Long-Term Incentive Design

Part 2. The Basics of Executive Compensation Design

If annual incentive design could serve as the basis for a book of its own, then long-term incentive design could be a multi-volume set. Long-term incentive design raises complicated questions about accounting, tax treatment, shareholder approval, plan administration, and governance. Fortunately, compensation committees have the management team and external advisors to help in addressing the technical aspects of long-term incentive design. For the purposes of our discussion, we will provide a brief overview of the different vehicles and how they address the company’s compensation objectives, while only glossing over the more technical aspects.

Long-Term Incentive Opportunity

Most companies have an overall target compensation structure composed of base salary, target annual incentive, and an annual grant of long-term incentives. As the base salary and annual incentive are generally denominated in cash, it is straightforward to put a monetary value on them. For simplicity, most companies will also establish a dollar value for long-term incentives, often equal to a multiple of base salary (e.g., 150% of base salary) or a dollar amount (e.g., $500,000).

Like annual incentive opportunities, covered in the previous chapter, long-term incentives are often tiered by executive level, with the most senior executives having the highest percentage of their total pay in the form of long-term incentives. The table below demonstrates illustrative opportunities for a company with revenue in the range of $2B-$10B.

*Executive Level*	*Base Salary*	*Long-Term Incentive % of Base Salary*	*Long-Term Incentive*
CEO	$1,000,000	350%	$3,500,000
COO	$600,000	200%	$1,200,000
EVP	$450,000	150%	$675,000
SVP	$300,000	100%	$300,000
VP	$200,000	50%	$100,000

Long-Term Incentive Mix

Public companies typically use three long-term incentive vehicle categories:

Stock Options or Stock Appreciation Rights (SARs): Provides value to executives based on appreciation in the stock price, subject to vesting criteria
Restricted Stock or Restricted Stock Units (RSUs): Provides executives with the full value of a company share, subject to vesting criteria
Performance Plans: Function like an annual incentive plan, but with actual performance measured and/or award vested over multiple years. Performance plans can be granted as performance shares with a target opportunity denominated in shares or as performance cash/units, with a target value established independent of the stock price

Restricted Stock vs. Restricted Stock Units (RSUs)

Some companies use restricted stock, while others use RSUs. What’s the difference and why would a company use one vehicle rather than the other? Restricted stock is a grant of property, with restrictions on the vesting of the property. RSUs are a promise to deliver property at a future date in time. The key differences are that restricted stock entitles the executive to the dividends on the shares and the right to vote the shares during the vesting period. With RSUs, on the other hand, the executive does not have the right to vote the shares or receive dividends during the vesting period, since no shares are issued until the date of settlement (which may be different from the vesting date). However, some companies will provide payment of dividend equivalents (a cash value equal to the dividends paid on shares that is typically accrued over the vesting or deferral period) when the RSUs are settled. If they do not receive dividends or get to vote the shares, why might executives prefer RSUs? The key advantage of RSUs is that they provide flexibility to defer the receipt of shares (and taxation) that is not feasible with restricted stock. In addition, the company benefits because it can choose to settle RSUs in cash or in stock, though there will be accounting implications for this decision.

Most of the CAP 120 use at least two of the above vehicles, and 38% use all three of them.

While stock options and performance shares are commonly used for senior executives, lower-level executives and individual contributors are more likely to receive a higher portion of their long-term incentive in the form of time-based restricted stock.

*Employee Level*	*Long-Term Incentive Mix*
*Employee Level*	*Performance-Based Long-Term Incentive*	*Stock Options*	*Time-Based Restricted Stock/Units*
CEO	64%	14%	22%
Other NEOs	59%	15%	26%

Source: CAP 120

Determining the Number of Shares to Grant

To determine how many stock options, RSUs, or performance shares to grant to employees, the target long-term incentive opportunity is typically first divided into component parts. For example, an executive with a $1,000,000 annual long-term incentive target opportunity and a vehicle mix of 25% stock options, 25% RSUs, and 50% performance shares would expect to receive a grant value of $250,000 in stock options, $250,000 in RSUs, and $500,000 in performance shares. The executive’s target long-term incentive values then need to be converted into a number of shares for each of the vehicles.

