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Design of share incentive plans

This guide is based on UK law as at 1st February 2010, unless otherwise stated. It is part of a series on Remuneration of directors . This guide considers some of the key issues for companies when...

This guide is based on UK law as at 1st February 2010, unless otherwise stated. It is part of a series on Remuneration of directors.

This guide considers some of the key issues for companies when designing share incentive plans. It describes the different types of plans and performance conditions and looks at their advantages and disadvantages.

Background

Share plans differ from other parts of the remuneration package in several important respects.

Under the Listing Rules, a share plan will require shareholders’ approval if:

  • it may involve the issue of new shares (or transfer of treasury shares) by the company;
  • it is a ‘long-term incentive scheme’ (ie it is conditional on service and/or performance over more than one financial year) in which the directors can participate.

Institutional shareholders publish specific and detailed guidelines for share incentive plans. This is not just because of the requirement for shareholder approval. Certain aspects of the plans will materially affect their interests: issues of new shares will involve direct dilution of their holdings.

Share incentives deliver rewards if disclosable performance conditions are met. Accordingly, shareholders focus on whether such conditions are, in their view, sufficiently demanding.

Design issues

1. Motivation and retention

To serve their commercial purposes – ie to achieve and sustain improvements in performance and increase the commitment of individuals to the business and its goals – plans must be valued by participants.

So both plan design and choice of performance conditions are crucial. A clear ‘line of sight’ between performance conditions and rewards will serve the interests of both companies and their shareholders.

Where companies step back and ask ‘is our plan working?’, the answer can result in a bespoke solution. An example is the approach taken by Venture, now part of Centrica, to the design of its long-term incentive plan in 2008.

As an oil production company, Venture took the view that profits-based measures were not the way to align managers’ interests with the strategic goals of the business. Profits could go up or down depending on factors that were outside managers’ control – particularly, the price of oil. In 2008, therefore, the company chose production as one of its performance measures. Under its long-term incentive plan:

  • one-third of awards were dependent on actual oil production targets;
  • one-third on proven or probable oil reserve targets;
  • one-third on annual growth in total shareholder return (TSR).

Awards would normally vest after four years, with the possibility of early vesting after three years if one of the oil production targets and an average TSR growth of 20 per cent a year were achieved.

2. Revised accounting treatment of share incentives

The introduction of the international accounting standard IFRS 2 on 1 January 2005 significantly changed the accounting rules for sharebased payments. For listed companies, an ‘expected value’ charge must be taken to the profit and loss account for all forms of share incentives. This rule has also applied to AIM companies since 1 January 2006.

The effect has been to alter significantly the previous distinction between share options with a market value ‘exercise price’, which had no profit and loss impact where new-issue shares were involved, and share plans that delivered ‘free shares’, where there was a profit and loss charge based broadly on the value of the underlying shares at the time an award was granted.

Put simply, share options are not cost free in accounting terms. Consequently, many companies have considered whether alternative plans may have more potential to deliver rewards for comparable profit and loss costs. This thinking has led to the predominance of Preference Share Plans or ‘LTIPs’ among quoted companies (see the table below showing the number of new share plans.)

3. Dilution pressures

Companies have to abide by the restrictions agreed with shareholders on the number of new shares they can issue under share plans. The longstanding limits contained in the ABI’s guidelines mean that:

  • shares equal to no more than 10 per cent of issued share capital are available to be issued as awards under share plans in any 10-year period;
  • shares equal to no more than five per cent of issued share capital are available to be issued as awards made under discretionary or ‘executive’ share plans in any 10-year period.

4. Views of institutional investors

As stated earlier, institutional investors pay close attention to the performance conditions that companies apply to share incentives. This has resulted in the following developments:

  • a range and ‘sliding scale’ of performance targets, with full vesting conditional on the attainment of the highest, and only a proportion (for example, 25 per cent) vesting for the lowest;
  • the removal of re-testing of performance conditions, so that if a condition is not met over an initial period the award lapses;
  • where companies propose earnings per share (EPS) targets, investors will compare these with consensus brokers’ forecasts to determine whether the conditions are sufficiently ‘stretching’;
  • a focus on the size and composition of groups of comparator companies selected for total shareholder return (TSR) targets.

