Restricted stock: the case for total shareholder return; Companies that adopt market-based and performance-based vesting conditions under FAS 123(R) can better reward high-level employees and create shareholder value--without increasing accounting costs--say three professionals.

In the wake of adopting FAS 123(R), some companies have shifted away from exclusively granting stock options toward exclusive use of restricted shares or a combination of the two. From 2003 to 2005, the prevalence of S & P 500 CEOs receiving both stock options and restricted share awards increased from 33.5 percent to 42.2 percent, according to an Equilar Inc. survey.

Clearly, companies are searching to improve equity plans by looking at a combination of options and restricted shares. However, for many senior executives there are better vehicles than simply a combination of these two familiar alternatives. Companies that design awards with market-based and performance-based vesting conditions under FAS 123(R) can better reward high-level employees and create shareholder value without increasing accounting costs.

[ILLUSTRATION OMITTED]

In particular, under the former standard, APB 25, shares that vest based on market conditions ("market-based" awards) were subject in the U.S. to variable accounting. FAS 123(R) has eliminated this unfavorable accounting treatment. As a result, U.S.-based companies are joining those in the U.K. and Continental Europe in recognizing the advantages of market-based awards over service-based awards.

Companies like Time Warner Inc., Pfizer Inc., Campbell Soup Co., Duke Energy Corp. and Viacom Inc., among many others, are awarding or will be awarding market-based shares as part of long-term incentive plans to senior executives. The number of companies granting market-based and performance-based shares is expected to grow dramatically as companies seek to better align executive compensation to shareholder returns.

Equity-based compensation strategy usually involves six considerations: keeping accounting costs under control; minimizing the variability of accounting costs; providing perceived value to employees; retaining employees; creating incentives for employees to increase share value; and limiting the complexity of plan administration. The following analyzes why market-based shares--as a key component of long-term compensation to high-level employees--can further these objectives.

Market-based Share Awards

The two most common market-based share awards have the following structure:

Absolute awards, for which vesting depends on a company's own stock price or total shareholder return. This is usually structured as a price or return target or hurdle.

Relative awards, for which vesting depends on a company's total shareholder return (TSR) rank relative to a set of pre-defined peers, or an index of companies in a relevant industry or broader market. TSR is defined as the return on the company's stock, assuming reinvestment of dividends.

An example of an absolute award is one where shares are granted when the stock price is $20, and vest immediately upon the stock price averaging $25 for 30 consecutive trading days at any time within two years.

A relative award, in contrast, might vest at the end of two years, with the number of vested shares depending on the company's TSR rank among its peers as follows: beginning with a fixed target of 10,000 shares, if the company TSR as compared to the TSR of its peers is below the 25th percentile, then no shares vest; above the 25th percentile, an interpolated amount vests beginning at 50 percent of the target and capping out at 200 percent of target. Table 1 on this page shows the payout schedule using 15 peer companies.

With a relative TSR award, the number of shares that the employee will receive varies, depending on actual relative performance; however, the accounting cost to the company remains fixed throughout the term of the award.

Companies can apply market-based vesting conditions to a diversity of vehicles including restricted stock, restricted stock units, stock options or stock-settled stock appreciation rights (SARs). The key factor in designing an absolute market-based award is appropriately setting the target price levels. The key factors in designing a relative market-based award are the choice of payout schedule and relevant peer group. Companies can vary the payout schedule with more or less differentiation, based on TSR rank.

For example, a flatter schedule might range from 50 percent to 150 percent, according to TSR rank; a steeper schedule might range from 0 percent below the 50th percentile to 300 percent at or near the top. When the schedule is flatter, the award has more of the characteristics of a service-based restricted share award. A steeper schedule makes the award more option-like, though the underlying driver is relative rather than absolute stock performance.

The peer group for a relative market-based award could be a custom index of a few competitors, an off-the-shelf industry index such as the S & P media index or the entire set of companies in a broad market index, such as the S & P 500. Using appropriate sensitivity analysis, companies can fix the accounting cost up front, and compare the effects of choosing optimal target prices for an absolute award, or payout schedules and peer groups for a relative award.