Stock options are usually assigned a dollar value based on an option valuation model (e.g., Black-Scholes or binomial). This amount is typically thought of as a percentage of the current market price of the stock because an option value will always be less than a price of the underlying stock. Since the company must account for stock options in its income statement, most companies use the accounting value of stock options as used for disclosure purposes in converting target option values into the number of options to grant. For example, if the company’s stock price on the date of an option grant was $20, a representative stock option Black-Scholes value could be $5.00 (or 25% of the stock price value on the date of grant). In order to provide $250,000 in stock option value, the company would need to grant 50,000 stock options.

The following table describes how fluctuations in input factors change the option value:

*Impact of Inputs to Option Valuation*
*Input Factor*	*Input Change*	*Option $ Value*	*Explanation / Theory*
Stock Price	▸	▸	A higher stock price produces higher option value since it increases the potential dollar gain for a given percentage of stock appreciation.
Exercise Price	▸	▸	The more one pays for the option, the lower the potential gain. If the stock price is constant, a higher exercise price creates a premium-priced option while a lower exercise price creates a discounted option.
Dividend Yield	▸	▸	Theory says TSR equals stock price appreciation plus dividends. Therefore, the higher the dividend portion of TSR, the lower the stock appreciation and the lower option value (since options typically do not pay dividends). Payment of dividends is viewed as a decrease to stock price.
Stock Price Volatility	▸	▸	Volatility measures variation in absolute movement in TSR. Since options cannot be worth less than $0, higher volatility provides more upside opportunity with no additional downside risk.
Option Term to Exercise or Expected Life	▸	▸	The longer the life of the option, the more time available for the stock price to increase, making the option more valuable.
Risk-Free Rate	▸	▸	The risk-free rate impacts the size of the “investment” necessary to pay the exercise price. The higher the interest rate, the lower the upfront cost necessary to cover the liability of the option exercise price at the end of the term.

The accounting value for RSUs is determined based on the closing stock price on the date of grant. To provide $250,000 in value with a stock price of $20, the company would need to grant 12,500 shares of RSUs. To smooth out stock price volatility, companies may use an average stock price over a period of time (e.g., 10 trading days) leading up to the date of grant to determine the number of shares. In these cases, the value used to determine the number of shares to grant will not be equal to the accounting value of the shares, and as a result, the value of the grant as communicated to the employee may differ from the value disclosed to shareholders.

The accounting value of performance plans will in most cases be equal to the target number of shares granted multiplied by the closing stock price on the date of grant. This means that in order to provide an executive with a target value of $500,000 at a stock price of $20, the company will grant the executive 25,000 shares. It should be noted that when the performance measure is based on the company’s stock price (e.g., in a performance share plan based on relative total shareholder return), the determination of the accounting value will be more involved and will likely be different than the closing stock price on the date of grant.

Long-Term Incentive Vehicles

Stock Options

Stock options used to be the most prevalent long-term incentive vehicle for senior executives. Why did stock options first become a common form of long-term incentive? Investors viewed stock options as a way to achieve the goals of pay-for-performance and alignment with shareholders through a single, long-term incentive vehicle. Options are inherently performance-based in that the executive can only realize value from the options if the stock price at the date of exercise exceeds the exercise price, which is typically set to be equal to the market price on the date of grant. In other words, executives only realize gains from stock options to the extent that they increase the stock price for shareholders. Another practical advantage of stock options is that the company and the board do not need to set specific goals for the executive and can therefore avoid having to predict future results. The implicit goal is to increase the stock price and the more it increases, the more value executives receive. Through the bull market of the 1990s, stock options became more prevalent and CEO compensation levels increased dramatically as a result. Another historical advantage of stock options was that they did not impact earnings on the income statement due to the accounting treatment for stock options at that time. As a result, stock options were a long-term incentive vehicle that helped to align management with shareholders, pay-for-performance, and avoid all accounting cost to the company.

