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-based vesting conditions under FAS 123(R) can better reward high-level employees and create shareholder value--without increasing accounting costs--say three professionals.
Title Annotation: executive compensation Author: Suzman, Peter Date: Dec 1, 2006 Words: 2577 Publication: Financial Executive ISSN: 0895-4186 In the wake of adopting FAS 123(R), some companies have shifted away from exclusively granting stock options toward exclusive use of restricted shares or a combination of the two. From 2003 to 2005, the prevalence of S & P 500 CEOs receiving both stock options and restricted share awards increased from 33.5 percent to 42.2 percent, according to an Equilar Inc. survey. Clearly, companies are searching to improve equity plans by looking at a combination of options and restricted shares. However, for many senior executives there are better vehicles than simply a combination of these two familiar alternatives. Companies that design awards with marketbased and performance-based vesting conditions under FAS 123(R) can better reward high-level employees and create shareholder value without increasing accounting costs. [ILLUSTRATION OMITTED] In particular, under the former standard, APB 25, shares that vest based on market conditions ("market-based" awards) were subject in the U.S. to variable accounting. FAS 123(R) has eliminated this unfavorable accounting treatment. As a result, U.S.-based companies are joining those in the U.K. and Continental Europe in recognizing the advantages of market-based awards over service-based awards. Companies like Time Warner Inc., Pfizer Inc., Campbell Soup Co., Duke Energy Corp. and Viacom Inc., among many others, are awarding or will be awarding market-based shares as part of long-term incentive plans to senior executives. The number of companies granting marketbased and performance-based shares is expected to grow dramatically as companies seek to better align executive compensation to shareholder returns. Equity-based compensation strategy usually involves six considerations: keeping accounting costs under control; minimizing the variability of accounting costs; providing perceived value to employees; retaining employees; creating incentives for employees to increase share value; and limiting the complexity of plan administration. The following analyzes why market-based shares-as a key component of long-term compensation to high-level employees--can further these objectives. Market-based Share Awards The two most common market-based share awards have the following structure:
Absolute awards. assuming reinvestment of dividends. TSR is defined as the return on the company's stock. the effect of factors in the broader market and/or relevant industry can crowd out the specific company factors. Conversely. Companies can vary the payout schedule with more or less differentiation. A Closer Look at Restricted Stock Economic factors on three levels generally drive the price of stock. an interpolated amount vests beginning at 50 percent of the target and capping out at 200 percent of target. stock options or stock-settled stock appreciation rights (SARs). Consequently. Using appropriate sensitivity analysis. or payout schedules and peer groups for a relative award. or an index of companies in a relevant industry or broader market. if the company TSR as compared to the TSR of its peers is below the 25th percentile. however. Therefore. the payout of restricted share awards: 1) the broader market. a flatter schedule might range from 50 percent to 150 percent. in contrast. A steeper schedule makes the award more option-like. a steeper schedule might range from 0 percent below the 50th percentile to 300 percent at or near the top. could appreciate when the market soars. service-based restricted share awards by themselves cannot meet the objective of long-term incentive plans of tightly linking management performance to the creation of shareholder value. such as the S & P 500. Relative awards. including poor management. 2) the relevant industry. Over any given period of time. The key factors in designing a relative market-based award are the choice of payout schedule and relevant peer group. though the underlying driver is relative rather than absolute stock performance. When the schedule is flatter. for which vesting depends on a company's total shareholder return (TSR) rank relative to a set of pre-defined peers. Companies can apply market-based vesting conditions to a diversity of vehicles including restricted stock. restricted stock units. the stock of a company with problems. A relative award. might vest at the end of two years. companies can fix the accounting cost up front. Further. an off-the-shelf industry index such as the S & P media index or the entire set of companies in a broad market index. the number of shares that the employee will receive varies. the stock of a company that is very well managed could decline when the overall market declines or the industry suffers a downtrend. and 3) the specific company. Table 1 on this page shows the payout schedule using 15 peer companies. The peer group for a relative market-based award could be a custom index of a few competitors. The key factor in designing an absolute market-based award is appropriately setting the target price levels. and vest immediately upon the stock price averaging $25 for 30 consecutive trading days at any time within two years. the accounting cost to the company remains fixed throughout the term of the award. then no shares vest. the award has more of the characteristics of a service-based restricted share award. This is usually structured as a price or return target or hurdle. With a relative TSR award. above the 25th percentile. according to TSR rank.000 shares. for which vesting depends on a company's own stock price or total shareholder return. the signal that Wall Street gets from a company favoring service-based restricted shares . An example of an absolute award is one where shares are granted when the stock price is $20. with the number of vested shares depending on the company's TSR rank among its peers as follows: beginning with a fixed target of 10. and compare the effects of choosing optimal target prices for an absolute award. For example. based on TSR rank. depending on actual relative performance. and therefore.
