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 professionals are putting the finishing touches on compensation committee materials. And everyone is living on a diet of carryout and caffeine.
Yes, annual grant season is here.
The annual grant brings many moving parts and interdependencies, and one of the most important to consider early is the valuation. Why? For one thing, fair value forms the basis for expense. But the valuations also have implications for the granting process itself.
To see why this is so, consider that companies are increasingly determining 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 his grant is smaller because of something called a “Black-Scholes formula” or a “Monte Carlo simulation?”)
What to Watch For
What causes these surprises, then? The answer depends on the type of grant. Let’s take a closer look at each grant type, in order of most to least predictable.
Restricted stock awards or units. There isn’t much that can go wrong here, since the fair value is usually simply the stock price. However, awards that don’t accrue dividends or equivalents do require a haircut to account for what 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 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.
Second, if you don’t have off-cycle option grants, your last 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 risk-free rates have gone up quite a bit recently and may have more of an effect than they once did.
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.
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 a just-in-time approach can still add value, as discussed below.)
Today, accounting and compensation are more interdependent than ever. That interdependency 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 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. 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 trumps 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 decompose award values into their top three drivers, which helps demystify the results and give the executive compensation team better insight into the cost of particular design decisions. Even if you are not asked for attribution analysis, be proactive in obtaining it in case you are asked and expected to have 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.