However, companies began to move away from stock option in the late 2000s due to several changes in the market and reporting practice. The bursting of the dot-com bubble in the early 2000s started the move away from stock options. While options were enormously popular in a bull market when stock prices were consistently increasing, in the new bear market, many stock options were underwater (i.e., the exercise price was well above the current market price) and provided little or no motivational value to management to increase the stock price. The trend away from stock options was given another push in 2004 with the publication of accounting standard FAS123R, now ASC 718, which required that stock options be expensed on the income statement. Once stock options were put on an equal footing with other long-term incentive vehicles, it became less compelling for companies to continue to use them to such a large extent.

Following both the dot-com bubble and the financial crisis of 2008–2009, critics of stock options raised concerns about the asymmetrical incentives they created. Stock options align management and shareholders on the upside, but an executive is less sensitive to incremental declines in the stock price below the exercise price. In fact, when an option is underwater, executives potentially have incentives to take risks with low expected returns but high variability in results. As a result, shareholder advisory groups now view a long-term incentive program that is overly dependent on stock options as potentially putting the company at risk of losses or, in extreme cases, bankruptcy, by encouraging executives to take on risky strategies.

While not a major driver of the move away from stock options, the options “backdating” scandal of the 2000s also harmed the reputation of the vehicle. Many investors and other observers formed the impression that executives were using options as a tool to line their pockets rather than receiving them as a reward for performance.

Today, stock options continue to be used, in most cases in combination with a performance plan or time-vested RSUs that can balance the risks of stock options. Companies are more likely to use stock options when the management team is optimistic about future stock price appreciation, the company has difficulty establishing multi-year performance objectives, and the option cost is viewed as comparable to the perceived value of the award. Certain industries that are viewed as high growth (e.g., biotechnology and software) may be more likely to use stock options as a major component of the long-term incentive program.

Key Questions for Committee Members to Ask:

Would using stock options send a signal to shareholders that the company is optimistic about the stock price?
Do the management team and other long-term incentive plan participants value stock options highly or do they have concerns about stock price appreciation and/or volatility?
Are a significant number of stock options from past grants underwater?

Time-Vested Restricted Stock/Restricted Stock Units (RSUs)

Time-vested RSUs continue to be used by most large public companies. The vehicle is frequently criticized as “pay for pulse” or a “giveaway,” as no performance goals need to be achieved in order for executives to realize value from restricted stock. If the compensation committee’s only goal was to ensure that the company has a strong pay-for-performance relationship, it is hard to argue that restricted stock belongs in an executive compensation program.

Despite concerns about their efficacy from a pay-for-performance perspective, time-vested restricted stock is very effective in attracting and retaining talent and therefore is an excellent tool for aligning management with shareholders’ interests. From an executive’s perspective, unvested restricted stock is a strong incentive to stay with the company and accumulate more wealth. The amount of wealth will move with the stock price, but it is unlikely that it will decrease significantly unless market conditions or company performance are very poor.

From a shareholder’s perspective, restricted stock has the advantage of focusing management not only on increasing the stock price of the company, but also on avoiding reductions in the stock price. This is a key difference between stock options and restricted stock: restricted stock encourages management to limit the downside risk to the company. Concerns about risk mitigation, along with a desire to attract and retain talent, can serve as the rationale for including restricted stock in the long-term incentive program.

Companies use time-vested restricted stock in three different ways:

Part of Annual Long-Term Incentive Programs: Restricted stock is included as part of the annual long-term incentive program, typically comprises less than 1/3 of the total value provided to executives, and vests over 3–5 years. For example, if a CEO receives $3,000,000 of long-term incentive value each year, $1,000,000 might be provided in the form of time-vested restricted stock vesting at the end of 3 years.
Sign-on Grant Upon Hire: Restricted stock is given as a special, one-time grant upon hire to help attract the executive to the company and retain the executive for a longer period. It often serves the dual purposes of making the executive “whole” for forfeited equity from a prior employer and provides the executive with an initial equity stake to encourage alignment with shareholders’ interests.
Special Grants of Restricted Stock: Some companies do not include time-vested restricted stock as part of their ongoing, annual, long-term incentive program. Instead, they use targeted grants of restricted stock to support the retention of executives that are at risk of being recruited away. Under this approach, restricted stock is typically an “add-on” to an already market-competitive compensation program and can be the basis for criticism of the company’s pay practices if used too often.