Main types of share incentive plan

There are three main types of share incentive plan currently used by UK companies.

1. Share options

Share options have been a popular way to motivate employees. They have several advantages:

  • they are straightforward and generally easily understood by participants;
  • they mean the interests of employees and shareholders are aligned – participants will want to see continued rises in the company’s share price;
  • up to £30,000-worth of HM Revenue & Customs approved options per employee are treated as capital gains rather than income for tax purposes and escape National Insurance. (Additionally, companies whose gross assets are less than £30m can benefit from the highly taxefficient Enterprise Management Incentive plans.)

Nonetheless, many quoted companies have chosen to review their share option plans. This is not just because of the accounting changes outlined earlier. Other factors are involved. Share options:

  • may not provide an adequate reward or retention mechanism in a sustained bear market;
  • can use up a company’s available dilution limits (because the advantage for the employee is the rise in the share price, the number of shares needed to provide a significant benefit can be large);
  • are subject to tough performance conditions at the insistence of institutional investors.

2. Performance Share Plans (PSPs)

Under a PSP, an executive is granted free shares – provided the company’s performance meets a set target, or targets, over a subsequent period (usually three years).

The previous accounting treatment of share awards involved a profit and loss expense to the company in the case of PSPs. With the introduction of IFRS 2, this distinction between PSPs and market value options has been lessened and the relative profit and loss costs of PSPs and share options can now be compared.

The main advantages of PSPs are that:

  • awards retain their value in a bear market and continue to be a useful reward and retention tool;
  • they can allow for a closer connection between individual management performance and reward than share options, where the main driver of value – absolute growth in share price – can be affected by general stock market or sectoral movements;
  • as awards are free, it is possible to deliver value equal to that of share option plans for fewer shares. This can help preserve a company’s dilution capacity.

The main disadvantages are:

  • Most use ‘market purchase’ shares – that is, existing company shares purchased on the market and held by an employees’ trust. There will be a cash cost to the company from acquiring the shares to be held in the trust.
  • Many use the market-driven performance measure TSR; executives often regard this as opaque and feel that it does not reflect their performance as directly as EPS growth. As a result, companies are increasingly using alternatives (EPS, profit before tax or PBT, revenue growth, cash flow) to supplement (or sometimes replace) TSR as a performance measure for PSPs. This allows them to retain the advantage of PSP structures while using performance measures that are more ‘sympathetic’.

The table below shows the number of new share plans introduced by FTSE All-Share companies between 2006 and 2009.

 

Share Options

PSPs

SMPs

2006

13

88

21

2007

26

80

21

2008

20

54

11

2009

27

17

5

Source: ABI IVIS service.

It is worth noting the tail-off in the total number of new plans introduced in 2009. Clearly, many companies felt that a severe recession was not the time to be introducing new benefits for executives. Interestingly, the number of share option plans held up. Many of these plans were put to shareholders in a low-key way, emphasising that companies were renewing existing plans rather than introducing ones that were wholly new.

3. Share Matching Plans (SMPs)

SMPs are similar to PSPs in that they can deliver free shares to executives. The accounting treatment of SMPs is similar to that for PSPs. Also, as with PSPs, performance conditions tend to be based either on TSR or on more stretching EPS conditions than have historically applied to share options plans.

‘Standard’ SMPs work like this:

  • An executive agrees to defer receipt of a proportion of their annual bonus – or (more rarely) is compelled to do so.
  • The deferred bonus is invested in shares on the executive’s behalf and held in trust for a period, usually three years.
  • At the end of the period, the executive receives their invested shares plus a matching award of free shares. Often, the match is ‘net to gross’ (ie an employee invests from post-tax income but matching awards are of shares worth the gross equivalent).
  • The vesting of the matching award is subject to the achievement of performance conditions.

The main advantages of SMPs are that:

  • they act as retention tools during the deferral period: matching awards are generally forfeited on leaving employment;
  • by investing a proportion of their bonus in shares, the executive effectively pays to participate in the plan and becomes a stakeholder in the future success of the company;
  • given the above, they tend to be favoured by institutional investors.

The main disadvantages are:

  • executives can view them as over-complex;
  • the link to the annual bonus can mean awards are low or even nonexistent in difficult years – arguably the times when a company most needs to incentivise and retain executive talent;
  • as with PSPs, there is a potential cash cost to the company and the risk that executives will be dissatisfied with the performance measure.

