Avoiding Annual Grant Cost Surprises
Accountants are setting budgets and prepping expense models. Plan administrators are gearing up for a major grant plus prior awards vesting. Compensation teams are putting the finishing touches on compensation committee materials. The caffeine is flowing, and the lights in those home offices are staying on later.
Yes, annual grant season is around the corner.
The annual grant brings many moving parts and interdependencies, and one of the most important to consider early is the valuation. Why? Sometimes, it’s simply expense sensitivity. But often, the valuations have implications for decisions around the granting process itself.
This is because a majority of companies determine their grant quantities by dividing a target compensation amount by the accounting fair value. This has the virtue of forcing expense and proxy disclosures in line with expectations and budgets. However, a lower-than-expected valuation means you burn through your share pool, and a higher-than-expected valuation means painful conversations with recipients about the number of shares they will receive. (Do you want to try explaining to your CEO that their grant is smaller because of something called a “Black-Scholes formula” or a “Monte Carlo simulation”?)
What to Watch For
What causes these valuation surprises? The answer depends on the type of grant, and even the simplest grants have a few pitfalls. Let’s take a closer look at each award type, starting with the simplest and ending with the one most likely to surprise.
Restricted stock awards or units. The fair value is usually simply the stock price, so surprises are less likely for these instruments (aside from major stock price swings that affect any award). The one pitfall to consider is for awards that don’t accrue dividends or equivalents, which require a valuation haircut to account for the amounts the holder will miss. This is fairly predictable, so just be careful if you’re granting awards or issuing dividends for the first time.
Options or stock appreciation rights. Option value factors (fair value as a percentage of the stock price) tend to be mostly consistent over time, but a few things can upend that. First, most companies update the expected life assumption annually in advance of the annual grant, which is a source of potential noise. We recommend performing this updated analysis far enough in advance of the grant that any change doesn’t become an eleventh-hour headache.
Second, if you don’t have off-cycle option grants, your most recent volatility and risk-free rate calculations are probably stale. Volatility might not move much over a week or two, but it certainly can over several months — and Q1 2021 volatility measurement is certainly elevated over the pre-pandemic Q1 2020 measurement used for last year’s annual grants. Even risk-free rates are a source of noise, having dropped significantly in 2020 but potentially increasing in the future as we exit the recession.
Either way, accounting, administration, and compensation teams should get aligned well ahead of the grant date so they can update expectations and avoid a last-minute scramble.
Performance awards based on financial or operational metrics. Like plain-vanilla restricted stock awards or units, those with a financial or operational performance condition typically have a fair value equal to the stock price. Again here, there is a small wrinkle based on dividends or equivalents.
If the award isn’t entitled to dividends at all, there should be a valuation haircut. If the award is entitled to dividends, but those dividends don’t scale with the earned payout multiple — either dividends are non-forfeitable, or dividends pay out on target shares regardless of over or under-performance — then the accounting and valuation will need to be tailored to the facts and circumstances.
Finally, consider the performance outcome that’s probable at the time of grant. Most often, the probable outcome is deemed to be a target payout, as the award is so early in its life that anything else is unsupportable. But there are exceptions. We’ve seen cases where past performance indicated a structural advantage leading to systematically above-target payouts, or where the few months of pre-grant performance in the year already had the company far ahead of its goals. In these cases, the companies expected above-target performance at the time of grant. This shows up both in the initial expense accruals and, critically, in the Summary Compensation Table of the proxy statement.
TSR or other market-condition awards. Awards with market conditions, especially relative total shareholder return (rTSR) awards, are the type of grant most likely to vary significantly each year. The biggest reason for this is what we call “realized performance,” which is how your company actually performs compared to your peers during the period from the beginning of the performance period through the grant date. This may be a short period — around one to three months for most companies — but it has a large effect on the value. (A great analogy is to think about how different the odds would be for a horse race if you were to place bets on the front or back horses coming around the second turn, rather than at the starting gates.)
In addition to variance from performance, TSR awards are much more likely than options to have small year-over-year changes that affect their fair value. You can get a general idea of the effect by looking at design changes or performance charts. But the only way to know where the value is trending is to test it. Fortunately, pro forma valuations are very cost effective. Our clients typically perform at least a couple between design season, the performance period start, and the grant date. But even a just-in-time approach can still add value, as discussed below.
Today, accounting and compensation are more interdependent than ever. That cross-functional dependency, which also includes legal and investor relations, will only grow as executive compensation oversight gets more complex and quantitative.
Simply bringing the right parties together to vet potential issues can go a long way toward avoiding downstream headaches. Compensation should share even preliminary design decisions with accounting so they can prepare appropriately and share any concerns with unintended consequences while they’re still easy to sidestep. And accounting should keep compensation informed of current values so they can let stakeholders know where things will land. As a first step, consider doing an early pro forma valuation for each grant type so that there are tangible numbers to discuss before finalizing the grant.
Even in the heat of grant season, it’s not too late to run pro forma valuations so you can see how an award’s value is trending during the days leading up to grant. This can be an invaluable figure to have in your back pocket for the compensation committee meeting. If the aggregate award value is higher than expected (or, similarly, the number of units that will be granted is lower than expected), this gives you the opportunity to initiate a very important discussion rather than merely reacting to a valuation surprise. In that discussion, you can either help stakeholders understand the drivers behind the value or potentially propose a last-minute design tweak to bring the value in line with expectations. In any event, a proactive approach always beats a reactive one.
Finally, after the grant has been made, take steps to unpack the drivers of the value, especially if the value is higher or lower than stakeholders expected. We go to great lengths with our clients to break down award values into their top drivers, which helps demystify the results and give the executive compensation team better insight into the cost of particular design decisions. Even if nobody has asked you for attribution analysis yet, obtain it anyway in case someone does ask later and expects a quick response.
As always, we’re happy to discuss any of these ideas and the situations you might be facing. Contact us anytime.
For more about annual grants and valuations, especially for less-predictable TSR awards, see the following resources:
David Outlaw is a director of Valuation and HR Advisory Services at Equity Methods.