Key Questions for Committee Members to Ask:

Has the company been challenged in attracting executives to the company?
Has the company had difficulty retaining executives? Has compensation been cited as an issue in any unwanted executive departures?
If the company’s stock options are underwater and/or one or more performance plan cycles are unlikely to pay out, does the company have effective retention tools in place?
Does the stock price tend to be volatile (e.g., in a cyclical industry) where stock price movements are often driven by factors outside company control?
Has the company been criticized by shareholders or shareholder advisory groups for excessive use of time-vested restricted stock or a weak pay-for-performance relationship?

Performance Plans

Performance plans are similar to annual bonus plans, except that performance and/or vesting is typically determined over a multi-year time frame rather than within a single year. These plans have become increasingly popular over the past 5–10 years, as they tend to be well received by executives and shareholders alike. Executives like performance plans because they can be customized to company-specific objectives, and shareholders like them because they have a more explicit pay-for-performance structure than stock options or time-vested restricted stock.

Another attractive quality of performance plans is the flexibility they provide in accommodating a multitude of design objectives. Plan designs vary in the denomination of awards (cash vs. shares), performance periods, performance measures (both absolute and relative), vesting periods, and forms of payment. Companies can tailor these designs to meet their strategic objectives and specific context. While there may be some redundancy with the design decisions for annual incentive plans, we will review the key design decisions involved in performance plans and highlight the differences from annual incentive plans.

Denomination of Award

While annual incentive plans are generally denominated as a cash opportunity, performance plans can be denominated as a cash/cash unit target or a share/share unit target. Executives prefer cash performance plans that keep them focused on the achievement of the specific performance objectives identified under the plan and insulate them from the impact of stock price movements. While this may not support the objective of alignment with shareholders as effectively as a share-based plan, another reason cash payouts tend to be favored by executives is that they do not need to sell shares to realize value from these awards. Given the insider trading rules that restrict an executive’s ability to sell shares and the scrutiny that investors apply to insider sales, a cash-based plan has obvious advantages. Since stock options and time-vested restricted stock are both stock denominated, performance plans are frequently the only cash-based, long-term incentive offered by publicly traded companies. In addition, companies that have had high levels of shareholder dilution from stock-based compensation may prefer a cash-based, long-term incentive, as they do not need shareholder approval to fund shares for awards.

Key Questions for Committee Members to Ask:

Do we have adequate shares available under our shareholder-approved plan to fund awards if delivered in shares? Will it reduce the number of years of long-term incentive plan awards that we can make under the existing reserve?
Are executive plan participants’ liquidity constrained? Would they benefit substantially from a plan design feature that improves liquidity?
Do executives have enough “skin in the game”?

Performance Period

The decision on the performance period is frequently intertwined with the selection of performance measures. Approximately 80% of performance plans use a three-year performance period. For companies that use financial performance metrics, this usually aligns with the length of time that the companies project future performance in their mid-term/long-term financial plans. For companies that use stock price-based metrics, such as TSR, though there is no obvious reason for a three-year performance period, it remains the most common practice. Regardless of the denomination used, very few companies use performance periods that extend beyond three years. For financial performance objectives, this is likely due to the difficulty of making long-term projections. For stock-price based measures, the performance period is likely selected to ensure that the award feels tangible to executives. Given the diminished role of stock options in long-term incentive designs, there may be pressure over time to lengthen performance periods for relative TSR plans given the emphasis most shareholders place on long-term performance.

