Jessica Pollock, a Senior Research Associate at FCLTGlobal, has highlighted a significant disconnect between the mathematical formulas used by proxy advisory firms, particularly Institutional Shareholder Services (ISS), and the economic reality of equity compensation for public companies. Her analysis, based on an FCLTGlobal memorandum, suggests that ISS’s current methodology for calculating dilution from equity awards can lead to inaccurate assessments, potentially influencing shareholder votes against beneficial compensation plans. This issue is particularly pertinent for companies actively engaging in share repurchase programs, where the gross issuance of shares for employee incentives is often offset by significant buybacks, rendering the concept of net dilution far less impactful than ISS’s calculations indicate.
The core of the issue lies in ISS’s dilution formula, which is widely used by institutional investors to guide their voting decisions on shareholder proposals. This formula, as detailed in ISS’s U.S. Equity Compensation Plans FAQ, calculates potential dilution by summing requested, available, and outstanding shares under equity awards and dividing this by the company’s total shares outstanding. For S&P 500 companies, exceeding a 20% threshold, or 25% for Russell 3000 companies, typically triggers an “Against” recommendation. However, this calculation method focuses on gross share issuance rather than the net impact on shareholders after accounting for share repurchases.
The Mechanics of ISS’s Dilution Calculation
ISS’s dilution formula, explicitly defined in Question 40 of their FAQ, is represented as (A+B+C) ÷ CSO, where:
- A represents new shares requested for equity awards.
- B signifies shares remaining available under existing equity plans.
- C denotes unvested and unexercised outstanding awards.
- CSO is the company’s Common Shares Outstanding.
This formula aims to capture the total potential equity that could be issued. However, it notably excludes any shares that a company has repurchased or is actively repurchasing from the open market. ISS maintains a clear stance on this, as stated in Question 6 of the same FAQ document: equity compensation and share repurchases are treated as “separate and distinct decisions.” This deliberate policy choice means that ISS does not offset equity grants with shares bought back by the company. The implication is that a company could issue shares to employees for compensation, simultaneously execute a substantial share buyback program to maintain or even reduce its outstanding share count, and still face a “dilutive” assessment from ISS based on the gross issuance of new shares.
The Disconnect Between Gross Issuance and Net Dilution
The framing of “dilution” is crucial here. Dilution, in an economic sense, refers to the reduction in the ownership percentage of existing shareholders. When a company issues new shares without a corresponding increase in its market capitalization, existing shareholders’ stakes are diminished. However, for companies with robust share repurchase programs, the economic reality is often different. Billions of dollars are returned to shareholders annually through buybacks, which actively reduce the number of outstanding shares.
For companies that do not engage in share buybacks, the distinction between gross issuance and net dilution is minimal. The shares issued for compensation directly increase the outstanding share count. But for companies with active buyback programs, the two metrics can diverge significantly. ISS’s methodology, by focusing solely on gross issuance, can lead to an overstatement of the actual dilution experienced by shareholders. Institutional investors who rely on ISS recommendations may, therefore, be voting on a figure that does not accurately reflect the economic impact on their holdings. This can result in recommendations against equity compensation plans that, in reality, have a neutral or even positive impact on share count and shareholder value due to concurrent buyback activities.
Scenarios of Dilution Assessment
The impact of ISS’s formula varies depending on the specific proposal brought before shareholders. Pollock’s analysis outlines three primary scenarios:
Scenario 1: Standalone Employee Equity Plans
When a company seeks shareholder approval for an employee equity plan, ISS applies its standard dilution calculation. A key point of contention is that the formula treats all shares issued under such plans equally, regardless of the recipients. Whether grants are directed towards the chief executive officer or thousands of frontline employees, the calculation for dilution remains the same.
While ISS does acknowledge a concept of “broad-based” plans, this distinction is primarily applied in their pay-for-performance analysis, not in the dilution calculation itself. As noted in Question 39 of the FAQ, a plan might be deemed not broad-based if executive officers receive a disproportionate share of grants (e.g., CEO receiving over 30% or all named executive officers receiving over 60%). However, this qualitative assessment does not alter the quantitative dilution calculation. The numerator of the dilution formula remains indifferent to the distribution of shares. This means a company striving to foster a widespread ownership culture through broad-based grants faces the same dilution math as a company concentrating equity at the executive level, potentially penalizing the former for its inclusive approach.
