The value of equity-based compensation

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1 The value of equity-based compensation VALUATION AND ACCOUNTING FOR TOTAL SHAREHOLDER RETURN (TSR) PLANS By David Howell and David Grubb Overview Performance-based equity compensation plans continue to be an increasingly popular component of long-term incentive programs, for a growing range of companies. These plans initially emerged in the Fortune 500 market in response to pay for performance and other objectives. Today, performance-based plans have expanded into nearly all sectors, including small cap and privately owned companies. Total shareholder return (TSR) plans are a form of performance-based equity compensation that uses return on equity as a vesting condition. TSR plans have several features that create benefits for both the company and the employee. These include payouts over a range of performance, a full share value equity award, and an incentive tied directly to shareholder value creation. This article provides an overview of TSR plans, describes special valuation requirements, and summarizes their unique accounting treatment. Total shareholder return (TSR) plans are a form of performancebased equity compensation that uses return on equity as a vesting condition PLANTE MORAN 1

2 TSR plan basics TSR plans are used to provide equity (share) based compensation to attract, retain, and incent employees. They are closely aligned with shareholder value creation, with performance vesting conditions tied to the future equity returns of the company. Target returns are set over a certain period of time (the performance period) and then compared to actual results to determine the number and value of shares or units that will ultimately vest (the payout). Performance periods are aligned with long-term results and are typically one to three years, although any time frame could be used. Continued employment is also a requirement for most plans, and a continued service vesting condition may extend beyond the performance period. The form of equity granted in TSR plans is generally structured as a restricted stock award (RSA), restricted stock unit (RSU), or performance stock unit (PSU). However, any type of equity related interest could be awarded. In this article, we refer to the equity interests granted as units. Most TSR units are considered full value awards, meaning their value is fully equal to the value of the underlying equity interest in the company. The benefit of a full value award is units that vest will generally have value, without a limit or threshold, as long as there is value in the corresponding equity interest. Employees generally do not have to make any payment (or a nominal one) for the awards they receive. This is in contrast to awards such as stock options, where employees pay an exercise/strike price to receive the shares. With a full value award, the company can issue fewer units to achieve a target award value, creating less ownership dilution and more units available to be distributed in the incentive pool. TSR plans are typically granted to executives, and can also be provided to broader employee levels. These plans may be combined with or replace other equity or cash-based incentive compensation programs. Depending on the plan design, vested TSR units PLANTE MORAN 2

3 may be settled (paid out) in shares (equity) or cash. As a form of compensation, TSR awards are subject to potential income taxation for employees and a deduction for the company. A full discussion of the tax treatment for a TSR plan depends on facts and circumstances and is beyond the scope of this article. However, as a general principal, taxation occurs when the employee has access to the full value of the TSR award and/or there is no longer a substantial risk of forfeiture. This is usually on or after the vesting date rather than the grant date, unless a special tax election is made. Performance vesting requirements TSR plans fall into the general equity compensation category of performance awards. Plans in this category have two basic approaches to measuring vesting requirements: company and market performance conditions. Company performance condition vesting can be based on improvement in internal financial measures such as revenue, EBITDA, profit margins, or cash flow. Company performance could also target operational measures such as division results, completing an acquisition, or launching a new product or service line. TSR plans fall into the general equity compensation category of performance awards A TSR plan is classified as having a market performance condition when vesting is based on changes in the market value of an equity related interest. As a result, when compared to other types of equity compensation, TSR plans have special accounting and valuation requirements that are discussed in later sections of this article. Examples of market performance measures include changes in the value of common shares, total equity, or preferred shares. TSR plans target the future return on equity or investment to shareholders. Since company performance is generally expected to have an effect on the value of equity, market performance measures conceptually incorporate changes in company performance that affect value. PLANTE MORAN 3