Performance conditions

The choice of performance conditions is of critical importance.

There are two main types – Earnings Per Share (EPS) growth and Total Shareholder Return (TSR). The principal differences between them are outlined below. In addition, there is an important distinction in the ways they are treated under international accounting standards, and this is explained below (see: Impact of IFRS on Performance Conditions).

There is an increasing trend, however, for companies to use a wider range of measures for performance conditions. Investors are willing to accept bespoke measures if an appropriate case can be made. Examples of ‘non-standard’ performance conditions include profits before tax (PBT), return on capital employed, sales growth and free cash-flow targets.

Earnings Per Share (EPS) Growth

EPS targets are usually expressed as absolute growth targets in excess of growth in the retail prices index over the performance period. They are the common measure for share option schemes, where value is contingent on share price rises.

Key advantages of EPS are that:

  • it is a measure that executives can relate to: it can be directly influenced by the performance of the management team;
  • it is widely recognised, used both by companies internally and by external analysts;
  • the level of targets for vesting awards is set by the company, and the initial hurdle is not a median relative to a peer group that the company cannot control.

Key disadvantages include:

  • fair, long-term targets can be difficult to set. Performance targets that are company-specific and take little account of sectoral or market trends may prove too difficult – or too ‘soft’. This is a particular challenge in an economic downturn;
  • executives are not rewarded according to how their company’s performance compares with that of its peers;
  • some institutional shareholders fear that EPS is open to manipulation and view TSR as a better means of aligning executives’ interests with their own.

Total Shareholder Return (TSR)

TSR, commonly used with PSPs and SMPs, measures share price growth and dividends. Almost invariably, a company’s TSR is compared with that of other companies and ranked. Investors oppose any payment for below median ranking. At median, a proportion of an award will vest (for example, 25 per cent). An upper quartile or higher ranking is required for full (100 per cent) vesting. There is proportionate vesting for achieving rankings between the median and the upper threshold.

TSR targets are typically supported by a secondary target that is a ‘financial performance underpin’, for example an EPS growth target. Investors are in favour of secondary targets that are company specific to complement TSR, which is market driven.

Key advantages of TSR include:

  • It aligns the interests of shareholders and executives by linking rewards to the returns shareholders make on their investments in the company. This is particularly important in a PSP or SMP, where executives can benefit even if the share price remains static or falls.
  • Many investors prefer it.
  • Performance is measured on a relative basis, so setting long-term targets is reasonably straightforward – ie full vesting occurs at upper quartile performance, partial vesting occurs at median performance, etc.

Key disadvantages include:

  • While institutional shareholders insist that awards lapse even if the company’s TSR performance is only just below the median of its chosen comparator group, a substantial proportion of an award (for example, 25 per cent) can vest at median performance. A small differentiation in performance can therefore have a huge impact on payments to executives.
  • Finding an appropriate comparator group can be difficult.
  • As the measure is share-price-dependent it is influenced by market sentiment towards particular sectors, which will not necessarily reflect a company’s underlying financial performance. Within a peer group, takeovers or mergers can have a disproportionate impact.

Impact of IFRS on Performance Conditions

Under international accounting standard IFRS 2, TSR is treated as a ‘market-based’ condition and EPS as a ‘non-market based’ condition. This leads to an important difference in the way the share plans are charged to the profit and loss account.

  • There is an initial discount factor for a TSR performance condition in the formula used to calculate the ‘expected value’ charge. This level of charge is then fixed and accrued over the vesting period. There is no ability to ‘true-up’ (ie to adjust accruals) where an award does not actually vest because the performance condition was not met.
  • There is no initial discount for an EPS performance condition. However, in calculating their annual accruals, companies must estimate the extent to which they believe awards will vest, thereby reducing the level of charge. Accruals can be trued-up so that the final level of charge taken is only for awards that vest.

While this is a very important distinction, opinions vary as to whether it means EPS or TSR is the more attractive option.

For example:

  • certain companies will prefer to use EPS as they wish to have a charge only for awards that vest;
  • others will prefer to use TSR – the fixed nature of the charge means that the effect on profit and loss will be less volatile.

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