Design of share incentive plans
This guide is based on UK law.
This article 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” in which the directors can
participate (i.e. it is conditional on service and/or performance
over more than one financial year).
These requirements for shareholder approval have been unchanged
since the mid 1990s.
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
(i) Motivation and retention
To serve their commercial purposes – i.e. 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. Two examples are the plans
introduced by Kingfisher in 2003 and Cable and Wireless in
2006.
- Kingfisher’s 2003 plan saw the company move from traditional
long-term performance plans based on three years’ performance to a
hybrid deferred annual bonus plan. This plan delivers rewards based
on attainment of annual bonus targets. As a retention mechanism,
half of all bonus amounts earned must be deferred into shares for a
further three-year period (the other half is paid immediately in
cash). There is also a linked long-term incentive award, the amount
of which is set by reference to the annual bonus result but which
can only vest if further TSR targets are met. (TSR is defined in
“performance conditions” below.)
- Cable and Wireless introduced a very innovative, if not
radical, plan in 2006 that won widespread investor support. The
plan reflected a strategic shift from overall group performance to
separate business unit performance. Cable and Wireless is now one
company with two operationally separate entities – a UK business
and an international business. The Long Term Cash Incentive Plan
valued each business separately at April 1, 2006 and will reward
participants for growth in the value of their own business over the
periods to March 31, 2009 and March 31, 2010. If the growth in
value equals or exceeds a threshold of eight per cent per annum
compound, then a proportion of the value above the threshold will
generate a pool from which cash bonuses will be paid. Although this
is not a share plan in the strict sense, it replaced existing share
plans as the long term incentive for executives within the two
businesses.
(ii) Revised accounting treatment of share incentives
The introduction of the international accounting standard IFRS 2
on January 1, 2005 significantly changed the accounting rules for
share-based payments. For quoted companies, a new “expected value”
charge must now be taken to the profit and loss account for all
forms of share incentives. This rule has applied to AIM companies
since January 1, 2006.
The effect has been to alter significantly the traditional
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 no longer without cost.
Consequently, many companies have been asking whether alternative
plans may have more potential to deliver rewards for comparable
profit and loss costs. This is reflected in the types of new share
plans that companies have been introducing since 2004 (see table on
page 139).
(iii) 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 long-standing 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.
(iv) Views of institutional investors
As stated above, in recent years, institutional investors have
paid 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”.
(EPS is defined in “performance conditions” below.)
- a focus on the size and composition of groups of comparator
companies selected for TSR performance targets.
Main types of share incentive plan
There are three main types of share incentive plan currently
offered by UK plcs.
(i) Share options
Share options have traditionally 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 H M Revenue and 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 tax-efficient 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 above. Other factors are involved:
- concerns that share options may not provide an adequate reward
or retention mechanism in a sustained bear market; • as the value
of awards depends on share price rises, the number of shares
required to deliver a significant benefit can be large, and this
can use up a company’s available dilution limits;
- performance conditions for share options have become tougher at
the insistence of institutional investors (e. g. by removal of
re-testing).
(ii) 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). New PSPs have been
introduced by a significant number of quoted companies since
2004.
Under the traditional accounting treatment of share awards, a
PSP involved a profit and loss expense to the company. However,
with the introduction of IFRS 2 (see above), this distinction
between PSPs and market value options has been lessened; the
relative profit and loss costs of PSPs and share options can now be
compared.
The main advantages of PSPs are that:
- in contrast to share options, 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;
- most 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. Interestingly, companies are
increasingly using alternatives (EPS, PBT, revenue growth,
cashflow) to supplement (or sometimes replace) TSR as a performance
measure for PSPs. This is allowing them to retain the advantage of
PSP structures while using performance measures to which executives
feel a stronger affinity.
Share Matching Plans (SMPs)
SMPs are similar to PSPs in that they can deliver free shares to
executives. Like PSPs, they have become more popular with quoted
companies over the past few years. 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” (i.e. 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;
- they tend, given the above, to be encouraged 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
non-existent 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 in the box on page
142.
A key development in recent years has, however, been the use of
a wider range of measures for performance conditions. Investors are
more willing to accept bespoke measures if an appropriate case can
be made. Examples of “non-standard” performance conditions used in
new plans in 2006 include profits before tax (PBT), return on
capital employed, sales growth and free cash flow targets.
(i) Earnings Per Share Growth (EPS)
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 of EPS 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”;
- 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.
(ii) Total Shareholder Return (TSR)
TSR, commonly used by 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 or 30 per cent; possibly less if the
award is worth more than 100 per cent of base salary). 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 level of returns that 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 – i.e. 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.