4 Public vs. private companies In a public company, common shares are usually the basis for determining returns and vesting under a TSR plan, and returns may be based on changes in share value (price) only, or it can also incorporate dividends (total return). In private companies, the calculation could be based on returns on common shares, preferred shares, waterfall rights, a specific investment interest, or the overall enterprise value of the company. For private companies, the TSR may also consider distributions, preferred dividends, and other equity related items. Further, in both public and private companies, the TSR may be based just on results for the company, or could use a relative TSR measure that compares company returns to a peer group, market index, or another benchmark. Payouts There is no standard design or payout schedule for a TSR plan. This provides the flexibility to establish a program to match specific needs of the company. One of the attractive features of a TSR plan is the opportunity it offers to have payout ratios on a sliding scale based on a range of results. Higher returns and the corresponding greater company value creation can result in larger payout rates. Lower returns may have capped or reduced payout rates. Against a designated target payout, this provides the ability to leverage the incentive feature in a TSR plan. Valuation of TSR awards For financial reporting purposes, the units awarded under a TSR plan require a determination of fair value at grant or other measurement dates. The fair value is used for recording the expense or balance sheet liability for financial reporting. In certain situations, a value may be required for tax purposes. The overall TSR plan may also require The units awarded under a TSR plan require a determination of fair value at grant or other measurement dates PLANTE MORAN 4

5 valuation to support the reasonableness and/or the fairness of the awards. The number and value of units that will vest under a TSR plan depend on future results which are not known on the grant or measurement date. Therefore, the estimated number and value of units to be awarded are generally determined using a special option-based valuation method, known as a Monte Carlo simulation. This approach takes into consideration the terms of the plan, potential future returns, payout rates, and other factors to estimate a fair value of the award. The Monte Carlo simulation method uses factual data for the company, some assumptions, and generally accepted finance theory. Factual data consists of: the starting value of the equity interest at grant or measurement date, performance period, and a risk-free rate of return. Assumptions used are an estimated future volatility (risk) factor and expected dividends (if any). When a relative TSR is being evaluated, expected volatility, dividends, and correlations will also be developed for the peer group or index. The Monte Carlo method is built on basic notions of chance. While future changes in value/returns are unpredictable, they are expected to have a defined range of possible outcomes (distribution). In basic terms, the future equity values/returns will change based on current value, volatility/risk, and the period of time. These results are assumed to be what is referred to as log-normally distributed. This means most results are in the middle of the range, some at the outskirts, there are a few outliers, the downside limit is zero, and the upside is not limited. The finance theory behind a Monte Carlo method is consistent with the widely accepted Black-Scholes equation used to value stock options. However, because of the range of possible payouts and other factors, Black-Scholes generally cannot be used to value a TSR award. In a TSR based just on the company s equity performance, the projected equity values and returns are only developed for the company. If a relative performance TSR is being used, then projected PLANTE MORAN 5

6 equity values and returns are computed for the peer group or index as well. Each scenario is evaluated to determine the vesting and payout based on the plan agreements. When a Monte Carlo method is used to value a TSR, a large number of potential future price/returns scenarios are generated and analyzed. This might include several hundred thousand, to over a million, possible outcomes. The aggregate results of the scenarios are assembled, analyzed, and used to create a distribution of possible range and frequency (probability) of potential future payouts. The average amount (weighted) of all the payout scenarios is calculated and used as the estimate of the projected value. This projected value is then discounted to present value, using an appropriate risk-free rate, to arrive at the fair value of the TSR award. Most companies do not have the in-house resources, time, or experience to run Monte Carlo simulations. The required models can become complex and are highly customized to the individual company and plan. While software packages and spreadsheets exist that can be used to create Monte Carlo simulations, most management teams do not attempt these calculations on their own. An independent valuation consultant is typically retained to assist in determining the fair value of a TSR plan and assist with the support needed for review and audit. Accounting requirements As a form of compensation, the units awarded under a TSR plan are subject to various financial reporting requirements in order to comply with US GAAP. Under accounting guidelines, TSR awards are considered share-based payments with market and service conditions. The accounting for awards with market conditions is different than grants with company performance or only service vesting conditions. PLANTE MORAN 6

