Many performance-based equity plans use relative total shareholder return (rTSR) over a three-year period as a primary metric in determining the payout of the award. The accounting of these awards is typically valued using either the Black-Scholes or Monte Carlo accounting models, where the theoretical cost of these awards is commonly described as the grant date fair value (GDFV) and the accounting rules do not allow for adjustments up or down based on actual performance.
However, according to a recent Semler Brossy memo, high inflation combined with increased volatility is the perfect storm to see potentially significant increases in compensation expense, because GDFV increases as these external market conditions increase.
Why is this important? Semler notes that GDFV is the compensation that is disclosed in the Summary Compensation Table and incurred as an expense on the income statement. According to their research, the cost of a share award today may be 10 – 30% higher than the same award granted one year ago. While technically correct from an accounting perspective, these changes in the value do not necessarily translate to an actual increase in the award amount due to improved financial results and are not perceived to be more valuable by the participant. As an example, they cite an executive who earns 70% of their total pay in equity, 50% of which is based on rTSR. In this case, a 20% rTSR cost increase results in a 7% pay increase, all other factors excluded. Although investors would be able to account for the factors driving the pay change, compensation committees would need to discuss the appropriateness of the increase given all other performance factors.
How can senior management and compensation committees prepare?
Review award design and valuation by modeling. Ask questions to get a sense of what the valuation change impact will be. Have any inputs changed? What would last year’s payout look like under the current valuation? Are there any concerns about the impact to the compensation expense? And, does the valuation change feel reasonable and appropriate?
Consider if it’s appropriate to use metrics less dependent on accounting. Metrics that are less dependent on macro factors may result in awards that are better aligned with company financial performance and reduce overall risk associated with external conditions.