary,” Key states.

“The money we’ve spent on David has been well worth it,” he adds. “If we can see similar results with some of our other executives, it only makes sense to do it.”