June 17, 2013 Executive Compensation Executive & Director Pay Design Articles

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Executive & Director Pay Design

The Fallacy of Grant Date Fair Value

The great challenge in benchmarking a company’s executive compensation plan against the plans of peer companies arises from a simple fact: not all long-term incentive programs are created equal. Because companies use differing types and mixes of incentives, with the value of each calculated differently, comparison among programs can be a matter of some complexity.

Typically, however, heads of HR, board compensation committees, and compensation consultants cut through the complexity by applying Grant Date Fair Value (GDFV). GDFV certainly makes the task of benchmarking the value of long-term incentive approaches at different companies far simpler. But that simplification comes at a cost.

Because GDFV is the dollar value used by companies to recognize the accounting expense for long-term incentives and the value reported in the Summary Compensation Table and the Grants of Plan-Based Awards Table in the proxy, it is understandably seen as an appropriate way to value different types of long-term incentives — stock options, restricted stock, performance shares, and others. Using the individual GDFVs reported in the proxy you can add the values and generate a single number representing the value of all long-term incentives awarded by a company — basically treating all long-term incentives as equal and interchangeable, i.e., fungible. Then you can simply add that value to the value of base salary and annual bonuses to arrive at a total direct compensation value.

But before adopting that deceptively simple approach, consider how GDFV is calculated for three common forms of long-term incentive:

  • Stock Options that vest with time: GDFV is a fairly sophisticated calculation that takes into account historic volatility, dividend rate, risk free rate of return, and expected time to exercise. Using these inputs and the Black-Scholes formula, a GDFV is derived for a stock option. Frequently, the result is GDFV in the neighborhood of 25 to 50 percent of the simple face value at date of grant, which for stock options is the number of options granted multiplied by the exercise price.
  • Restricted stock that vests with time: While the GDFV for stock options is derived from a sophisticated calculation, the GDFV of restricted stock reported in proxies is simply equal to the value of the restricted stock on the date of grant (i.e., the number of shares multiplied by the stock price at grant). Unlike with stock options, where volatility, dividend rate, risk free rate of return and expected time to exercise is used to calculate the GDFV, no factor other than the stock price at date of grant is used to calculate the GDFV for restricted stock. For example, 1,000 shares granted at $20 are valued at $20,000 whether the stock vests 100% after one year or is cliff vested at the end of five years.
  • Performance shares that vest based on company financial performance: Despite the existence of performance measures and upside and downside leverage, the GDFV reported in proxies for performance shares is set equal to the value of the shares earned at “target” based on the stock price on grant date. So, 1,000 restricted shares granted at $20 that vest based on time have a grant date value of $20,000. Similarly, 1,000 performance shares granted at $20 that vest based on the achievement of a set of three-year revenue, EPS and ROE targets are also valued at $20,000.

Consider, now, whether these long-term incentive vehicles really are fungible. Fungibility implies that a recipient of long-term incentives would be largely indifferent to the type of vehicle so long as it was of equal GDFV to other vehicles. Ask yourself whether your personal experience lines up with this notion. You are a senior executive and you are told that you are eligible to receive $1.5 million of GDFV in long-term incentives. You are given three choices: $1.5 million in stock options which vest over four years with a ten-year exercise period, $1.5 million in restricted stock which vests over three years or $1.5 million in performance shares that vest based on three-year performance. Which do you take?

If you are bullish on the stock price and have a long horizon to take advantage of the ten-year exercise period, you probably take the stock options. If you think the company’s three-year goals are attainable, you might prefer the performance shares. However, if you are unsure what will happen to the stock price and you believe that your company will perform well versus competitors, but think the three goals are a bit of a stretch, you will opt for restricted stock.

So while GDFV represents the accounting value faithfully reported in the proxy, as a single number it clearly does not represent the differences in the risk profile of the various equity vehicles — suggesting that the fungibility of long-term incentive vehicles is, in fact, a fallacy. (While worthy of its own article, GDFV also does not take into account the ability of an equity vehicle to be aligned with and supportive of the company’s desired rewards philosophy and business strategy.)

What can you do about it?

First, resist the temptation to only look at the aggregated value of various long-term incentives as a single number. Be willing to examine the value of stock options, value of restricted stock and value of performance shares separately so that you can more meaningfully compare the plans of peer companies. If your peer group only provides restricted stock and you propose to provide stock options, then that is a materially different construct and approach — even if the GDFV is identical.

Second, consider a more dynamic analysis of the vehicles. For example, value each of the equity vehicles of the peer group based on three or four potential performance scenarios — and contrast your company’s equity vehicles under each of the performance scenarios. To illustrate, four potential scenarios could be: “¢ Low Performance: Stock price appreciation of ““10 percent for next four years, threshold payout at 50 percent of target payout for performance shares

  • Anticipated Performance: Stock price appreciation of 8 percent for next four years, target performance and 100 percent of target payout for performance shares
  • Very Good Performance: Stock price appreciation of 12 percent for next four years, 125 percent of target payout for performance shares (for those plans with upside leverage)
  • Lights Out Performance: Stock price appreciation of 20 percent for next four years, 150 percent of target payout for performance shares

This type of dynamic modeling will allow you to understand how your program will fare under a variety of performance outcomes and if you will be rewarding appropriately given different outcomes. Therefore, we believe that this approach will better allow you to align your plan with your rewards philosophy and business strategy. Most importantly, whatever the application and mix of long-term incentive vehicles in your company and across your peer group, be aware of how GDFV is calculated for each vehicle and do not let the appeal of apparent fungibility lull you into oversimplifying what is in fact a far more complex question of value and design.

View the full article as it was originally published.

Chip Thomas

This article was originally published in NACD/Directorship.

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