Performance shares earned contingent on a performance metric of Relative Total Shareholder Return (RTSR) is the most prevalent metric seen globally. However, the design of a RTSR plan can be quite challenging if not done appropriately. The checklist below is intended to provide a high-level summary of the design process, and some of the considerations throughout the process. Note that all steps may not be done in sequential order, and some decisions may be iterative requiring additional consideration to prior steps.
Step 1: Determine an Appropriate Peer Group using Rigorous Testing
- Do you have custom peers that appropriately align pay and performance? How about peers as determined by ISS or Glass Lewis?
- If not, are your compensation peers disclosed in your Proxy comparable for financial/TSR purposes? What about companies in your GICS code?
- Are there any single-sector industry Indices that are appropriate? What Indices are you currently in? What Indices do your largest investors compare you to?
- Would it be appropriate to use a multi-sector broad Index such as the S&P 500 or the Russell 2000?
- Would the quantity of peers that you have create a reasonable distribution of future TSRs, keeping in mind that mergers and acquisitions will reduce the number of peers by the end of the period?
- Do the peers have a similar volatility level to yourself, high correlation by stock price, or comparable debt leverage? These are all new statistics to help identify idiosyncratic volatility.
- Are there any global peers that you compete against operationally? What challenges are there in selecting and administering international peers?
- Consider the impact of peer company changes over the performance period, like mergers, acquisitions, spin-offs, and bankruptcies.
- Have you back-tested historical periods of time to ensure that both TSR and hypothetical earnouts are reasonable?
Step 2: What is the Design Format that is best to use between an Independent or a Modifier style plan?
- Is there an operational metric that has a stronger line of sight (EPS growth, cashflow, etc.), and therefore is it preferable to use RTSR as a modifier to another primary metric?
- If your peers are highly clustered and/or the peer group is small such that small changes in TSR could create big changes in your ranking and/or earnout, then is an Outperform style plan more appropriate? If so, what would be the appropriate upward or downward slope of this plan?
- Is it simplest to understand and administer the new RTSR award if it is treated independently from any other performance metrics?
- Learn more about these design formats here.
Step 3: How do we determine the Target grant sizes?
- Is it best to use the grant date stock price (or some commensurate averaging around the grant date)? This is conceptually easiest. Could this lead to too much dilution? Could the disconnect with what is disclosed in the Proxy be problematic?
- Is it preferred to use the accounting value under ASC718? Then the value communicated would match the value disclosed in the Proxy. Would that be too confusing to participants? What if this number is different than an internal operational metric and different grant sizes are created for different types of metric?
- Is it problematic if we have multiple types of performance metrics (for example 50% on an operational metric and 50% on RTSR) that we have different grant sizes for each?
- Read more about grant sizing here.
Step 4: When should the Performance Period occur?
- Is a 3-year performance period appropriate? Is that long-term enough for long-term investors? The majority of companies by far use this duration.
- Should the performance period begin at the calendar or the fiscal year? That intuitively makes the most sense to participants.
- However, sometimes the board authorization doesn’t occur until more than 2 months after the beginning of the performance period. Is that “stub period” an issue?
- What strategies can I use to mitigate the “stub period”?
Step 5: What about some of the other important design provisions that affect both perceived value by participants, and the accounting fair value?
- What should we set the Maximum payout to be? 200% of Target is what most do in the United States, but does that contain too much incentive for risk?
- What percentile should Threshold be set at? Is it important to have some prescribed risk of forfeiture (i.e. 25% of time not vesting)?
- How can you create an earnout schedule that has close to a normal distribution?
- What would the accounting fair value be under initial design estimates under ASC718? Would that fair value be viewed as too costly, or would it limit the number of shares granted?
- How should TSR be calculated? How long should the beginning and ending average periods be? How should dividends be reinvested over the performance period? Should there be any “risk-adjustment” for volatility (such as the Sharpe Ratio)?
- For dividend paying companies, should dividends or equivalents be accrued over the performance period? Not accruing dividends can reduce the fair value, but does this impact perceived value? Should it be consistent with other equity grants?
Step 6: What are some of the other nuanced design considerations that can help to lower the accounting fair value and provide good corporate governance?
- Should there be a goal to design a plan such that the accounting fair value would approximate face value?
- Is it important to include a mandatory holding period after vesting to align the performance metrics to a long-term investor?
- Should there be a negative TSR threshold such that earnout is capped at 100% if you have a negative TSR?
- Would a dollar-value payout cap help to mitigate accounting value?
- What would the accounting fair value be with these plan provisions? Would the reduction in accounting cost more than offset the reduction in perceived value? (Is it worth re-thinking Step 3?)
- Read more about design levers that can lower your fair value here.
Step 7: What provisions should we include for M&A, Retirement, Termination, Death, or Disability?
- Should we have retirement provisions that allow for the awards to continue to vest after retirement? If so, have you considered a discount for illiquidity after the retirement eligibility date.
- With TSR, you can measure an ultimate ranking on the close date of a M&A, which best replicates an investor earnout. Should that be used for TSR shares, when other types of Performance Shares typically cannot be ultimately measured?
- Should treatment for Death or Disability be any different than other types of employee equity? Should the treatment for those contingent events pay at Target?
Step 8: What should we do for initial education and then for ongoing communication going forward?
- What initial education should we plan on? Webcasts, brochures, videos?
- How often will we update the calculation of ongoing performance during the performance period (quarterly is required for diluted earnings per share purposes)? Should we communicate it that frequently to our employees?
- Should we consider a fully transparent and automated solution that is updated daily. Learn more about My Performance Awards here.
These steps are not intended to be all inclusive, but intended to help comprehend some of the critical and challenging questions as companies work through the design. Please contact the authors at Infinite Equity if you would like to discuss them in greater detail.