Once a company decides that it is going to grant performance shares contingent on Relative Total Shareholder Return (“RTSR”), one of the initial plan design considerations is the “classification” of RTSR plan you are considering, of which there are generally three:
- Component Rank Plans
- Composite Outperform Plans
- Component Outperform Plans
Each of the classifications have their own pros and cons, which we have summarized below.
Note that in designing a performance share plan, one of the primary guiding principles should always be that “small changes in performance (TSR) should NOT create large changes in earnout.” With this maxim in mind, the decision of what classification of design to utilize may change. First, let’s describe each of the three broad classifications.
Plan Design Classification #1: Component Rank Plans – The final earnout of shares is determined based on calculating TSR for each of the determined peers, ranking them in order, and then dependent on the company’s ultimate percentile rank within the group. For example:
| Percentile Rank | Payout Percentage |
|---|---|
| >= 75th Percentile | 200% Earnout |
| 50th - 75th Percentile | Interpolated |
| 50th Percentile | 100% Earnout |
| 25th - 50th Percentile | Interpolated |
| 25th Percentile | 25% Earnout |
| <25th Percentile | 0% Earnout |
Plan Design Classification #2: Composite Outperform Plans: Some companies have trouble developing custom peers to compete with. Instead, they opt to compete against either a single-sector or multi-sector index that they or their investors believe to be appropriate. The final earnout of shares is determined based on a comparison of TSR for the company against the TSR of the Index. The magnitude of the difference between the TSRs will determine how many additional (or fewer) shares will actually be earned out.
| △ Between TSR and Benchmark TSR | Payout Percentage |
|---|---|
| >=33.3% (+3300 bp) | 200% |
| For each +1% (+100 bp) | 103% (an additional 3%) |
| RTSR Benchmark (Delta from TSR of S&P 500) | 100% |
| For each -1% (-100 bp) | 97% (less 3%) |
| <-33.3% (-3300 bp) | 0% |
Plan Design Classification #3: Component Outperform Plans: Similar in style to Classification #2 (Composite Outperform plans), this plan determines TSR as the magnitude of difference between the company’s TSR compared against a benchmark TSR. However, the benchmark in this case is equal to the median (or potentially average) TSR of a bespoke group of companies.
| △ Between TSR and Benchmark TSR | Payout Percentage |
|---|---|
| >=33.3% (+3300 bp) | 200% |
| For each +1% (+100 bp) | 103% (an additional 3%) |
| RTSR Benchmark (Delta from TSR of Median of S&P 500) | 100% |
| For each -1% (-100 bp) | 97% (less 3%) |
| <-33.3% (-3300 bp) | 0% |
Returning to our maxim of “small changes in performance (TSR) should NOT create large changes in earnout”, what are some of the situations that could violate this principle?
- Small peer groups – With a peer group of 20 or less peers, a single change in ranking will create more than a 5% change in Percentile Rank, which would represent more than a 20% change in earnout in most plans.
- Homogenous industries with tightly clustered TSRs. In this fact pattern, a small change in TSR could cause significant movement in rankings and earnout, when ultimate performance is minimally different.
- Comparator groups that are based on multi-sector indices are more likely to have pay for performance disconnects. Generally, multi-sector comparator groups are less well correlated, and are more affected by systematic risk, which can create big changes in earnout for small changes in your own idiosyncratic TSR returns.
The difference between these 3 classifications may seem small and nuanced. However, the choice of design can be quite impactful to the final results and can create disconnects between earnout and performance.
| Classification | Pros | Cons |
|---|---|---|
| #1: Percentile Rank | • Most prevalent approach for designing a RTSR plan • Very intuitive for a compensation committee to understand the probabilities of hitting Threshold, Target, and Maximum | • With smaller peer groups (<20), can have large changes in earnout based on small changes in ranking • Does not capture the magnitude in which you outperform your peers, but simply your ranking |
| #2: Composite Outperform | • Captures the magnitude that you outperform/underperform • Simplest to administer as there are only 2 TSR’s to track and certify | • Academic studies have identified indices as doing a poor job of filtering systematic risk (i.e. creating poor alignment between earnout and performance). Indices are inherently less volatile than individual securities • Can be challenging to determine the “slope” of additional earnouts |
| #3: Component Outperform | • Captures the magnitude that you outperform/underperform • May be preferential for small custom peer groups compared to a Percentile Rank plan | • Can be challenging to determine the “slope” of additional earnouts |
Of the methodologies summarized above, there is no right or wrong answer. There are strengths and weaknesses for each of the approaches. The most critical detail is that there is strong awareness by a company’s leadership and Compensation Committee to understand these nuances so nobody gets surprised by any of the potential risks or outcomes.
