TSR Award Design | FAS Solutions

Let FAS Solutions help your company meet the challenges of designing relative TSR awards as you enter into the first of these four sequential steps:

We have seen many of our clients transition away from stock options to equity awards with vesting contingent on total shareholder return (“TSR”) and in particular, relative TSR. This reflects the trend market-wide as relative TSR has evolved to the ubiquitous metric for performance share/unit awards. In addition to being encouraged by the proxy advisory firms – most notably ISS, many in the investment community argue that relative TSR most clearly aligns pay with the creation of shareholder value.

Our thousands of valuations position us uniquely to understand the ramifications of design choices and to help companies get more bang for their compensation dollar. Whether creating good “optics” or mitigating the effect of double leverage, here’s how we can help:

1. Peer group selection – Should your company choose to measure performance against a custom set of industry peers, an industry index, an ETF and/or a broader market index such as the Russell 2000, 3000, or S&P 500? This is the first step in award design. We help our clients choose an off-the-shelf index, a custom index, or a set of industry peers. We help our clients look prospectively as well as retrospectively to determine the best peer group.

2. Spread metric vs. Rank metric – Your company can measure performance using the TSR vis-à-vis an index or an average peer TSR. This typically is defined in terms of basis-point spread. Or your company can measure performance using TSR percentile rank among the constituency returns of an index or peer group. I.e., unpacking an index to a chief a finer measuring tool.

3. Payout Shape – How should your company define the domain and range of the payout function? I.e., what are the threshold, target and max levels and what are the corresponding multiple payouts. Analyzing these benchmark alternatives using scenario analysis with Monte Carlo simulation models is key to designing an award to meet expectations.

4. Award by Parts or in Combination – There are many permutations and combinations and FAS Solutions can help your company determine which fits your company’s outlook and compensation objectives:

Absolute TSR and Relative TSR components
Two-step awards with Relative TSR modifying Absolute TSR
Two-step awards with Relative TSR modifying an internal
performance metric
Combination awards using a 2×2 array of internal performance and Relative TSR
Combination awards using Relative TSR with an internal performance safety net

5. Grant Timing – Whether the performance period is based on the fiscal year or calendar year the timing of the grant is a key TSR award design decision. Any grant intra-period (once the performance period commences) introduces fair value volatility that is important to understand either from the expensing perspective or the grant-size perspective. Additionally, trading day averaging prior to the performance in the calculation of the TSR beginning price can add to fair value volatility. The only way to avert this volatility is to grant at-the-money which describes the state of the “horse-race” at the beginning of the performance period when the horses have not left the gate. The performance period might extend to an anniversary of the grant date or to a fiscal or calendar year-end; however the key to granting at-the-money is to align the grant date with the performance period start date. All trading day averaging for the TSR beginning price must also occur from the performance period start date forward. As a practical matter companies often cannot always grant at-the-money. So if your company grants in February for example and the performance period start date is January 1, FAS Solutions can help manage the volatility of intra-period granting.

6. Survivorship Policy in Case of a Rank Metric – this is the policy covering which constituent companies remain in the rankings intra-period and at the end. For an index comparator group it is typically either (a) the companies that remain in the index for the entire performance period, or alternatively (b) the companies in that start in the index and trade continuously during the performance period even if they are not in the index continuously. The latter policy might state that a company must trade on a “national securities exchange” (see https://www.sec.gov/divisions/marketreg/mrexchanges.shtml). For a set of peers the policy might also require continuous trading and a companion replacement policy to determine when to replace a company that seizes trading for a variety of reasons from acquisition to privatization to bankruptcy.