Performance Awards: Grant Structures and Administrative Challenges

Denise VitaleVP Product Development

Equity Compensation Management

Plan designCompany senior executivesCompensation department/consultantsLegal councilFinance/AccountingBoard of Directors or Compensation Committee

The natural result of a well-designed plan is that each company will have a unique plan that suits the goals and objectives unique to that company.

Once terms and conditions are outlined in a plan document and grant agreement, the company is contractually obligated to adhere to them.

Equity Compensation Management

Administration of stock plansCompliance (Taxation, securities, accounting, corporate law, data privacy, labor law, etc.)Transaction processing and record-keepingReconciliation and reportingCommunicationsDocumentationSystem maintenance

The natural result of well-designed stock plan administration software is that the needs of the stock plan administrator are met with a minimal amount of manual intervention.

Performance Awards Defined

Umbrella terminology that covers a number of award types and vesting/earning scenarios.

With these stock / unit grants, there is some aspect, such as vesting schedules or amount of award shares that may be acquired, that is conditioned upon meeting personal, company or stock performance criteria.Most common for restricted share awards or unitsMay be applied to options, SARs, phantom awardsMay be paid out in cash or shares (We will focus on share-payout awards)

Performance Awards Defined

There are three categories of vesting conditions that may be incorporated into the award

Service conditions (continued employment, time-based vesting)Market conditions (tied to stock price)Performance conditions (EPS, ROI, sales revenues, etc. -May be company, divisional or individual measurements)

Awards may incorporate multiple conditionsIt is common to have service conditions applied in addition to performance and/or market conditions

The type of vesting condition applied to the award will impact the accounting treatment of the award

Terminology check: Performance conditions are a type of vesting condition applied to performance awards.

Performance Award Characteristics

Components that differentiate performance awards from non-performance awards

Number of shares: Earned shares may be adjusted based on performance goals attained Performance metrics: Specified goals drive the ultimate payout

Single and multiple metrics may be defined for an awardPerformance periods/cycles: Defined measurement period(s) during which goals will be measured for possible attainment (earning shares)

A metric may be measured for a specific target as of a specific date: Is earning per share at least $25 as of the end of the last reporting period of the fiscal year?A metric may be measured for a range of performance over a specified period of time: Has earning per share been at least $25 for 3 out of the past 4 quarters?A metric may be measured until it occurs. Once earnings per share reaches $25…

Performance Award Vesting

Vesting schedule:Specific dates attached to specific award shares that define when the award shares are available to the participant.

A System may have a vesting schedule to cover just the time-based service vesting or it may combine time/service and performance earning

Vesting from a tax standpoint:The point when there is no longer a substantial risk of forfeiture

Vesting and Earning from a performance award standpoint:

The point when vesting and earning conditions have been met:Performance hurdles (performance and/or market conditions) (event-based vesting)Service conditions (time-based vesting)– Typically, the service conditions are met after the performance cycle

is completedThere may be two schedules required to track these two types of conditions

Performance cycle schedule and time-based vesting schedule

Performance Award Vesting

How vesting might look for a performance award:Vesting may occur all at once (cliff) or in tranches (graded/incremental)Vesting may occur as of specific dates with attainment of specified goals impacting the number of shares earnedVesting may occur only upon the attainment of specified goalsVesting may be accelerated upon the attainment of certain goals, but payout ultimately occurring on a set date whether goals are attained or notTime-based vesting may coincide with performance periods/cycles or occur over a period of time after performance earning has been measured

Software Application Considerations

What accounting/taxation/reporting record-keeping software doesn’t have to do:It is not up to the software to determine if performance goals have been met

What accounting/taxation/reporting record-keeping software should do:

Calculate earned shares based on achievement of performance goalsComply with applicable regulationsHold all applicable grant/vesting/cancellation information with meaningful labelsAccurate calculationsAccurate reportingProper plan share-pool trackingMeaningful communications

Performance Award Models

Acceleration: Vesting accelerates upon meeting specified goals

Incremental Earning (Multiplier): Grant of a target number of shares is issued. Participant may earn fewer or more than the target number of shares

Banking: Awarded shares are earned based on a specified performance cycle and “banked” while a time-based vesting schedule continues over an additional specified period

Fixed Value: The number of shares issued is based on a specified dollar value derived from the fair market value of the awarded shares as of one or several dates

Grant Lifecycle

Grant

Measure success in meeting performance / market goals. Determine shares earned.

