It starts out simply enough. If an executive performs well he/she is paid shares. These are held for “skin in the game”, to ensure alignment with shareholders.
Unfortunately, it does not stay simple. The Corporations Act, ASIC class orders, taxation, ASX listing rules, proxy adviser guidelines, investor requirements, accounting expenses, executive expectations, documentation, market practices, Monte Carlo simulations, and shareholder disclosures and approval are a lot to take in and absorb.
This article provides a Remuneration Committee checklist to ensure the simple starting premise is effectively followed through to completion. It assumes the committee has undertaken the work as to whether the equity grant is part of fixed pay, a sign on grant, a retention incentive, an STI or an LTI, and the performance and service requirements for a grant.
1. Determine the equity vehicle, which may include one of the following common types:
- A share right, where one right entitles a person to one share or stapled security, is the common vehicle, easily understood, and easy to administer. But it has an accounting and economic value that is less than the face value of a share, because it usually does not include dividends, it is usually less dilutive than alternatives (assuming new issue shares are used on exercise), and it is usually not tax deductible until vesting. The negative aspects of a share right can be fixed if you are open to doing things a bit differently.
- An option over a share or stapled security is useful if there is significant growth or transformation opportunities. It is useful for start-ups, or companies going through significant change, or companies taking big investment decisions. Because the employee has to pay an exercise price equal to the market price at grant, the option on average is worth about a third of a share right, so three times as many need to be offered for the same economic value. If new issue shares are provided on exercise it is more dilutive of shareholders’ interests than an equivalent grant of rights. An option has more significant upside than a share right when share price increases, but may end up being of no value if the share price declines.
- Cash, with a value determined as if an option or right has been granted. For companies with healthy cash flow, cash has several advantages. For the Australian based employee it permits tax to be deferred if vesting is post employment. It is also easier to administer and apply to overseas-based employees, and is less dilutive.
- A derivative, which permits the executive to receive the equity value of options or rights in either cash or shares. This provides the ultimate flexibility so that while shares may be the desired end result, the company can use cash in lieu if it is more convenient from a tax or administration point of view, especially for overseas employees and employees who may receive the benefit post employment.
- Shares acquired with a company low or no interest loan, and held in trust. As recipients get most value from an increase in share price they work like an option. However, unlike options, they also get benefit from dividends, which pay down the loan. The gains in share price are also capital gains taxed. While these are more expensive to administer, they are also the most tax effective for both the employee and the company.
2. Confirm the method to determine how many to grant.
This can be a prickly issue when seeking investor approval for director grants. On the one hand, the board needs to be have a view on the likely economic value that the grant will have to ensure it meets attraction, retention and motivation needs. On the other, investors like to see grants presented in the least complex manner. Therefore, for transparency and ease of communication, we suggest grants of rights, options, derivatives and loans be based on share price as a multiple of fixed pay. But, the underlying basis of these grants should be the underlying economic value of the grants in terms of both the maximum value and the probable value. For example, a share right in a company with a $1 share price, average volatility and a 6.25% dividend yield subject to a relative TSR performance condition will have a maximum economic value of about 80 cents (because the executive will miss out on dividends), and a probable economic value of about 45 cents (because the TSR test reduces the probability that the right will vest). So an executive on a fixed remuneration of $200,000 receiving a grant based on a multiple of 50% of his/her fixed remuneration is granted 100,000 rights ($200,000*50%/$1). These have a maximum economic value of $80,000 (100,000*$0.80) and a probable economic value of $45,000 (100,000*$0.45).
So, the basis of the grant for all employees is the multiple of fixed pay divided by share price (or average share price over several days to ensure there are no anomalies). This is undertaken knowing the underlying economic value is sufficient for the plan to meet its objectives.
3. Confirm that the value granted is consistent with market practice.
For a plan to meet its objectives, the value granted must be reasonable relative to competitor practice. Otherwise, there is the risk that investors will not approve director grants, and/or the best performing executives leave the company for competitors. For this purpose a remuneration survey is required. Unfortunately, most surveys are of poor quality and will not provide valid data for both the maximum and probable economic value of competitor equity grants. This is because most surveys rely on lazy and cheap methodologies that either use:
- Face value of the grant (i.e. the number granted by the share price at grant date); or the
- Accounting fair value, which under the accounting standards could be just the maximum economic value, the probable economic value, or both; or the
- Accounting expense, which under the accounting standards usually comprise multiple years’ unvested grant fair values amortised over the expected service period and may even be negative.
Make sure your external service provider provides maximum remuneration value and probable remuneration value. It will cost more, but unlike the above alternatives, is a valid basis to ensure the value granted is, to paraphrase a fairy tale, is not too large, not too small, but just right.
4. Disclose, communicate and disclose:
- On engagement visits, ensure the board and/or remuneration committee chair test the basis of the grants with external stakeholders. Have management or your external adviser prepare a presentation of 2 or 3 slides. Be open with the basis of the grant, and its underlying economic/remuneration values.
- Communicate both the basis of the grants and the underlying economic values with executives. This is usually in the invitation letters approved by the board. It would include the basis of the grant, the maximum and probable remuneration value, and the actual number offered.
- Disclose in the notice of meeting for any director grants: the basis of the grant; the maximum and probable remuneration value; and the actual number to be granted. Disclose in the remuneration report how surveys of economic value make sure your pay positioning is about right, the basis of converting economic value of the share right (or other vehicles) as a proportion of share price, and how in turn share price was used as the basis for the multiple of fixed pay percentage.