March 8, 2011

I will be posting a series of blog posting on the topic of performance-based equity.  The market has continued to be volatile since 1999, making equity compensation favorties, stock options and restricted stock units (RSUs) less effective than hoped.  In addition, Say on Pay regulations are the ultimate driver of performance equity. I predict that 95% of companies with share-based compensation will have significant performance-based components by the end of 2012.

Let's talk about the most common performance equity metric TSR. TSR is the growth of the companies stock price coupled with the impact of dividends paid expressed as a percentage of growth (or lack thereof). This metric is usually measured against a peer group in something called a Relative-TSR (R-TSR) plan. The basic idea is that your companies performance is measured against your peers.  If you have a better TSR, then you win.

Shareholders love TSR as a guidepost of corporate success. Companies in the UK have increasingly used this metric since the advent of Say on Pay almost a decade ago. So, if shareholders love it and there is a history of usage, what's the trouble?

1. R-TSR plans attempt to remove arbitrary market movements from the performance measurement.  Unfortunately when we have a market that moves on mega-trends, stock prices can move so dramatically, and against fundamental performance that realtive performance can be flattened to a point of become inconsequential.

2. Peer groups can be too large to be meaningful.  If your peer group is the S&P 500, or the Russel 3000, your relative performance may be impacted, postiviely or negatively, by industry swings that have nothing to do with your company.

3. Peers groups can be too small to have long-term impact.  If you have a peer group of 10 or 15 companies and measure R-TSR over a period of 3-4 years, it is almost certain that some of those companies will not exist at the end of the period.  This can skew your companies performance payouts by moving poor competitors into great competitors and making your relative performance looks worse than it should.  On the flip side, if your plan is designed to pay nothing if you are below than 20th percentile and you only end up with four companies at the end of the performance cycle, your participants are guaranteed a payout even if your performance is awful

4. Relative performance payouts may not coincide with the impact of real-time corporate performance.  Imagine being the 95th percentile and paying out awards at 200% of target, when your current performance requires you to be simultaneously cutting bonuses or, even worse, staff!

5. Timing becomes an issue much like the timing of stock options.  With market movements lasting 2-3 years, you have to be a pretty good prognosticator to set your Peer Group, Percentile Rankings and Payout Percentages correctly.

6. Accounting, and noreversal of expense.  R-TSR is a market goals for the purposes of accounting.  This means that the likelihood of making or missing the goal is built into the Fair Value (compensation expense) for the award.  Becuase the probability of success is built in you do not have to adjust expense if you pay out more than expensed.  BUt, if you miss your goals, you do not get to reverse expense. (I recently spoke to company who has paid about $25Million a year in expenses for awards that never paid out a single share)

7. Valuation requires and outside expert and associated fees.  Modeling the value of market-based metrics is complex and most companis do not have the internal expertise to do this.  This can add a significant implementation cost to these plans

ON THE BRIGHT SIDE
TSR is a great metric when combined with other, usually financial, metrics. 

It can be used a minimum threshold. Plans can be designed so that no goals pay unless yhit an R-TSR threshold.

It can be used as a sweetener. Plans can be designed for goals pay at a higher level depending on R-TSR ranking.


Watch out for more postings on this topic.  If you are on this path, or considering exploring it (whether you are a corporate issuer or external compensationconsultant), please don't hesitiate to contact me.

Dan