A minority of companies — approximately 10% — use a one-year or two-year performance period and will typically have additional vesting of 2–3 years on the award to ensure that executives cannot get paid until at least three years from the grant date. The rationale for this approach is that these companies do not have confidence in projecting financial performance objectives three years out. Additional vesting beyond the performance period is added to assure shareholders that the award is intended to reward for the long term, even if the performance objectives are short term in nature. Shareholder advisory firms prefer that companies commit to multi-year performance goals and view one-year goals as problematic, particularly if they overlap substantially with the annual incentive performance goals.

Key Questions for Committee Members to Ask:

Does the company have a credible mid-term financial plan that can be used as the basis for setting long-term performance objectives?
What is the appropriate period of time for assessing whether or not management is making progress in achieving its strategic objectives?
Will the program be externally credible with the performance period we have selected?

Performance Measures

In contrast to annual incentive plans, where companies rarely use stock price as a performance measure, in long-term performance plans, relative TSR is the most common performance measure and is used by 69% of CAP 120 companies. While many companies use TSR, financial performance measures (e.g., revenue, EPS, ROIC) are the most common metrics. Most companies use a blend of 2–3 performance measures.

* Return measures include return on invested capital, return on equity and return on assets. Source: CAP 120

Companies that use TSR will, in most cases, establish performance goals relative to other companies, as it is very difficult to predict what level of absolute performance will be viewed as strong performance over a multi-year period. Relative TSR plans tend to be well received by shareholders because outperforming a group of competitors in terms of stock price performance is an indicator that the company was a better investment than alternatives over that investment period. From an executive perspective, relative TSR can be viewed positively as it helps to insulate management from movements that affect all companies under comparison and offers rewards for the company’s relative performance. While in an “up” stock market, it may be harder to earn large payouts under a relative TSR plan than under a stock option plan, in a “down” stock market executives can earn payouts in a relative TSR plan when stock options would likely be underwater.

Accounting: Market Conditions vs. Performance Conditions

For accounting purposes, a market condition is an award that depends on stock price-based measures (e.g., stock-price appreciation, total shareholder return), and a performance condition is an award that is subject to internal financial performance metrics. These awards differ dramatically in how they are treated for accounting purposes.

For a market condition, a model is used to determine the probable payout of the award and hence its expected value at the date of grant, not unlike a stock option. For example, to determine the cost of a relative TSR performance share grant, a Monte Carlo simulation model is used to determine the fair value based on the expected value for the award. This value is “locked-in” as of the date of grant if the award is settled in stock and cannot be adjusted based on actual performance relative to the market condition.

In contrast, awards with a performance condition “lock in” the value per share on the date of grant, but the number of shares expensed can be “trued up” to the number of shares actually earned based on actual performance. Some companies find the fact that you cannot reverse the expense for a market-based award if the award is not earned frustrating as they would be recognizing an expense when the participant received no value.

As was the case when setting short term incentives, a key challenge in implementing a relative TSR plan is identifying the right peer group of companies to use as a comparison. Since two of the main goals are to reward executives for outperforming alternative investments and to insulate management from external factors beyond their control, a natural starting point is to identify companies that are viewed as viable investment alternatives or impacted by similar market conditions. Companies that meet these criteria can be identified by looking at who investment analysts compare the company to and by identifying which companies have had stock price movements that are highly correlated with movements in the company’s stock price. For companies with a clear set of industry competitors or a well-defined industry index, this is likely the best set of companies for TSR comparisons. Companies with few direct industry competitors may either decide not to use relative TSR as a metric or may select a broad market index (e.g., the S&P 500) as the basis for comparison. However, some may criticize the use of a market index because movements in stock price relative to the broad market can be driven by general sector performance, as opposed to company-specific performance.

Companies that use financial performance metrics in their long-term performance plans will generally use the performance measures that they view as most clearly aligned with shareholder value creation over the long term. These performance measures will be embedded in the company’s strategic plan and viewed as keys for long-term success. For capital-intensive industries, a return measure like return on net assets or return on invested capital may be used in combination with an earnings measure like net operating profit or EPS. For high-growth industries, the performance measures may be revenue growth and operating margin. Multiple measures are often used in tandem to recognize that there may be tradeoffs between different objectives (e.g., growth at any cost vs. profitable growth).

