UK: Incentive plans: still getting enough bang for your buck?

Soon IFRS2 will no longer be an academic exercise for the finance teams of UK companies operating share incentive plans for employees. The standard comes into force for listed companies for periods beginning on or after 1 January 2005, and comparatives will be required for the previous year.

While this development creates a level playing field between different types of employee share incentives (they will now all generate a profit and loss charge), the extent to which the standard will affect the profits of a business depends on the type and number of awards made, as well as the performance conditions attached.

Ignoring performance conditions, the value of a performance share award (one where the participant is promised a number of shares for no or negligible payment, if performance criteria are met) is usually very close to that of the underlying shares when the award is granted. Typically the only adjustment is to reflect the effect of dividends foregone between grant and vesting.

Valuation of an option is much more difficult as it must be calculated using an option pricing model, which takes into account share price volatility, as well as dividends, interest rates, exercise price and expected life. The value of an option as a percentage of the underlying share price can vary significantly according to these factors, but values of between 20% and 40% are common, and can sometimes be higher than 50%.

Although, at first sight, options appear cheaper than performance shares, to ensure employees are adequately compensated, companies typically grant more options than performance shares. This means the actual profit and loss account cost can be quite similar.

Where an award is granted with market-based performance conditions such as total shareholder return (TSR) attached to their vesting, the fair value of the award is reduced to reflect the likelihood of the performance target being met. Accordingly, a lower charge per share will arise in the accounts. However, this charge cannot be adjusted if performance conditions are not met or are met to a lesser extent than anticipated.

In contrast, where non-market based performance conditions such as earnings per share (EPS) are used, the fair value is not adjusted to reflect the performance conditions, but the charge made to the accounts is adjusted based on estimated and then actual performance and vesting levels.

This difference means that, if performance conditions are not met, an award made with a TSR performance condition would affect the reported results in aggregate over the vesting period, whereas an award made with an EPS performance condition would not. Naturally, companies are now looking at the implications of choosing one performance condition over another.

As yet there is no consensus over the most appropriate valuation model for calculating the charge (Black-Scholes, binomial, Monte Carlo simulation, etc.). A binomial model was expected to be favoured by the Financial Accounting Standards Board in the US, but the Board has recently announced that it has no explicit preference for one model over another, leaving companies free to consider the pros and cons of all the available models.

Black-Scholes is by far the most straightforward to use. It consists of a single formula, with five variables. The drawback of using Black-Scholes is that it was originally designed for valuing European traded options (which can only be exercised on the date of expiry) and cannot take into account performance conditions or the range of exercise dates that are typically available to an executive once his award has vested. It also assumes that the award can be traded in the period before exercise, which is rarely a feature of incentive awards. In relation to share plans, it is probably of most use when valuing SAYE (or similar) options, which have a relatively short exercise window and are not dependent on performance conditions.

A binomial model uses a decision tree approach to consider a range of outcomes for the award to produce an expected value. It is highly flexible and can be built to accommodate many different factors, including performance conditions and different exercise behaviours. This flexibility does mean, however, that each model needs to be adjusted specifically for the award in question, which can take time and money.

The Monte Carlo approach involves running a number of simulations of performance results to give a probability of awards vesting, which can be used to adjust the fair value of an award. The results are based on random simulations of events and therefore do not necessarily reflect actual expected vesting.

Deloitte has developed a model which is an alternative to Monte Carlo simulations to simplify the way TSR performance is fed into the fair value calculations. The model uses a number of inputs to calculate a fair value of the share award taking into account the TSR performance conditions.

Companies are naturally looking to mitigate the profit and loss account expense that will be generated by the introduction of IFRS2 and considering whether their plans represent good value (in terms of reward strategy and incentivisation) for the accounting cost they incur.

Companies are reviewing the number of awards granted to individuals and the number of employees who participate. The option versus performance share debate is also being re-opened particularly for companies with high share-price volatility share options, where the IFRS2 charge can be high.

Some companies have explicitly amended the design of their share option plans to take into account the impact of IFRS2. As disclosed in the shareholder circular, in July, Johnson Matthey’s shareholders approved a proposal to cap the maximum gain on share options at 100% of the (market value) exercise price which reduces the profit and loss expense arising under IFRS2 by 38%.

However, it is important not to lose sight of the purpose of the share plan: reward and incentivisation. In addition to the financial impact, there are many other factors to be considered when deciding on which type of plan to use, the plan design and who should participate.

In the new environment, companies should review the way share plans are financed (newly-issued shares, treasury shares, marketpurchased shares). IFRS2 means that the costs of acquiring the shares to satisfy the awards are not relevant in determining the profit and loss charge (although any additional external financing required by a company to fund a share acquisition will be reflected in increased interest charges).

This means the funding decision should become a treasury decision based on cash flows and dilution. In theory, purchasing shares should become more attractive as it has the potential to enhance earnings per share (EPS) and can help with share plan headroom limits. Of course, the Waterloo (i.e. transfer pricing) implications of introducing purchased shares into the sourcing arrangement need to be considered but this is a complication, rather than a reason not to use purchased shares. And if the current regulatory and ABI limitations on using treasury shares were relaxed, this method of holding shares could, in any case, significantly reduce the Waterloo issues.

IFRS2 provides a new opportunity for companies to revisit the incentive plans and to consider whether they continue to provide the biggest bang for their buck! 

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.