The “Stub Period” Challenge
Relative Total Shareholder Return (RTSR) awards are the most prevalent type of performance awards in the global marketplace. The accounting fair value under ASC Topic 718 for RTSR awards is estimated using Monte Carlo simulation that reflects all known information as of the grant date, which often occurs several weeks or months into the TSR performance period (e.g., awards with a performance period from January 1, 201X from December 31, 201X+2 are granted on February 15, 201X). The known information as of the grant date includes stock price returns (i.e., TSR) for the issuing company and peer group from the beginning of the performance period (including the beginning average period) to the grant date. The effect of this “stub period” prior to the grant date can have a signification impact on the accounting fair value.
Effect of a Stub Period
Within a Monte Carlo simulation, the final TSR of a given entity is based on the product of i) the actual return of the entity from the beginning of the performance period to the grant date and ii) the simulated return of the entity form the grant date to the end of the performance period. The actual return prior to the grant date is based on known trading information, while the simulated return uses financial theory and entity-dependent assumptions to project the return of the entity from the grant date to the end of the performance period. The assumptions for each entity include the risk-free rate, expected volatility, dividend yield, and the correlation to peers.
|An RTSR award with a stub period can be viewed as a horse race in which every horse starts at a different place. A bettor would certainly consider these starting points when making bets, as it stands to reason that the horses that start furthest ahead will finish at the top more often. Similarly, an RTSR award for a company that is ahead of its peers on the grant date is more valuable compared to if the company started equal to its peers or behind.|
A high TSR relative to the peer companies prior to the grant date will shift the distribution of an entity’s total TSR towards the high end of the peer group, leading to higher stock prices and higher payouts, which drives the accounting fair value up. The opposite is also true, where low TSR relative to the peer group over the stub period will shift the distribution of an entity’s TSR over the entire performance period to the low end of the peer group, leading to lower stock prices, lower payouts, and driving the accounting fair value down.
Developing a rule of thumb to estimate the magnitude of the impact that the stub period has on the accounting fair value is difficult because of the number of variables that impact the Monte Carlo simulation. However, at a high-level, a company can expect to see the following impact:
- For every 100 basis points (1%) that your company’s TSR exceeds the median TSR of the peer group of companies, the fair value will increase by approximately 75 basis points (0.75%).
- For every 100 basis points (1%) that your company’s TSR trails the median TSR of the peer group of companies, the fair value will decrease by approximately 75 basis points (0.75%).
Additionally, the following items will affect how much the stub period impacts the accounting fair value:
|Design Feature / Assumption||Impact|
|Period over which returns are simulated||The longer the period of time over which prices are simulated, the less the impact that the stub period TSR will have on the accounting fair value|
|Payout Schedule||The higher the maximum payout, the greater the impact that the stub period TSR will have on the accounting fair value|
|Expected Volatility||The greater your company’s expected volatility, the less the impact that the stub period TSR will have on the accounting fair value|
|Expected Correlation||The greater the correlation between your company and the peer companies, the greater the impact that the stub period TSR will have on the accounting fair value|
It is not uncommon to see the accounting fair value for the same RTSR award vary 25% or more year to year. Depending on how your company determines target grant sizes, this movement in fair value can lead to:
- Target Award Sized Based on Target Value Over Stock Price at Grant: Significant changes in anticipated compensation expense under ASC 718, which is also disclosed in the Summary Compensation Table in the Proxy Statement.
- Target Award Sized Based on Target Value Over Accounting Fair Value: Significant changes in the number of awards granted. An employee could effectively be rewarded for poor performance during the stub period (lower fair value leads to more shares) and punished for good performance over the stub period (higher fair value leads to fewer shares).
Mitigating Stub Period Impact
Broadly speaking, there are three approaches to mitigate the impact of the stub period on fair value.
- Alternative 1: Move grant date to beginning of performance period (e.g., January 1, 201X) or prior to performance period (e.g., November X, 201X-1). Because board authorization is required to establish an accounting grant date, this is not realistic for many companies.
- Alternative 2: Start the performance period on the accounting grant date. For example, if the board authorizes the awards on February 15, 201X, define the performance period as February 15, 201X to February 15, 201X+3. Under this approach, the TSR performance period will typically no longer align with the company’s fiscal year and other performance metrics/awards. Also, if the beginning average period precedes the performance period, there will still be a stub period, although the impact will be smaller since it immediately precedes the performance period. A beginning average that proceeds the performance period (i.e., the first twenty trading days of the performance period) or is based on the spot price (but could still apply an ending average period) would fully eliminate the stub period.
- Alternative 3: Shorten the performance period to run from the accounting grant date to the end of the 3rd fiscal year (e.g., 2.85-year period from February 15, 201X to December 31, 201X+2). The challenge with the beginning average period still exists, but can be mitigated using one of the approaches mentioned above.
None of these solutions is perfect, but each could be appropriate given a company’s facts and circumstances. Most importantly, companies should be aware of the potential impact of the stub period on the fair value of their RTSR awards so that they can avoid surprises when the grant date rolls around.