Performance shares earned contingent on a performance metric of Relative Total Shareholder Return (RTSR) is the most prevalent globally as seen in the marketplace. Performance awards that are contingent on Relative TSR are deemed market conditions and will generally require a Monte Carlo simulation to determine the fair value under ASC718.
Unfortunately, the fair value can frequently be volatile and yield valuations significantly higher than anticipated. In our experience, we frequently see corporations with valuations at 130% or greater. If not properly planned for, this can either lead to grant values less than anticipated, or compensation expense greater than anticipated – both of which are poor outcomes.
The intent of this summary is to outline several design decisions that can help to lower the accounting fair value for Relative TSR awards. For purposes of this brief, we will apply the following example.
Example 1: Company X grants performance stock units that are earned based on relative TSR over the three-year period following the grant date against a select group of peers. The payout schedule is:
| 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 |
Let us also assume that the fair value of this award equals 130% of face value. (A $13 valuation when the stock price equals $10.)
Design Lever #1 – Lower Maximum Earnout Level or Amount – The upside at the 75th percentile of 200% yields a large portion of the fair value. Therefore, adjusting this level can help mitigate the impact. Some alternatives are:
- Lower the maximum earnout from 200% to 150% (could lower the fair value by ~5%)
- Raise the bar for the maximum earnout from the 75th percentile to a higher level such as the 90th percentile. (could lower the fair value by ~5%)
- Raise the bar for threshold/target earnouts from the 25th and 50th percentile respectively to something higher like the 30th and 55th percentile. (could lower the fair value by ~5%)
Design Lever #2 – Optimize Peer Selection – The determination of peers is one of the most challenging design decisions. Since the goal is to strengthen the pay for performance alignment, it is critical to pick appropriate peers. Further, a strong set of peers that are well-correlated (by stock price) and have similar volatilities also benefit in helping lower the valuation. When higher correlation coefficients are used in the valuation, then the simulated TSRs will be more tightly clustered and payouts will be in the middle of the range more frequently. Conversely, lower correlation coefficients will yield earnouts more frequently in the extremes, and subsequently create higher valuations.
Interestingly enough, in theory if all peers had the same volatility, and all peers had a correlation coefficient of 1.0, then all simulations for all peers would yield identical TSR’s and payouts would always be at Target. Therefore, the fair value would then be equal to 100% of face value. We know that it is not realistic for this to occur, but the theory is interesting to think about.
To be clear, peers should not be selected solely based on their correlation coefficient or their volatility level. Instead, they should be based on a best fit to tighten alignment with investors. But there are financial statistics that should be considered in picking peers. The potential fair value impact of optimizing correlation coefficients and volatilities can be ~5%.
Design Lever #3 – Use a Dollar Payout Cap – Not only can a company put a cap on the number of shares earned out (e.g. 150% or 200%), but a company can put a dollar value payout cap on the final value delivered, for example 400% or greater of the grant date price, which can be set as something unlikely to be achieved, or where there would not be a significant loss of perceived value by award holders. A 400% payout cap would not only require a 200% earnout of shares, but it would also require the stock price to double in the 3-year performance period. The reduction in fair value would be largely a function of the stock price volatility and the magnitude of the cap, however, in our experience a 400% cap would be ~5% (low volatility) all the way to ~20% (high volatility).
Design Lever #4 – Apply a Mandatory Holding Period – An additional restriction on the performance awards which may not have a significant loss of perceived value is a mandatory holding period after vesting. Since most executives have ownership requirements and are limited on their ability to sell shares, a mandatory hold can be an attractive feature to reduce the fair value. Since the shares are owned after vesting and can be retained by executives even in the absence of employment, the only real additional restriction is illiquidity during the mandatory holding period. A reduction for mandatory illiquidity would be driven by the company volatility and the length of the holding period. But generally the reduction for a 1-year holding period ranges from 5% (low volatility) to 15% (high volatility).
Design Lever #5 – Apply a Negative TSR Threshold – Many organizations believe that there should not be any potential for payout to be above target when TSR has been negative over a 3-year period, as investors have lost money during that timeframe. Others believe that limiting payouts to target upon a negative TSR is contrary to the theory of a relative performance plan, since you still need to outperform your competitors, and therefore you have performed better than alternative investments of your peers. That being said, the additional hurdle of having a positive TSR in order to pay out about target during a 3-year performance period will reduce the fair value of your RTSR performance awards by ~5%, and have a minimal impact on the perceived value of your awards.
Design Lever #6 – Avoid “Stub Periods” Overlapping the Performance Period – During the interim period after your performance period begins (assume January 1) and the board authorization date (assume March 15) – the “stub period”- a company’s accounting fair value can be significantly impacted by actual stock price movements that occur in that timeframe. The final valuation needs to consider all actual performance that occurs between January 1 and March 15. If a company has significantly outperformed its peers during the stub period, then it can anticipate that its valuation will also increase significantly. Similarly, if a company has significantly underperformed its peers during the stub period, then it can anticipate that its final valuation will decrease significantly. There are many variables that govern this (such as volatility and the magnitude of over/under performance), however, a rule of thumb is that a valuation will increase 7.5% (750 bp) for every 10% (1000 bp) that a company’s TSR over/under performs the median of its peers. To read more about “stub periods” and some strategies for eliminating stub period volatility, read our brief here.
The provisions summarized above are just some of the strategies that can be used to mitigate the relative TSR accounting cost. Please feel free to contact our authors to learn more.