shares are limited or forfeited if the company substantially underperforms its peers. FAS 123(R) requires that companies reexamine internal performance metrics each reporting period and evaluate if targets will be met. Consequently. but it can be zero if the stock fails to appreciate. such as a write-off related to an acquisition. directly measure how investors change their relative valuation of the company over a period of time. the swings in value are exaggerated relative to the underlying stock. relevant industry and specific company. Accounting Cost Variability FAS 123(R) distinguishes between three basic types of equity awards: service-based. All three types are valued at the date of grant and then amortized over the requisite service period. Relative marketbased metrics. options also link to economic factors on the same three levels: broader market. If one performs the true-up . The volatility of option returns is much higher than that of service-based restricted shares and significantly higher than that of typical market-based restricted shares. Internal performance metrics include operating income. * Pure service-based awards have some moderate amortization variability related to the estimated forfeiture rate over the contractually-defined service period. all is not lost in a bear market so long as the company does not perform substantially worse than its peers. market-based metrics are the direct measure of value creation. The estimate almost always needs to be adjusted before the end of the service period. Like service-based restricted shares. It will also dominate the payout from an option unless the stock appreciates more than 50 percent in absolute terms over three years.over options or market-based shares is a lack of internal enthusiasm for the future return on the company stock. some of the volatility of the award is not company-specific. so can the compensation cost. the effect of factors in the broader market and/or relevant industry can crowd out the specific company factors. A company can use internal performance metrics or market-based metrics as the basis for comparison to its peers. strategy and management policy. For traditional option awards. then the payout to the employee will always dominate the payout from service-based restricted shares. company-specific accounting methods." Relative Performance Best Matches Payout to Performance How can a company mitigate the effect of general market or sector performance on compensation? The answer lies in using a metric of company performance relative to peer company performance. If the TSR is in the 75th percentile among peers. the cost and structure of capital. declared its intention to move from options to restricted stock in July 2003. Indeed. net income or return on equity or capital employed. Internal metrics can also be volatile and dominated by non-recurring events. when Microsoft Corp. The option payoff can be extraordinary if the stock soars. performance-based and market-based. Due to the implicit leverage of an option. such as company TSR relative to the TSR of peer companies. which creates the potential for significant earnings variability. particularly near the end of the service period. Of course. as well as restricted share awards. Business Week noted: "The new pay plan is a tacit admission that Microsoft isn't the growth stock it used to be. Additionally. As the probability of targets being met changes. Comparison across companies can be difficult or impossible due to the dependency of internal metrics on company size. A marketbased award using relative TSR can be thought of as an indexed stock award that can pay off extremely well in the best case. But there are important differences in the variability of the subsequent amortization. In contrast. On the other hand.
