June 7, 2017
Adding a Performance Plan into your Equity Compensation
Posted by Laura Verri
The selection, design, and implementation of a successful equity compensation plan can be a complex undertaking. There are two fundamental types of equity compensation instruments that can be issued to a participant: time-based and performance-based instruments. Performance-based awards and performance-based options are a trend that continues to be on the rise, not only among public companies, but even within privately owned companies.
A company who wants to include a performance-based equity program should spend some time to scope out the right performance target and the right equity vehicle to issue to the participants. The target should be realistic and achievable. If the target is too hard it might discourage the participants, if it too easy it will fail to align participants with shareholders. Further, consideration should be given not only to the difficulty of attainment, but also the difficulty of measuring the performance itself. Simpler is often better.
Performance awards are earned over a performance period with vesting contingent upon a pre-set target. The final number of shares vesting is conditional upon the achievement of the performance metric(s). In some cases, the participant has the potential to earn additional shares if the final performance exceeds expectations. Conversely, the participant can receive fewer or no shares if the goal falls below expectations or the target is not achieved.
At the end of the performance period (or when a performance milestone is met if allowed to be sooner), the company will determine the final performance payout. This goes back to the earlier statement that careful consideration should be applied when designing and adopting a performance-based plan. We recommend limiting targets that are too broad or too vague that might cause the performance period to be “undefined.” For example, performance targets tied to achieving FDA approval, raising the next round of capital, or other broader milestones may create additional challenges and layers of complexities not only in the administration, but also with the expensing and financial reporting of the grants. Also, if participants feel that they cannot directly impact the goal, grants might be perceived negatively rather than as an incentive.
The design of the plan differs from company to company. One thing to keep in mind is that there cannot be shortcuts and there is no “one size fits all” plan.
Some of the most underestimated key issues when designing a performance-based plan are:
- Performance program participation:
a. Does the plan apply to executives only or a larger pool?
b. Is the program designed for continuous, long-term goals or a one-time incentive?
- Performance period and vesting:
a. Should the performance metric be applied to a short, mid, or long term goal?
b. Should the vesting be accelerated if the specified target is achieved earlier?
c. Are there any additional time vesting requirements to be met?
- Metric selection practice:
a. What are the best performance metrics for your company: individual goals, company goals, or market-based goals? An example of a personal goal is finalizing the product testing on time, while a company goal might be the release of the new product by the end of the current fiscal year. Market-based goals are generally tied to stock price or total shareholder return (TSR). An example can be the stock price has to increase by 20% and stay above the specific target for a minimum of 30 days continuously within the current fiscal year.
i. Care should be given to not creating too many awards with different personal goals as this becomes a challenging administrative and accounting burden.
b. Should the performance goal have a multi-tier vesting metric that allows for interim vesting of a portion of the shares?
c. If there are multiple goals, are the goals interdependent?
Do not underestimate plan communications to your participants. Be clear about the program’s objectives, terms, and how the performance awards play into the overall mix of incentives granted to your company’s participants. It will helpful to give an example or “what if” scenario to illustrate the potential of the final outcome.
Laura Verri is a Senior Manager with Armanino’s CFO Advisory Services practice, specializing in equity plan design, administration and accounting. As a financial reporting manager for Solium Capital, she moved to the United Kingdom to better support the requirements and needs of the European market and clients for equity financial reporting and IFRS 2. She is a Certified Equity Professional and a member of the National Association for Stock Plan Professionals.