One of the significant complexities of executive remuneration is valuing and communicating equity grants, both to executives and to shareholders. The risk is that using a value that is not appropriate for the purpose will result in misleading communications. The remuneration report may end up incorrectly describing the company’s pay mix, or the proportion of remuneration that varies with performance, or statements of the value of an executive’s equity grant.
Similar issues arise when determining the number of shares, rights or options etc. to grant. Where a specified annual long-term incentive grant value is to be converted into a grant of equity, the dollar value of the grant (which is the maximum dollar value assuming all equity vests) should be divided by the value of the equity vehicle to be used. And this is where confusion arises, because different companies use different definitions of ‘value’ for this purpose.
In short, when calculating the maximum number of equity units to grant to an executive, a fair value that assumes all units will vest should be used. In principle, it should be the “fair value”, which is the value at which an asset could be bought or sold in a transaction between willing and knowledgeable parties. If the equity has a market price at grant, the fair value should be the market price. If there is no market price, the fair value should be determined using a fair and rational method. The number of shares, share rights or options to grant will be this fair value divided into the annual grant value.
Very different grant amounts will result where, for example, the number of share rights to be granted is determined using the current share price rather than the appropriate fair value.
A share right is a right to receive a share when the right vests. Today’s share price will include a value ascribed to dividends received on the share. Where the share right recipient does not receive dividends on the underlying share during the vesting period, the value of the share right will be equal to today’s share price less the present value of dividends foregone during the vesting period. For high dividend yield stocks the value of a right with no entitlement to dividends during the vesting period could be 20% to 25% less than today’s share price. Calculating the number of share rights to be granted using the full share price in this situation would mean executives receive fewer rights than the policy implies, while misleading messages are being given to shareholders.
Conversely, where the number of rights to be granted is determined using a Monte Carlo-based valuation, executives will receive more rights than the policy implies, and as a consequence, executives may be paid higher than generally acceptable market standards.
A Monte Carlo based valuation is a calculation of average fair value over hundreds of thousands of simulations of different share prices at the end of the vesting period, usually relative to the share prices of peer companies calculated using correlation statistics. Simulations build in a discount for the fact that some will not vest, along with a discount for foregone dividends. Yet the number of rights granted represents the maximum value of an equity grant, assuming that all equity will vest. So using a (lower) value that assumes some equity will not vest to determine the grant quantum means executives will receive more rights than they should, and potentially result in executives being overpaid.
The situation is different where the value to be communicated is an executive’s target LTI value, expressed as a target dollar value in the same way that an STI has a target value less than the maximum STI value. Where a target LTI value is to be communicated, a value that includes a discount for the probability that some will not vest should be applied to the number of rights etc. granted. A Monte Carlo valuation is appropriate for this purpose. However, using the share price, or an accounting fair value for a grant based on a non-market hurdle such as EPS growth , will overstate the target value.
Board remuneration committee members need to ask the following questions of those implementing board approved LTI grants:
1. Are grants based on the maximum value an executive can earn? If so, is the equity value based on fair value (i.e. share price less present value of dividends)?
2. Are grants based on the target value an executive can earn? If so, is the equity value based on fair value discounted by the probability that some will not vest, regardless of the hurdle?
3. Has this been the way we have described the basis of grants in our remuneration report and for the Managing Director’s grant in the AGM notice?
The table below provides a guide.
Table 1: Methods for determining the number of LTI vehicles to grant
Fair value discounted for vesting probability, regardless of whether the hurdles are market or non-market conditions. This includes companies using the accounting fair value for grants with only a market condition. The method delivers the highest number of vehicles to the recipient and is best described as target LTI
Fair value not discounted for vesting probability. Usually this is a binomial or Black Scholes fair value applied to grants with a market condition or a non-market condition. The resulting LTI grant value assumes full vesting and is best described as maximum LTI.
A combination arises from applying accounting fair values where both market and non-market measures are used. The fair values incorporate a value based on the partial vesting of a grant subject to a market condition (target) and the full vesting of a grant subject to a non-market condition (maximum). No rational description can be ascribed to this methodology.
Share price, typically VWAP over 5 to 30 days. This method delivers the least number of vehicles to the recipient. This policy is consistent with the underlying maximum value of the grant only if the reward vehicle are shares or share rights inclusive of dividends. Otherwise, the value ascribed is higher than the highest possible value of the grant.