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Performance-Based Equity Compensation

An NCEO Issue Brief

(Print Version)

by Dan Walter

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Equity compensation, as we have known it for years, was started as a revolution in pay and corporate success that swept through Silicon Valley in the 1970s and 1980s, then spread throughout the world in the 1980s and 1990s. Stock options ruled the scene and provided opportunities for private and public companies alike to grow in new and sometimes unexpected ways. However, in subsequent years companies reevaluated the almost single-minded use of stock options. By 2010, performance units, performance shares, and performance awards were common discussion items in boardrooms and the media. As we move into the latter half of this decade, most publicly traded companies offer some form of performance equity to their executives. The growth in performance equity plans at privately held companies has also taken off. Proper diagnosis, design, execution, and adaption of these plans is critical in defining their future success or failure. Best practices will continue to evolve, but we have a good idea of what success entails and what results in failure. This issue brief provides the insight needed to create and manage a successful performance equity program.

Publication Details

Format: Perfect-bound book, 38 pages
Dimensions: 8.5 x 11 inches
Edition: 1st (June 2015)
Status: In stock

Contents

Introduction
Hypothetical Case Studies
Section 1. Performance-Based Equity Compensation Defined
Section 2. Diagnose: Identify Objectives and Issues, and Describe Potential Solutions
Section 3. Design: Creating a Plan and Its Features
Section 4. Execute: Implement, Administer, and Communicate
Section 5. Adapt: Adjust to Results and Changing Needs
Appendix A: Accounting and Financial Reporting Issues
Appendix B: Additional Information About Income and Taxation
Appendix C: Examples of Performance-Based Equity Compensation Programs
Appendix D: Articles on Performance-Based Equity
About the Author
About the NCEO

Excerpts

From "Section 2. Diagnose: Identify Objectives and Issues, and Describe Potential Solutions"

There is a practical business aspect to every successful program. A company must understand what it can afford, what will be supported by stakeholders, and how the program will drive, or reward, the desired achievement. Affordability is a matter of realistic modeling and an understanding of what part the program will play in the total compensation structure. Stakeholders include shareholders, management, and the individuals participating in the plan. Each of these constituents should be included in the diagnostic phase. Although it may not be possible to meet all of their desires or expectations, incorporating them into your decision-making process makes for a better program and more effective communication in the future.

For larger publicly traded companies, this may require the inclusion of TSR as a metric within the program. For some private companies, this may be tightly aligned to profitability or revenue growth, either of a specific product or in a specific location. The key is to balance stakeholder needs as the plan is designed.

How a company is established as a legal entity, as well as the investor makeup, business model, future expectations for growth, and evolution also all play into the plan. Delivering the final reward in stock may not always be possible, or even preferable. Overly leveraged incentive structures may not be allowed by rules applicable to the company type, the trustees for a benefit plan (such as an employee stock ownership plan [ESOP]), or other internal or external factors. These factors may also limit or direct the size and type of individual awards. The legal limitations for these plans must be evaluated, but defining the depth and breadth of this evaluation is outside the scope of this publication.

Companies must also understand market trends and evaluate available market data. Due to the wide variety of plans, and the businesses that are supported by them, most published information on performance-based equity is simplified for easy consumption. Whether they are articles on trends, or compiled data from surveys, there is very little specific detail. Much of this is by design. Companies with effective plans have little motivation to give away their secrets.

From "Section 3. Design: Creating a Plan and Its Features"

Before a company can choose the metrics for a plan, it must first understand that accounting rules differ for metrics that are deemed "market conditions" and those that are deemed "performance conditions." Market conditions are metrics that have a basis in the stock price. This list includes the total shareholder return (both absolute and relative) and index-priced awards. Performance conditions are those metrics that reference only the company's own operations or activities. The accounting consequences for these two types of metrics are different enough to discuss briefly.

The impact of market conditions is included in the initial calculation of the fair value for an award and is not adjusted based on actual results. This means that if the payout is five times the initial calculation, the company gets the benefit of giving greater compensation with no additional expense. It also means that if a goal is missed completely, the expense associated with the award is stuck on the company's books even though no value was delivered to the participant.

Due to the added market condition hurdles on an award, one might believe the fair value would be lower than that calculated for service or performance conditions. While this is true for some awards, many market condition awards actually have a higher fair value per share. This is because of the need to factor in the possibility of overachievement, or performance above the target level. Generally, 100% of compensation that is associated with an award subject to a market condition metric must be amortized over the shorter of the requisite service period or the time to performance achievement.

This type of award can be especially frustrating if the goal is ultimately missed. Designing these awards requires significant time, effort, and mathematical modeling. They can also be difficult to communicate since the alignment between individual performance and the change in the metric achievement may not be clear to the participant. It should be noted that despite these issues, market condition metrics, mainly using TSR, are the most common type of performance-based equity for publicly traded companies.

Performance conditions encompass every performance metric that is not based on the stock price. There are a couple of key differences in accounting when compared to market conditions. First, the impact of the metric and associated goal is not factored into the fair value at the time of award. Fair value is determined in the same manner as a service-based award. The company must then amortize expense based on the probability of attaining goals and how that affects the timing and number of awards estimated to vest in the future. The probability of potential achievement should be analyzed during each reporting period and adjusted as needed. This creates the unusual circumstance of having an amortizing compensation expense, which may vary each reporting period, for an award that may otherwise have a fixed total expense that was calculated at the time of grant.

From "Section 4. Execute: Implement, Administer, and Communicate"

Successful implementation and rollout of a performance equity plan is essential for the program's long-term success. This may require new internal communication and data integration techniques. The diagnosis and design phases will provide the foundation needed to perform final reviews and planning with other departments that have execution responsibilities. The same information will allow the company to define administration requirements and create the outline of participant communications.

Many companies fail at implementation because they have no plan beyond: "Give this to the compensation or stock administration department and have them get to work on it." Unlike the service-based awards of the past, which required little in the way of regular management unless there was a major corporate or individual event, performance equity requires integration at the time of the award, at regular intervals (at least quarterly) during the measurement period, at the time of final measurement, and at the time of vesting and payout. Building these processes at the outset will afford focus on the effectiveness of the plan rather than on the process.

Creating an actionable implementation plan is critical and relatively easy. Use the summary documents from the design approval process to make a checklist of what must be accomplished. Identify any potential obstacles and work with your team on an approach to address each one. With this task completed, prioritize everything and determine what can actually be accomplished by your deadline.

Table 1 includes some of the key tasks that should be addressed during implementation. Each plan will include additions and variations.