The Cost of Board Discretion

Would your Board permit vesting of LTI grants based on relative total shareholder return (TSR) in the event that the absolute TSR was negative for the performance period? If you answered “no”, read on, because you may increase your NPAT.

Many Boards retain discretion to adjust the vesting outcome in just such an event. Investors are likely to take a dim view of large allocations of shares to executives if their investment return has been negative. While it is desirable for Boards to retain the right to exercise their discretion in relation to vesting outcomes, there are accounting advantages to incorporating additional requirements into the vesting conditions.

Relative TSR (a market condition) is the most commonly used LTI hurdle among ASX 100 companies. LTI grants that vest based on TSR are expensed based on the amortised accounting fair value of the instrument. This value is generally estimated for accounting purposes using a Monte Carlo simulation and must take into account the vesting conditions. Any requirements in addition to the relative ranking of TRS will reduce the fair value and therefore reduce the accounting expense. No accounting adjustment is permitted in relation to the forfeiture of grants assessed against a market condition, whether it is based on Board discretion or failure to achieve performance hurdles.

We assessed the likely impact of incorporating an additional requirement that TSR must be positive into existing relative TSR valuations. Based on these hypothetical simulations, the cost impact for most companies is likely to be between 7% and 15% of the expensed value, depending on the other assumptions used in the simulation, such as share price volatility and correlations between peer companies returns.

While the fair value is lower, the expensed value will only be lower if the grant size is not increased. That is, if the allocation of rights or shares is based on the accounting fair value, then the lower fair value will simply increase the grant size and the expensed value will be the same. However, if the allocation is made based on share price (VWAP) or a fair value only including a discount for foregone dividends (and not vesting probabilities), then the grant size will not increase and there will be a reduction in the expensed value.

For example if an LTI share rights grant with a face value of $1m and a share price of $10 is made to an executive, then 100,000 rights will be granted. Assuming dividends accrue on any vested rights, the accounting fair value of a relative TSR hurdled grant is likely to be around $6.50. Incorporating a requirement that TSR be greater than zero for the performance period is likely to decrease this value to around $5.85. Therefore the expensed value of the grant reduces from $650,000 to $585,000.

Reducing share-based payment expense by 7% to 15% may be small in the context of total employment expense. However, if Board discretion is highly likely to be exercised in the event that TSR is negative over the performance period, then it is worth considering incorporating the requirement into the vesting conditions. Of course, Board discretion can still be exercised over the final vesting outcome. 

© Guerdon Associates 2021
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