A Closer Look at Restricted Stock

Economic factors on three levels generally drive the price of stock, and therefore, the payout of restricted share awards: 1) the broader market; 2) the relevant industry; and 3) the specific company. Over any given period of time, the effect of factors in the broader market and/or relevant industry can crowd out the specific company factors. Consequently, the stock of a company with problems, including poor management, could appreciate when the market soars.

Conversely, the stock of a company that is very well managed could decline when the overall market declines or the industry suffers a downtrend. Therefore, service-based restricted share awards by themselves cannot meet the objective of long-term incentive plans of tightly linking management performance to the creation of shareholder value.

Further, the signal that Wall Street gets from a company favoring service-based restricted shares over options or market-based shares is a lack of internal enthusiasm for the future return on the company stock. Indeed, when Microsoft Corp. declared its intention to move from options to restricted stock in July 2003, Business Week noted: "The new pay plan is a tacit admission that Microsoft isn't the growth stock it used to be."

Relative Performance Best Matches Payout to Performance

How can a company mitigate the effect of general market or sector performance on compensation? The answer lies in using a metric of company performance relative to peer company performance. A company can use internal performance metrics or market-based metrics as the basis for comparison to its peers.

Internal performance metrics include operating income, net income or return on equity or capital employed. Comparison across companies can be difficult or impossible due to the dependency of internal metrics on company size, the cost and structure of capital, company-specific accounting methods, strategy and management policy.

Internal metrics can also be volatile and dominated by non-recurring events, such as a write-off related to an acquisition. Additionally, FAS 123(R) requires that companies reexamine internal performance metrics each reporting period and evaluate if targets will be met. As the probability of targets being met changes, so can the compensation cost, which creates the potential for significant earnings variability, particularly near the end of the service period.

In contrast, market-based metrics are the direct measure of value creation. Relative market-based metrics, such as company TSR relative to the TSR of peer companies, directly measure how investors change their relative valuation of the company over a period of time. A market-based award using relative TSR can be thought of as an indexed stock award that can pay off extremely well in the best case. On the other hand, all is not lost in a bear market so long as the company does not perform substantially worse than its peers. Of course, shares are limited or forfeited if the company substantially underperforms its peers.

Like service-based restricted shares, options also link to economic factors on the same three levels: broader market, relevant industry and specific company. The option payoff can be extraordinary if the stock soars, but it can be zero if the stock fails to appreciate. Due to the implicit leverage of an option, the swings in value are exaggerated relative to the underlying stock. The volatility of option returns is much higher than that of service-based restricted shares and significantly higher than that of typical market-based restricted shares.

For traditional option awards, as well as restricted share awards, the effect of factors in the broader market and/or relevant industry can crowd out the specific company factors. Consequently, some of the volatility of the award is not company-specific.

If the TSR is in the 75th percentile among peers, then the payout to the employee will always dominate the payout from service-based restricted shares. It will also dominate the payout from an option unless the stock appreciates more than 50 percent in absolute terms over three years.

Accounting Cost Variability

FAS 123(R) distinguishes between three basic types of equity awards: service-based, performance-based and market-based. All three types are valued at the date of grant and then amortized over the requisite service period. But there are important differences in the variability of the subsequent amortization.

* Pure service-based awards have some moderate amortization variability related to the estimated forfeiture rate over the contractually-defined service period. The estimate almost always needs to be adjusted before the end of the service period. If one performs the true-up regularly, the expense corresponding to broad-based awards can be fairly predictable. The expense corresponding to high-level employees is more variable, because such grants are larger and made to only a few individuals whose turnover rate is less predictable.

* Pure market-based awards, whether absolute or relative, have the least variability of the three types. One values the award once and for all at the grant date, and amortizes the expense over a "derived" requisite service period. Pursuant to paragraph A60 of FAS 123(R), the derived service period is the median time from grant date to vest date taken over the set of stock price scenarios that satisfy the market condition.

The only source of variability in the amortization is from the possibility of vesting prior to the end of the derived service period. In this case, the remaining unamortized expense is recognized immediately upon vesting. Amortization costs are not modified if shares fail to vest due to the market condition or if more shares than the target number ultimately vest.

This is because the probabilities associated with market-based vesting conditions are already taken into account in determining the grant date fair value. Often, service requirements are used as an additional condition in conjunction with market-based vesting. This, again, creates the potential for moderate amortization variability related to estimated forfeitures and subsequent true-up.

