What Are Appropriate Risks of Forfeiture for Performance Equity?
Performance-based compensation makes up a significant portion of executive pay in the form of both short and long-term incentives. However, it can be quite challenging to develop performance goals that are reasonable to the executive team and have sufficient rigor for investors, regulators, and corporate governance watchdogs.
Appropriate Levels of Rigor
Much discussion can be had on the appropriateness and rigor of performance measures. Some payout curves are very steep, while others may be less so. There are no regulatory requirements from the SEC, the IRS, or FASB when developing appropriate performance measures. Instead, it is left to the Compensation Committee to be stewards, ensuring that decisions by management teams align with long term investor returns. However, it is our opinion that the probability of earning less than Threshold (therefore no earnout) and the Maximum earnout should occur ranging between 17.5% to 32.5% of the time, with a midpoint of approximately 25%. Note that there are unique facts and circumstances for any single company, however, our broad opinion is based on the following:
- The IRS had provided some guidance on the setting of performance metrics in Section 162(m) (“the $1 million compensation cap”), which applied from 1996 through 2018 (which was amended by the Tax Cuts & Jobs Act). The IRS had required that performance goals needed to be “substantially uncertain”, which was only defined by a lengthy set of Q&A and examples. At the same time, the tax industry has provided confidence levels for written tax advice that applies to many aspects of Securities law, accounting, and tax.
| Definition | Probability Range |
| “Will” | 90%-95% |
| “Should” | 70%-85% |
| “More Likely Than Not” | >50% |
| “Substantial Authority” | 35%-50% |
| “Reasonable Basis” | 20%-35% |
- Unfortunately, there was no definition for “Substantially Uncertain”. However, in our opinion, the semantics of “Substantially Uncertain”, best tracks with “Should Not” (the converse of “Should” and ranges from 15%-30%) along with a “Reasonable Basis” (ranges from 20%-35%). The average of these two broad confidence intervals ranges from 17.5% – 32.5%, with a midpoint of 25%.
- Some performance measures are based on relative goals against peers. One of the beauties of relative measures is that goal setting becomes easier, because typically the Threshold and Maximum goals are defined as a percentile rank against your comparators. When defining these measures, the most prevalent goal for Threshold is the 25th Percentile, and the most prevalent goal for Maximum is the 75th Percentile. A relative earnout structured as a percentile rank creates a uniform distribution of payouts, and it can be easily illustrated what the expected earnout is at Threshold (~25%) and the expectation of earnout at the Maximum (~25%).
- Therefore, to keep comparability between a company who uses absolute performance measures with one that use a relative measure, we believe that the distribution of earnouts for absolute performance measures should be similar to what we see with relative performance measures. Rather than point to a single numerical datapoint, we believe a range from 17.5% – 32.5% is appropriate, with a midpoint around 25%.
Conclusion
This is a very broad range, but it aligns nicely with other forms of performance measures, as well as the tax and accounting industries definition of “substantially uncertain”. We recognize that certain practitioners may opt to design programs on the lower end of the range or 17.5%, on one or more of the tails, while others may opt to be on the higher end of the range or 32.5%. However, we believe it imperative that a Compensation Committee clearly understand the probability distribution, albeit low or high.
How Infinite Equity Can Help
Our holistic approach helps companies with the design and implementation of performance programs. Specifically, our services comprehensively cover the following areas:
- Infinite Equity will collate historical and prospective financial data for you and your industry peers to understand historical and future modeling assumptions including growth rates, standard deviations, and correlations of performance metrics. We will work with leadership to develop “best case” scenarios along with upper and lower bound scenarios for extreme economic markets.
- Infinite Equity will certify the probabilities and the expected distribution of earnouts and your organization can feel comfortable to respond to proxy advisors if the rigor of your performance metrics is ever questioned.
- Infinite Equity will provide scenario-based outcomes and expected earnouts based on proposed design criteria using quantitative methods such as Monte Carlo simulations.
- We will reverse engineer potential goals as to yield a desired risk of forfeiture and/or distribution of expected earnouts. Various structures can also be examined through a sensitivity-based analysis to optimize the risk-return profile of the performance-based compensation package.
- Infinite Equity will be there to help you comply with the narrative and disclosure of metrics in securities filings, compliance with other filing requirements, and accounting/valuation requirements under ASC718.