creates the potential for moderate amortization variability related to estimated forfeitures and subsequent true-up. * Pure market-based awards. whether absolute or relative. performance-based awards are analogous to the old APB 25 variable accounting. the remaining unamortized expense is recognized immediately upon vesting. The quarterly updates raise the potential for swings in expense as a condition moves between "probable" and "notprobable. service requirements are used as an additional condition in conjunction with market-based vesting. Although all awards require attention to the quarterly calculation of diluted earnings per share (no dilution results from market-based or performance-based awards unless the award is dilutive and the condition is met at the end of the reporting period) market-based and service-based awards result in more predictable expense amortization. For performance awards with a variable payout. Pursuant to paragraph A60 of FAS 123(R). one must determine the most likely payout and update the "implicit" service period each quarter. This is because the probabilities associated with market-based vesting conditions are already taken into account in determining the grant date fair value. but the performance condition is met." Here. the expense corresponding to broad-based awards can be fairly predictable. based on changes in fair value. Amortization costs are not modified if shares fail to vest due to the market condition or if more shares than the target number ultimately vest. the derived service period is the median time from grant date to vest date taken over the set of stock price scenarios that satisfy the market condition. and amortizes the expense over a "derived" requisite service period. companies can also augment a market condition with a performance condition. have the least variability of the three types. The only source of variability in the amortization is from the possibility of vesting prior to the end of the derived service period. . the model generates payoffs along a set of possible future share price paths and discounts the payoffs back to the grant date. one must fair value the award and mark to performance based on a fixed fair value. However. while performance-based awards require a repeated assessment of probabilities and can potentially produce substantial variability. as nearly the entire grant could be expensed or reversed in a single quarter. One values the award once and for all at the grant date. In this case. * Combination awards. because such grants are larger and made to only a few individuals whose turnover rate is less predictable. the resulting variability could be material. market conditions are set in combination with service conditions.regularly. If the company TSR ranks poorly compared with peers. The expense corresponding to high-level employees is more variable. [GRAPHIC OMITTED] Valuation of Market-based Restricted Shares Valuing awards with market conditions requires a lattice or Monte Carlo simulation model. again. The correct way to value any market-based award is the "contingent claim method. Often. instead of mark-to-market. * Pure performance-based awards have the most complex amortization. and that implied by a median TSR rank. depending on the characteristics of the award. One approach is to structure the award so that the performance condition serves as a "safety net" that ensures the vesting of some shares if either the market condition or performance condition is met. In some respects. Typically. then there is a compromise payout between that implied by the actual TSR rank. All such awards have an embedded condition that requires quarterly review to determine whether the condition will "probably" be met or not. This." If a swing occurs near the end of the implicit service period.
RELATED ARTICLE: takeaways * Since adopting FAS 123(R). with their typically short measurement periods--often under four years--is less challenging than volatility estimation for longer option awards.abrams@fas123solutions. 3) perceived value to the employee.com) are Partners with FAS123 Solutions. For the same FAS 123(R) accounting cost and cost variability relative to restricted shares and/or options. Pfizer. Simply discounting today's share price by the probability of shares vesting fails to take this correlation into account and results in valuation error. market-based relative TSR awards have the flexibility to maintain or increase perceived value to employees. * Companies like Time Warner. Monte Carlo simulation models can be used to generate computerbased payout distributions. while motivating them to maximize value to shareholders. * Plans with market-based and performance-based vesting conditions can award high-level employees and create shareholder value without increasing accounting costs. In conclusion. 5) the incentives created by an award.1% .7% 171.4% 157. These models can forecast the risk and potential return of equity awards by generating millions of future stock price scenarios that incorporate assumptions such as the stock price volatility of a specific company or the correlations between the stock prices of various companies. such that the correlation between vesting and intrinsic value is taken into account. and 6) the administrative complexity.com) is Executive Director of Financial Reporting and Assistant Controller for Time Warner.firstname.lastname@example.org@timewarner. leading to more precise fair value estimation.com) and Peter Suzman (peter. 4) the retention effects. provide better incentives and similar retention effects and maintain administrative simplicity.The contingent claim method integrates vesting and intrinsic value consistent with the modern financial theory. but there are other alternatives. some companies have shifted away from exclusively granting stock options toward exclusive use of restricted shares or a combination of the two. Volatility estimation for market-based awards. Daniel Abrams (daniel. Table 1 TSR Performance Rank Relative to 15 Companies in Peer Index 1st 2nd 3rd 4th Payout (% of Target) 200. Campbell Soup and Viacom will be awarding marketbased shares as part of long-term incentive plans to senior executives. 2) cost variability. Companies should evaluate six criteria: 1) Compensation accounting cost to the company up front. * The two most common market-based share awards are absolute awards and relative awards. Scenario analysis of this type is a key component of both designing an award and communicating the potential award payout to employees. the main objective of equity-based awards is to maximize value to employees.0% 185. Allan Cohen (allan. To help understand the payout possibilities associated with equity awards from both the company and employee perspectives.
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