The key advantage of using financial performance objectives over relative TSR plans is that financial performance objectives are generally viewed as being more within the control of management. A three-year EPS goal provides management with a clear message about what the compensation committee is expecting from them in terms of performance. Management can think through the specific activities that can contribute to improved earnings. With a relative TSR plan, there is no clear goal. It is much more challenging to identify the decisions and activities that will contribute to outperformance in the stock market. As such, relative TSR plans are considered to be less effective at driving management decisions and better at aligning management pay with shareholder outcomes.

Key Questions for Committee Members to Ask:

What are the best measures of the company’s success in achieving its mid-term business strategy?
What measures do investment analysts focus on in evaluating our company’s performance?
Do most senior executives understand how they can impact performance on the measures under consideration? Are there alternative measures that are easier to understand and still accurately capture the economics of our business?
Is there a credible basis for establishing mid-term performance goals on performance metrics? If not, can we assess our performance relative to peers?

Absolute vs. Relative Measurement

Similar to annual incentive plans, most companies set long-term performance plan goals to be equal to the performance levels in the company’s mid-term or long-term business plan. Where companies have extreme difficulty in setting multi-year goals, a few alternative approaches are available:

Use of a Performance Standard: Companies can base their performance on growth from current levels using a long-term standard for the industry (e.g., EPS growth of 10%) or based on a long-term industry standard of performance (e.g., ROE of 12%). This avoids an internal negotiation with management about the level of difficulty of the goal. While this approach may be effective over a long period, it may be challenging for any one performance cycle because it does not take market conditions into consideration.
Relative Performance Assessment: Instead of establishing an upfront goal for a multi-year performance period, the goal can be established relative to other companies, a market index, or the companies that compose the index. While this does not take into consideration the absolute level of performance, it does implicitly correct for external market conditions.

Relative performance measurement can be challenging for financial measures as it is sometimes difficult to provide apples-to-apples comparisons. The most common financial measures assessed on a relative basis are financial returns or profit ratios (e.g., return on equity, return on capital, operating margin, etc.). As mentioned earlier, total shareholder return is also frequently measured on a relative basis.

When TSR is measured on a relative basis, most companies use percentile rank among the comparable companies as the basis for the comparison. This is a relatively straightforward approach as the company’s payout relative to target will be tied to the company’s relative performance, as demonstrated in the table below:

*Performance*	*Percentile Rank*	Shares Earned as a % of Target
Below Threshold	<25th	0%
At Threshold	25th	50%
At Target	50th	100%
At Maximum	75th	150%
Above Maximum	>75th	150%

Performance and corresponding payout levels are generally interpolated between threshold and target and target and maximum. A similar approach can be used for financial measures. A key issue in implementing this approach will be the treatment of companies that exit the peer group due to bankruptcy or acquisition. The “rules” for how to handle companies that exit from the peer group should be defined at the beginning of the performance period to avoid any uncertainty or potential legal and accounting issues.

An alternative approach, which can be difficult to calibrate and may overly rely on large cap index constituents, is to set goals relative to the performance of a market index itself (e.g., the S&P 500), rather than the component companies of the index. This approach is much less common than the approach discussed above. Below is an example of what performance goals might look like for this approach:

*Performance*	*Annualized TSR Performance vs. Index*	Shares Earned as a % of Target
Below Threshold	5% or more below	0%
At Threshold	2.5%–5% below	50%
At Target	2.5% below–2.5% above	100%
At Maximum	2.5%–5% above	150%
Above Maximum	>5% above	150%

Key Questions for Committee Members to Ask:

Do we have a credible basis for establishing long-term performance goals? Is there a risk that we will overpay or underpay if we do a poor job of projecting market conditions?
Is the preferred measure readily used for relative performance comparisons?
Is there a good group of companies or a market index available to use for relative performance comparisons?
Should we use the same peer group for performance comparisons that is used for pay comparisons?

