Long Term Incentives

Long Term Incentives: What is the difference between Restricted Stock or Restricted Stock Units (RSU), Performance Shares, Employee Stock Options (ESO) and Deferred Cash?

All of these are long term incentives, employee compensation awards designed for more long-term results and behaviors. They all work differently and have individual advantages and disadvantages. Depending on the country, the employees, the company and the company’s financial outlook the type of long-term incentive deployed may need to differ. For instance stock options may make sense for start-up companies low on cash but high on potential that want employees to be ambitious and ‘buy-in’ to the long term vision for the company. A mature company generating reliable cash flow but with limited opportunity for growth (for the company and the share price) may choose to award performance shares or restricted stock units (RSUs) which may be a better LTIP vehicle for their employees as they maintain significant value even if the share price is remaining steady or even declining slighty.

Let’s look at these different types of long term incentive awards individually:

Restricted Stock / Restricted Stock Units (RSU)

These plans are time based and deliver the full market value of the stock at the end of any vesting period. Restricted Stock Units are generally preferred to actual Restricted Stock as this means that for the vesting period allocation of actual company stock and the possible taxation requirements that come with that are delayed.

These plans are very common in the market particularly in North American companies, they are very simple for employees to understand and for companies to administer/account for. They align employees to shareholders as both groups will benefit from an appreciating share price. They can therefore incentivize senior execs to focus on general long term performance but don’t have any mechanism to drive more specific performance outcomes.

Performance Shares

Performance Shares are effectively Restricted Stock Units where the number of units that vest can increase or decrease based on results against performance metrics over the vesting period. This means that specific KPIs can be set meaning employees can be driven by more than just share price appreciation through the LTIP. Performance Share plans are also very common in the market these days – European based companies in particular seem to use this approach.

A well though out performance share plan has potential to drive very good outcomes but it is important that it does not over leverage good and bad outcomes. I once worked for a company that would pay out up to 200% (of target RSUs) if the company outperformed market peers during the vesting period. The plan would however pay out as low as 0% (of target RSUs) for underperformance. The problem was that the KPIs that drove the performance outcomes were highly correlated with the company share price. This meant that a key Executive could get a 300,000 EUR award granted that by the vesting date (at target) was worth only 200,000 EUR due to share price decline. However add the performance outcome to that and maybe only 25% of target vesting occurs meaning by the time it vests it was worth 50,000 EUR. This may keep shareholders happy by holding Executives accountable but it ensures a significantly below market LTI outcome which may trigger need for cash retention awards or loss of critical Executives needed to turn the company around to competitors.

On the flip side if the 300,000 EUR award is worth 400,000 EUR at vesting due to share price growth everyone is happy – employees and shareholders. Is there really a strong ROI to pay that out at say 200% of target and deliver 800,000 EUR when market aligned value for that role/Exec was 300,000 EUR? These type of highly leveraged plans can be very volatile which in my view is appropriate in a short term incentive but for a long term incentive I think stability and perfect alignment with shareholders outcomes generally make more sense.

Employee Stock Options (ESOs)

Employee Stock Options are what they say in the name – an option for employees to buy company stock in the future at a pre-agreed price. The employee can choose if and when they take up the option to buy. Many employees can struggle to understand stock options as the value is not always clear. As well as understanding how many options they have and the prevailing company share price they also need to understand what the option or exercise price is, what the vesting schedule is and what the window is they have to exercise the options.

In simple terms while restricted stock or restricted stock units are worth the full market value at vesting the stock options once exercised are worth the full market value less the exercise price. An option to buy at $20 for a share that is currently worth $30 means the value if exercised is $30-$20 = $10. Conversely a restricted stock unit would be worth the full $30. Employees do however have the advantage of choosing when to exercise their options between when they vest and when the options expire. This window is typically a few years and means that even if the current share price is below the option price or ‘underwater’ the options still have some value as there is a chance of the share price rising above the option price before the option expires.

Employee stock options used to be more popular but are still widely used in the market today. They have the benefit from a company point of carrying a cost that is correlated with share price appreciation so are not a costly liability for a company that has not managed to drive the required growth in the share price. Theoretically if stock options do become very valuable for employees the company can afford that as the share price has presumably risen significantly based on great company results.

Employee stock options are typically granted to employees with an option price at a discount to the share price at the time of granting and/or the number of options granted is much higher than a similar award of RSUs. For example 100 RSUs granted when share price is $10 would have a nominal value of $1,000 (100 x 10). 200 stock options with a $5 option price granted when the share price is $10 would also have a nominal value of $1,000 (200 x (10-5)).

Deferred Cash

Deferred cash is the last long-term incentive I will talk about today. This is not as common as the plans we have just covered but is often the best option in countries where legally implementing share based plans is difficult or when a company is not publicly listed and cannot easily use stock unit based plans for their LTI. Similar to the other plans deferred cash can be used to support retention of employees over a period of time. It can also have performance metrics like performance shares and deliver below or above target outcomes at the end of the time period based on KPIs. That is often necessary as without it and without cash plans being aligned to stock prices there is otherwise no impact on the outcome from good/bad company performance.

If you are asking these questions about long term incentives:

How do I calculate the value of my Restricted Stock Units (RSUs)?

How do I calculate the value of my Performance Shares?

How do I calculate the value of my employee stock options (ESOs)?

How do I calculate the value of my deferred cash?

Then please use our free online valuation report where you can get an accurate valuation in less than 5 minutes or alternatively contact us at support@sharpevaluation.com especially if you would like a more technical analysis performed on your performance shares or stock options.

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