Reflect incremental shares earned above targetOrEarned shares = target shares OrCancel shares if earned shares below target

Apply time-based vesting

Apply Release / Payout

Accounting Overview

Measurement Date: When the value of a grant is measured to determine the AMOUNT of the potential compensation expense

Attribution: Recognition of the expense (WHEN /HOW the expense is recognized)

Attribution of the compensation expense generally occurs over the service period for an award

Service Period: Generally the time-based vesting period for an award

Time-vesting based on continued service: Recognize expense over vesting period

Accounting for Performance AwardsMeasurement Date: Grant Date

Attribution:Service-based vesting accelerated upon reaching performance goals: recognize expense over period up to when goals are expected to be reached

Period adjustments may be necessary if expectation of when grants will vest changes

Performance-contingent vesting (non-market conditions): Only recognize the expense for the portion of the grant expected to vest and recognize expense over period up to when goals are expected to be reached/vesting is expected to occur

Reevaluate vesting expectations each reporting period and recognize expense based on current estimates of amount to vest and timing to vestOnly recognize expense for award shares that actually earned

Vesting Contingent upon Reaching Market Condition Goals: Fair value of grant adjusted based on expected likelihood of attaining the market conditions specifiedExpense recognized for full value of award even if market conditions are not met

– Forfeiture reversal of expense allowed if service conditions not met and unvested shares are cancelled upon employee’s termination)

Quarterly: Properly adjust the expected vest factor for the grants to ensure the expense properly reflects the expected earning (only for non-market-based performance measurements)Ensure the “Performance Cancelled” shares are addressed properly in the expense calculations

Performance Cancellations are not “forfeitures” for accounting purposes and shouldn’t impact the forfeiture rateMarket-based performance measures: expense is not reversed even if performance goal isn’t met

If market-based performance award shares are forfeited upon termination, expense is reversed (service requirement has not been met)

Administrative Tasks Supporting Financial Reporting

Taxation of Performance Awards

Tax timing and withholding requirements driven by the award type:Restricted share awards and restricted stock units: Ordinary income earned upon vesting (once there is no longer a substantial risk of forfeiture)

Ordinary taxable income = FMV at vest – purchase price x shares vesting

Withholding requiredCompany compensation expense tax deduction = ordinary income recognized by employee and reported on W283(b) elections

Participant may make an 83(b) election for restricted share awardsParticipant may NOT make an 83(b) election for restricted stock units awards

Restricted stock units: deferral elections may applyNon-qualified deferred compensation taxation addressed under IRC §409A

Administrative Challenges

Reporting and user interface views typically need to show target shares as “granted” shares

Companies vary in what they want to see whereTargetMinimumMaximumEarnedIncremental shares earnedPerformance shares cancelled

Pool of shares available for issuance needs to consider maximum shares that may be earned

Companies may want a separate number reflecting target shares granted

Administrative Challenges

Cancellation categoriesTermination (service conditions not met)

VestedUnvestedProration of unearned shares

Performance conditions not met: What date is applied to the cancellation record?ExpirationOther Vested & Unvested

Need to reflect different categories of cancellations and the type of vesting conditions that were applied

Service and Performance conditions: recognized expense reversedMarket conditions: recognized expense not reversed

Plan Reserve (available for issuance): Plan dictates cancellation types that are added back to the pool

Administrative Challenges

Reconciling Items:Transactions put into the system (activity date) in the current reporting period with a transaction date in the previous (closed) reporting periodBeginning balance for the current period reports do not match the ending balances from the previous period reports

Companies want to show target shares in Options Outstanding and other non-financial reports. When incremental shares are earned, this creates reconciling items.

Administrative Challenges

Performance Awards under a Multiplier Model:Target number of shares is designated with an earning potential ranging from zero to a specified amount above 100%. Each grant has a target number of shares granted, and a minimum and maximum earning potential.In this model, there are three possible outcomes for total shares earned, as follows:

Target with earning at 100%“Target + Incremental” with earning at greater than 100%“Target – Cancelled” with earning at less than 100%

Administrative Challenges

Communications, Calculations and Reporting (Including expense and earnings disclosure) need to be considered to determine how to reflect target, maximum possible, incremental and actual earned shares.

Expense CalculationsEPS: Common EquivalentsOutstanding Balance“Granted”Plan Share ReserveParticipant Communications

Administrative Challenges

Each software package will have its strengths and limitations that will influence how you will administer performance awards.Each grant type will have its own challenges:

Restricted Stock Awards with shares issued at Grant and released at vestingRestricted Stock Units with earned shares issued at vestingStock Options/SARs where earning occurs at vesting but exercise is at a later date