* Pure performance-based awards have the most complex amortization. All such awards have an embedded condition that requires quarterly review to determine whether the condition will "probably" be met or not. For performance awards with a variable payout, one must determine the most likely payout and update the "implicit" service period each quarter. The quarterly updates raise the potential for swings in expense as a condition moves between "probable" and "not-probable." If a swing occurs near the end of the implicit service period, the resulting variability could be material, as nearly the entire grant could be expensed or reversed in a single quarter.

Although all awards require attention to the quarterly calculation of diluted earnings per share (no dilution results from market-based or performance-based awards unless the award is dilutive and the condition is met at the end of the reporting period) market-based and service-based awards result in more predictable expense amortization, while performance-based awards require a repeated assessment of probabilities and can potentially produce substantial variability.

In some respects, performance-based awards are analogous to the old APB 25 variable accounting; instead of mark-to-market, based on changes in fair value, one must fair value the award and mark to performance based on a fixed fair value.

* Combination awards. Typically, market conditions are set in combination with service conditions. However, companies can also augment a market condition with a performance condition. One approach is to structure the award so that the performance condition serves as a "safety net" that ensures the vesting of some shares if either the market condition or performance condition is met. If the company TSR ranks poorly compared with peers, but the performance condition is met, then there is a compromise payout between that implied by the actual TSR rank, and that implied by a median TSR rank.

[GRAPHIC OMITTED]

Valuation of Market-based Restricted Shares

Valuing awards with market conditions requires a lattice or Monte Carlo simulation model, depending on the characteristics of the award. The correct way to value any market-based award is the "contingent claim method." Here, the model generates payoffs along a set of possible future share price paths and discounts the payoffs back to the grant date.

The contingent claim method integrates vesting and intrinsic value consistent with the modern financial theory, such that the correlation between vesting and intrinsic value is taken into account. Simply discounting today's share price by the probability of shares vesting fails to take this correlation into account and results in valuation error. Volatility estimation for market-based awards, with their typically short measurement periods--often under four years--is less challenging than volatility estimation for longer option awards, leading to more precise fair value estimation.

To help understand the payout possibilities associated with equity awards from both the company and employee perspectives, Monte Carlo simulation models can be used to generate computer-based payout distributions.

These models can forecast the risk and potential return of equity awards by generating millions of future stock price scenarios that incorporate assumptions such as the stock price volatility of a specific company or the correlations between the stock prices of various companies. Scenario analysis of this type is a key component of both designing an award and communicating the potential award payout to employees.

In conclusion, the main objective of equity-based awards is to maximize value to employees, while motivating them to maximize value to shareholders. Companies should evaluate six criteria: 1) Compensation accounting cost to the company up front; 2) cost variability; 3) perceived value to the employee; 4) the retention effects; 5) the incentives created by an award; and 6) the administrative complexity.

For the same FAS 123(R) accounting cost and cost variability relative to restricted shares and/or options, market-based relative TSR awards have the flexibility to maintain or increase perceived value to employees, provide better incentives and similar retention effects and maintain administrative simplicity.

Daniel Abrams ([e-mail]) and Peter Suzman ([e-mail]) are Partners with FAS123 Solutions. Allan Cohen ([e-mail]) is Executive Director of Financial Reporting and Assistant Controller for Time Warner.

RELATED ARTICLE: takeaways

* Since adopting FAS 123(R), some companies have shifted away from exclusively granting stock options toward exclusive use of restricted shares or a combination of the two, but there are other alternatives.

* Plans with market-based and performance-based vesting conditions can award high-level employees and create shareholder value without increasing accounting costs.

* The two most common market-based share awards are absolute awards and relative awards.

* Companies like Time Warner, Pfizer, Campbell Soup and Viacom will be awarding market-based shares as part of long-term incentive plans to senior executives.

Table 1

TSR Performance Rank Relative to 15 Companies
in Peer Index                                  Payout (% of Target)

1st                                            200.0%
2nd                                            185.7%
3rd                                            171.4%
4th                                            157.1%
5th                                            142.9%
6th                                            128.6%
7th                                            114.3%
8th                                            100.0%
9th                                             83.3%
10th                                            66.7%
11th                                            50.0%
12th or lower                                      0%