The SEC announced the adoption of its new pay versus performance rules, or Item 402(v) on August 25, 2022. A detailed summary of the new rules can be found within our Alert found here.
However, the intent of this shorter brief is to summarize the effect that a mandatory holding period after vesting has on the incremental compensation actually paid for a given fiscal year.
As a reminder, the new rules require all outstanding and unvested awards to be re-valued as of the end of the fiscal year and awards that vest during the fiscal year to be valued on their vest date. The incremental change in fair value from the end of the fiscal year (or vest date if sooner) as compared to the end of the prior fiscal year, is included as Compensation Actually Paid during the year. The guidance states “(3) Fair value amounts must be computed in a manner consistent with the fair value methodology used to account for share-based payments in the registrant’s financial statements under generally accepted accounting principles”. Therefore, it is critical to use a consistent process for pay for performance re-valuation to what was done on the grant date and disclosed in current financial reporting. To help illustrate the effect of mandatory holding periods, we will apply a very simplistic example.
Example: Company ABC has granted 50,000 time based Restricted Shares on 12/31/2021 which cliff vest in 1 year (12/31/2022). All shares earned at vesting are thereafter restricted for 1 year and become eligible for sale on the 2nd anniversary of grant (a 1-year mandatory holding period).The stock price of Company ABC is $20 on 12/31/2021. Company ABC performs an independent valuation as of 12/31/2021 of the post-vesting restrictions to determine the ASC718 fair value. Upon grant date, the expected volatility is 40% and the ASC718 is $18.19 using the Finnerty Model.
As of 12/31/2021, the accrual to Compensation Actually Paid for this award is $909,296 (50,000 shares x $18.19). During 2020, the accrual to Compensation Actually Paid will represent the re-measured Fair Value of this award minus $909,296. To help illustrate the effect of the mandatory holding period, we have created the Chart below. The 3 rows represent an appreciating return for 2022 (stock price gains to $30), flat return for 2022 (stock price stays flat at $20) and decreasing returns (stock price decreases to $10). Further the chart illustrates the Compensation Actually Paid (“CAP”) without a mandatory holding period and with a mandatory holding period. Lastly, in the scenario with a mandatory holding period, it shows the re-measured fair value at 12/31/2022 with changes in the original volatility from 40%.
Reviewing these numbers, and the results are quite intuitive:
- Incremental compensation directly aligns with stock price changes
- The holding period reduces the incremental compensation
- Increases in volatility from Grant Date to Vest Date lower your incremental compensation
The simplistic example chosen helps to illustrate the requirements and accentuates the importance to remember that vest date values may still need to be reduced to reflect for any restrictions that continue after vesting. Infinite Equity continues to examine the new pay for performance rules and how they will impact both the executive and equity compensation community. For more information on the new pay for performance regulations or assistance navigating these changes, reach out to us at Infinite Equity for help.