Absolute Performance Goals: Performance Calibration

The challenges faced in setting performance goals for a multi-year performance plan are similar to those for an annual plan but are complicated by the heightened degree of difficulty in projecting business conditions over a multi-year period. Depending on the business environment, making projections for business performance for one year may be difficult, let alone three. Still, the clear message that multi-year business objectives send to management about what the company is trying to achieve is so compelling that a majority of companies with performance plans set multi-year financial goals.

When looking at performance over a multi-year period, there are two main ways to assess performance:

Point-to-Point Growth: The company will establish a growth goal for the three-year period. For example, if EPS in 2022 was $1.50, the company may say that they want to grow EPS by $0.15 per year to $1.95 by 2025. This approach effectively puts all of the focus on the final year of the performance period and implicitly assumes that performance in the intermediate years of 2023 and 2024 will be progressing toward the 2025 level. The downside of this approach is that performance in 2023 and 2024 could be poor, but the plan will pay out well so long as 2025 performance is strong.
Cumulative Performance: In contrast to point-to-point growth, setting a cumulative performance goal requires summing the goals for each period in the plan to come up with a three-year total level of EPS (e.g., $1.65 + $1.80 + $1.95 = $5.40). In this structure, each year of the performance period matters in evaluating three-year performance — not just the final year of the performance period. The downside of this approach is that there may appear to be a pay-for-performance disconnect if performance is strong in the first two years of the performance period and then declines in the third year. In this situation, there could be a meaningful plan payout, even though performance looks average in the final year.

Similarly, for multi-year measurement of a return measure (e.g., return on equity), performance can either be assessed based on the level of attainment in the final year of the three-year performance period or on the basis of the average result on the performance metric over the full period.

Key Question for Committee Members to Ask:

Is it better to focus management on getting to an aspirational level of performance by the end of the performance period or should we assess management based on their performance throughout the entire performance period?

Form of Settlement

Most often, awards that are denominated in cash are settled in cash and awards that are denominated in shares are settled in shares. However, there are times when the form of payment will be different from the form of denomination. For example, in order to facilitate executive compliance with ownership guidelines or to conserve cash, awards that are denominated in cash will sometimes be settled (or partially settled) in shares. Alternatively, awards denominated in shares may be settled (or partially settled) in cash in order to conserve shares or to facilitate the payment of taxes. It should be noted that while the change in the form of settlement will not have any impact on the incentives that the executive has while the award is outstanding, it can have a meaningful impact on how the awards are treated for accounting purposes.

Equity-Grant Accounting: Share-Settled Grants vs. Cash-Settled Grants

The accounting treatment for grants that are settled in shares is different from the treatment if they are settled in cash. This difference applies not only to stock-settled performance shares vs. cash-settled performance shares, but also to stock-settled RSUs vs. cash-settled RSUs and stock-settled stock appreciation rights (SARs) vs. cash-settled SARs.

In contrast, with a grant of cash-settled shares, the award is subject to liability accounting. This means that the accounting expense associated with the award will be “trued up” each quarterly reporting period based on movements in the stock price and the ultimate amount expensed will be based on the actual value of the award at the time of settlement. This can create significant variability in the expense if the stock is volatile.

Examples of Performance Share Designs

Financial Metric Performance Share Plan: Shares are earned based on level of performance relative to pre-established financial goals over a three-year period (e.g., three-year return on invested capital (ROIC)):

*Performance Level*	*3-Year Average ROIC*	*Payout vs. Target Shares*
< Threshold	<7.5%	0% of target
Threshold	7.5%	50% of target
Target	10%	100% of target
Maximum	≥12.5%	200% of target

* Shares interpolated for performance between threshold and target, and target and maximum.

Relative TSR Performance Share Plan: Shares are earned based on relative TSR performance vs. an index (e.g., S&P 500 index) or a custom peer group:

*Performance Level*	*Performance Requirement*	*Payout vs. Target Shares*
< Threshold	<25th percentile	0% of target
Threshold	25th percentile	50% of target
Target	50th percentile	100% of target
Maximum	≥75th percentile	200% of target

* Shares interpolated for performance between threshold and target, and target and maximum.

