Wall St., High Tech Share Approaches To Stanching Brain Drain

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Includes: GOOG, MER, MSFT
by: Roger Ehrenberg

Attracting and retaining the best. This is the lifeblood of fast-moving, innovative fields like Wall Street and technology. And equity participation is a key vehicle for both aligning employee and shareholder motives as well as creating "golden handcuffs" though vesting provisions.

The problem is when the music stops: this could be due to the cooling of a rapid-growth phase and maturity of the business (read: Microsoft (MSFT) or an adverse business cycle together with poor managerial decisions (read: Merrill Lynch (MER)). In both cases the results are the same: brain drain. When the value of equity-based compensation either begins to stagnate or is simply perceived as worthless pieces of paper, a key lever of attraction and retention is gone. And in talent-intensive business like Wall Street and technology, this can mean permanent damage to a franchise and a brand that has been built up over decades. But what to do?

The New York Times carried a story outlining Merrill's plan for accelerating the vesting of certain equity-based compensation plans. This is invariably being used as a tool for retention in the face of an abysmal bonus year:

Merrill Lynch & Co Inc's move to accelerate vesting on previously awarded stock-based pay to employees could add to the huge fourth-quarter loss already expected by analysts.

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Last month, the company told employees they would get ownership of some stock-based compensation awarded in previous years earlier than planned, according to people who read the letter. The payout for some is expected at the end of the month.

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For employees, they'll receive money sooner than expected after huge mortgage-related losses hammered the company in 2007. Analysts expect Merrill's fourth-quarter mortgage losses to top $10 billion. As a result, bonuses for 2007 performance have been disappointing, some employees told Reuters.

This is not a dissimilar fact-set faced by Merrill back in the late 1980's, when a very smart and creative guy named Herbert Allison turned Wall Street comp on its head by structuring payouts based on ROE targets for both individual business unit and company-wide achievement. Not based on individual performance? What? While employees puked at first, as unit and firm performance picked up they ended up with bonus compensation far in excess of what it would have been under a conventional bonus plan.

Would such a plan work in today's market? Good question. I think it depends upon the job alternatives available to the middle 50% of the work force (the "soldiers"), the folks who are solid performers that generate value but not those on whose backs the franchise is built and potentially reliant (the "stars"). If the middle 50% has lots of options, then it likely wouldn't work. They would vote with their feet and grab the guaranteed hard dollars. However, given that the market for the middle 50% looks pretty poor right now, a "Herbie"-type plan might well be an effective vehicle for both managing cash and motivating employees.

The way most firms handled the weak 2007 bonus pool numbers is to further widen the chasm between the stars and the soldiers, making sure the stars were well-paid and not likely to move firms while the soldiers, who inherently have fewer options, got royally screwed. While some of this screwing is deserved much of it isn't, and this degree of pay-for-performance stratification can have horrible effects on both morale and motivation for those who received pay that was completely unrelated to performance. It remains to be seen how creative Wall Street gets during this cycle, as I have spoken to friends across the pay spectrum and one thing is clear; the status quo is not stable, and becomes increasingly unstable as the length of time to recovery gets longer and longer.

In the technology realm, Microsoft was the belle of the ball through the 1990s. Mr. Softee's employee stock options were gold. They were an amazingly powerful tool for attracting top talent and created thousands of Microsoft Millionaires in the process. It's fun to work in places like that, no? And then the company turned 25. The market crashed. Their core products were getting long in the tooth. Attempts at diversification were disastrous.

By 2002 the stock price dropped by around 60% from its 2000 high. This resulted in both a lot of unhappy employees (with deeply underwater stock options), as well as elimination of a powerful lever for bring the best and brightest into its fold.

And around this time you also had the rise of some pretty cool early-stage companies, like Google (NASDAQ:GOOG). The fact is that the chance to flex one's brain muscles and get rich at the mighty Microsoft was being eclipsed by hot, Ph.D-laden pre-public companies like Google. Maturity bites. Sure, they dropped some strike prices in exchange for shrinking the amount of options held and stuff like that, but that is only putting a Band-Aid on a deep gash. Fundamental change is required to get employees re-energized and to get recruiting back on track.

Google had the innovative idea of letting employees monetize a portion of their stock option holdings through their TSO program. This was a forward-looking HR maneuver to help employees diversify their holdings and to gain some liquidity, as living on pizza and beer and sleeping under your desk is only cool for so long.

Further, Google's stock price had been a moon shot since it went public, and along with it anxiety about its ability to rise as it had in the past. This is the natural outgrowth of success. Just like Herbies and Google's TSO program, continued innovation in compensation practices are what's required to deal with the problems of maturity, market cycles and mistakes. And the need for innovation hasn't been any bigger in the recent past than it is right now.