October 25, 2018
Relative TSR: Handling Negative Returns
– Liz Dunshee
Earlier this week, I blogged about typical terms for incentive plans that are based on relative total shareholder return. This blog from Hunton Andrews Kurth dives into another issue that pops up with these plans: how to handle payouts when relative TSR is good, but absolute TSR is negative. Should management still get a payout? Here’s some ideas:
– Elimination: Eliminate payouts when absolute TSR is negative over the measurement period (consider whether the reverse should apply – trigger a payout when absolute TSR is high but relative TSR is low).
– Cap the Opportunity: Implement a cap to the payout opportunity when absolute TSR is negative over the measurement period (consider whether the reverse should apply – same as above). When absolute TSR is negative, a cap would typically limit the payout at the target level.
– Downward Adjust the Payout: A modifier could be implemented to downward adjust the payout when absolute TSR is negative (consider whether the reverse should apply – trigger an upward adjustment to the payout when absolute TSR is positive).
We might be heading into a down market – and these alternatives can help you avoid the perception that you’re rewarding management for low returns, just because the company didn’t do as poorly as its peer group. But they do shift some general market risk back to executives. Also, keep this in mind:
It is common for compensation committees to initially denominate an executive’s award in dollars (e.g., the executive is awarded a target TSR equal to $300,000 as of the date of grant), and then convert that dollar amount into a number of shares covered by the relative TSR award. A design issue is whether the dollar amount should be converted into shares on the basis of grant date stock price or grant date “fair value” (the latter determined using a Monte Carlo simulation).
If the number of shares issued to your executives is calculated using the grant date fair value of the award, implementing any of the above design considerations will decrease the “fair value” of the award, thus having the direct result of increasing the number of shares subject to the award.