Scenario 2: Standalone Board Equity Plans
The assessment of standalone board equity plans operates differently and often more favorably for the company. According to Question 26 of the ISS FAQ, non-employee director (NED) equity plans are not evaluated under the standard Equity Plan Scorecard (EPSC). Instead, they are assessed separately, primarily against a plan cost benchmark. If this benchmark is exceeded, ISS supplements its analysis with a qualitative review of overall board compensation. This approach allows for more judgment and a narrative explanation of the compensation strategy, rather than the binary, quantitative override that can be triggered by employee equity plans. Companies seeking approval for only a board equity plan have a greater opportunity to present a compelling qualitative case for their proposals.
Scenario 3: Combined Employee and Board Equity Plans
The most complex and potentially problematic scenario arises when both an employee equity plan and a non-employee director plan are presented to shareholders concurrently. In this situation, as detailed in Question 33 of the ISS FAQ, the shares allocated for the NED plan are folded directly into the Plan Cost pillar of the EPSC evaluation. Both sets of shares, those for employees and those for directors, contribute to the same numerator in the dilution calculation.
This consolidation means that a grant to a board member is treated identically, in terms of dilution math, as a Restricted Stock Unit (RSU) awarded to a frontline employee. There is no inherent mechanism within the formula to differentiate between the recipient, the specific program design, or the underlying purpose of the awards. A company implementing a broad-based employee ownership initiative alongside a competitive compensation package for its board, which also includes equity, will see a combined gross issuance figure. This figure, unadjusted for any share repurchases and without any ability to articulate the distinct functions of these two pools of shares within the model, can lead to an exaggerated dilution assessment.
The Broader Implications for Corporate Governance and Shareholder Engagement
The discrepancy highlighted by Pollock has significant implications for corporate governance and the long-term alignment of interests between companies, their employees, and their shareholders. The fundamental question is whether a gross share issuance figure, which disregards the impact of share buybacks and treats diverse equity awards as interchangeable, should serve as the primary basis for negative recommendations on equity plans.
For investors aiming to make informed voting decisions, understanding the nuances of dilution calculations is paramount. When proxy advisors present a metric that may not accurately reflect the economic reality, it can lead to votes that do not serve the best interests of long-term value creation. Companies that are actively working to foster an ownership culture through broad-based employee equity participation, and which are also prudently managing their capital structure through share repurchases, may find themselves unfairly penalized.
The FCLTGlobal memorandum implicitly suggests that a more sophisticated approach to dilution calculation is warranted, one that acknowledges the economic impact of share repurchases. Such an approach would better align with the goal of promoting long-term shareholder value by supporting executive and employee compensation strategies that genuinely incentivize performance and ownership. It would also allow companies to more effectively communicate the value of their equity plans to shareholders, distinguishing between awards intended to drive broad-based ownership and those designed for executive or board compensation.
The Evolving Landscape of Equity Compensation and Proxy Advice
The debate over dilution calculations is not new, but the increasing prevalence of active share repurchase programs among large public companies has brought the issue to the forefront. Companies in the S&P 500, for instance, routinely return tens or even hundreds of billions of dollars to shareholders annually through buybacks. To ignore these significant capital allocation decisions when assessing the dilutive impact of equity awards presents a flawed perspective.
While ISS’s recent policy update, which introduced a new disclosure requirement for cash-denominated award limits for non-employee directors, represents a step towards greater transparency, it does not address the core issue of how shares are counted in the dilution formula. The challenge remains to develop a methodology that provides a more accurate representation of the economic consequences of equity compensation, particularly in the context of active share repurchase strategies.
Ultimately, the question of what “dilution” truly means in the context of modern capital markets is central. For investors and companies alike, the current ISS methodology, by failing to account for the offsetting effect of share buybacks and by treating all equity issuances as equivalent, may be hindering the adoption of compensation practices that genuinely align incentives and drive long-term value creation. The consequences of this disconnect can be substantial, influencing shareholder votes and potentially impacting a company’s ability to attract and retain talent through effective equity compensation programs. The need for a more nuanced and economically realistic approach to dilution assessment by proxy advisory firms remains a critical issue for the future of corporate governance.