7 Specific provisions relating to the accounting for share-based payments in public and private companies are provided under FASB Accounting Standards Codification (ASC) Topic 718 (the successor to FAS 123R) for grants to employees and directors. ASC Topic provides accounting guidance for awards granted to other service providers. Grants made under a TSR plan must be classified as either equity or liability awards. The classification of the award as equity or liability determines its accounting requirements. Generally, equity awards are settled (paid) in equity interests, and liability awards are paid (settled) in cash. However, equity awards that have certain put right features that could require repurchase by the company may also be classified as liability awards. In addition, limited liability companies (LLCs) and similar entities have the ability to structure their equity interests to grant specific rights and rewards to different classes of members, which could also affect the classification of an award. For equity classified awards, the fair value of the TSR unit will be established as of the grant date and recognized as an expense over the corresponding performance period (referred to as the requisite service period under U.S. GAAP), and an offsetting increase in additional paid-in capital is recorded. The performance period will be defined in the plan or grant agreements and may be adjusted if the vesting term varies from the performance period. The fair value of a TSR equity award is not adjusted for changes in fair value over the performance period. The fair value of a TSR award is also not adjusted at grant date for forfeitures related to not achieving performance vesting conditions, as this component is incorporated into the valuation method described in the previous section. Adjustments may be considered for estimated forfeitures related to service condition vesting, if these are reasonably determinable as of the grant date. Alternately, an election can be made to account for forfeitures related to service conditions as they occur. An election can be made to account for forfeitures related to service conditions as they occur PLANTE MORAN 7

8 For liability classified TSR awards, public companies record a liability for the fair value of the award at the grant date. Private companies can make an accounting policy election to measure the value of a liability award at either fair value or intrinsic value. Thereafter and until the obligation is settled or retired, the liability and expense are adjusted (marked to market) at each future reporting date reflecting any changes in value, forfeitures, or certain modifications. With liability awards, when returns over the performance period have been calculated and the actual payout determined, there is a final adjustment to the liability and expense to reflect the amount paid. In addition to the income statement and balance sheet treatment described above, both equity and liability TSR awards generally require footnote disclosures. For taxable entities, TSR grants will also result in the recognition of deferred taxes, reflecting differences in tax versus U.S. GAAP treatment. Public companies record a liability for the fair value of the award at the grant date. Depending on the type of unit awarded and the terms of the agreements, dividend or distribution payments may be made on TSR grants prior to vesting. These payments result in additional compensation expense for liability classified awards, and will be reported as a reduction in retained earnings or additional compensation expense for equity classified awards, depending on whether the award is expected to vest. For public companies, earnings per share (EPS) will generally incorporate the TSR units as share equivalents in the diluted EPS calculations. The diluted EPS in public companies may be higher with a TSR plan when compared with a similar stock option or equity appreciation right, as less dilution results from fewer share equivalents that may be granted with a full value award to achieve the same dollar value to the employee. EPS are generally not a significant factor for private companies. However a lower potential percent of ownership dilution under TSR plans may be a shareholder consideration. PLANTE MORAN 8

9 For entities that report under the International Financial Reporting Standards (IFRS), the accounting for TSR awards is similar in many respects to US GAAP, however, there can be differences in the accounting. Most significantly, there can be differences in how the awards are classified as either equity or liabilities, and the fair value method must be used in all circumstances. Regardless of whether an entity reports under IFRS or US GAAP, the accounting for TSR awards can introduce complexity that requires specialized knowledge and experience. Conclusion The use of TSR plans continues to grow as a form of compensation for employees that is aligned with the interests of shareholders and investors. TSR plans can introduce some complexity from a valuation and accounting perspective. However, the features of typical TSR plans described above can make them an attractive alternative to the long-term equity-based incentive strategy for public and private companies. plantemoran.com PLANTE MORAN 9