Termination Treatment of Long-Term Incentive Compensation

A fundamental characteristic of most long-term incentive awards is that executives are supposed to vest in their awards over time. In fact, one of the key objectives of long-term incentive design is to encourage executives to stay with the company longer by making it costly for them to leave the organization or to be recruited away. If employees leave, they will either walk away from any unvested awards or the company that recruits the employee will have to make the employee “whole” for forfeited awards through the provision of sign-on grants.

With that said, the treatment of vested and unvested long-term incentives upon an executive’s termination of employment often varies depending on the circumstances of the termination event. Generally, companies are more likely to have plan provisions that allow for continued vesting post-termination, pro-rata vesting, or accelerated vesting when the reason for termination is perceived to be less within the control of the executive. Conversely, they are more likely to call for forfeiture of unvested long-term incentives when the decision to leave is more within the control of the executive or is due to an executive’s failure to perform.

In practice, this means that executives who terminate due to death, disability, or retirement are typically treated more generously than executives who voluntarily leave the company or are terminated by the company with or without cause. Treatment upon retirement may be less generous in companies that provide for an earlier definition of retirement, as someone who retires at age 55 may be viewed as making a more elective decision to retire than an executive who retires at age 65.

When a company experiences a change in control, such as in the case of an acquisition, they tend to take a more lenient view of accelerated vesting of equity. In the past, it was common for all unvested equity to become vested upon the completion of a change in control. The rationale for this approach was that the change in control was an opportunity for shareholders to liquidate their investment and that executives should share in that opportunity. Also, for most executives, the change in control falls into the category of an event that is outside of their control. More recently, companies have been under pressure from shareholder advisory firms and institutional investors to move to a “double-trigger” approach for equity acceleration following a change in control. That is, executives will receive accelerated vesting on their unvested equity only if they are terminated (typically within 1–2 years following a change in control) or if the acquiring company does not assume the unvested equity of the acquired company. Proponents of double-trigger vesting argue that this more conservative approach to equity vesting makes the company more attractive to potential acquirers and provides the continuing entity with a tool (in the form of unvested equity) to retain executives following the acquisition.

The table below provides an overview of prevalent practices for the treatment of equity upon termination:

*Scenario*	*Stock Options*	*Time-Vested Restricted Stock*	*Performance Plans*
Death	Vested: Between three years and remaining term to exercise Unvested: Most common to accelerate vesting	Most common to accelerate vesting	Mixed practice between proration and full vesting; paid out based on actual achievement
Disability	Vested: Between three years and remaining term to exercise Unvested: Most common to accelerate vesting	Most common to accelerate vesting or provide continued vesting	Mixed practice between proration and full vesting; paid out based on actual achievement
Normal Retirement	Vested: Between three years and remaining term to exercise Unvested: Most common to accelerate vesting	Most common to accelerate vesting or provide continued vesting	Mixed practice between proration and full vesting; paid out based on actual achievement
Early Retirement	Vested: One year to exercise Unvested: Most common to forfeit	Mixed practice between forfeiture, proration, and continued vesting	Mixed practice between proration and forfeiture; if prorated, paid out based on actual achievement
Involuntary Termination (without cause)	Vested: Three months to exercise Unvested: Most common to forfeit	Forfeit	Forfeit
Voluntary Termination	Vested: 1–3 months to exercise Unvested: Most common to forfeit	Forfeit	Forfeit
Involuntary Termination (with cause)	Vested: Forfeit Unvested: Forfeit	Forfeit	Forfeit
Involuntary Termination (without cause) following a Change in Control	Vested: Either cashed out or full remaining term to exercise Unvested: Most common to accelerate	Accelerate	Accelerate; mixed practice between paying based on actual achievement and target performance

Key Questions for Committee Members to Ask:

Is our termination treatment consistent with peer practices?
Are our termination provisions viewed as “fair” by employees? By shareholder advisory groups?
Do our termination provisions undermine our ability to retain executives as they near retirement age?