Pros and Cons of Post-Vest Holding Periods
Meet Bob. He’s the brand-new CFO of Acme Holdings.
When Bob began work at Acme, he received a grant of restricted stock units (RSUs) worth $2 million. As usual, those shares have a standard vesting period of four years. This provides pretty good motivation for Bob to stay on the job and do well, and it keeps his interests aligned with shareholders’.
But if he’s like many, as soon as he’s vested Bob probably will look to sell or liquidate a large chunk of his shares. That’s why Acme is thinking about creating an additional one- or two-year “post-vesting holding period” for award recipients like Bob.
To understand Acme’s position, let’s rewind to a time when ownership requirements were unheard of. This created the possibility for a couple of adverse incentives to prevail. First, it motivated executive award recipients (as their final vesting dates drew near) to make decisions that drove up stock price in the short term at the expense of performance over the long term. And second, the impact of executives’ “skin in the game” could dissipate if selling their vested shares meant that their unvested shares weren’t a substantial fraction of their overall net wealth.
Either of these outcomes might negatively affect shareholder value and interests.
There are a few ways companies can manage that risk. One is to make more frequent, relatively smaller grants so that there’s always more on the line. Another approach is to maintain share ownership requirements, where the executive must hold a certain number of the company’s shares. While share ownership requirements are extremely difficult to track and manage, most governance experts consider them a major “win” for shareholders.
Lately, some companies are considering a third choice: imposing mandatory holding periods on vested awards. If recipients must hold their shares for a year or two after they vest, the reasoning goes, their interests will be more aligned with those of shareholders for a longer time without lengthening vesting periods.
Post-vesting restrictions offer other benefits as well. They make it easier to enforce clawback provisions. Proxy advisors and investor groups like them. And they can reduce compensation expense thanks to a valuation discount.
In fact, a valuation discount might allow the granting company to issue more awards for the same total cost (since the cost of each award is lower than an unrestricted award).
That last concept is important, and hints at an easily overlooked drawback. Mandatory holding periods reduce the fair value of a stock grant because they reduce flexibility for the holder, which makes it less valuable than an ordinary, unrestricted share. The lower fair value means lower expense, but it’s also a measure of how much worse off the mandatory holding period leaves award recipients.
Put another way, a post-vest holding period can hurt talent acquisition and retention. This may especially be true in markets where competitors have no such restrictions. The company could compensate for the lower value by awarding more shares, though additional administrative and compliance costs are unavoidable. Furthermore, to an executive who is already satisfying or exceeding obligatory ownership levels, the post-vest holding period penalizes a misstep that is already being avoided or managed.
Mandatory post-vest holding periods are a valid option for compensation professionals, but they do come with meaningful tradeoffs. For compensation groups weighing whether to incorporate these features in their officers’ awards, an expert valuation and scenario analysis can help them make the most effective decision for their unique situations.
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