5 Common Grant Agreement Mistakes for TSR Awards

Creating an optimal award agreement requires careful consideration of all the plan terms, and—as with anything—the devil is in the details. Failure to consider all of the details can lead to imprecise or even incorrect calculations and unintended payouts down the road. As design season approaches, now is a good time to highlight the finer points that often go overlooked. Here are five of the most common issues we see:

1. Not spelling out how dividend equivalents will accrue

The award agreement should clearly explain how dividend equivalents will accrue for the performance award. For one thing, it will affect the final payout recipients receive even though dividend equivalents won’t factor into the returns calculation. If your firm pays dividends, but you choose not to issue dividend equivalents to award recipients, your employees will ultimately receive less overall value from their awards. Clarifying this outright in the award agreement will avoid a lot of headaches with recipients down the road.

Secondly, for total shareholder return (TSR) awards, dividend equivalents can have an impact on the valuation. If recipients will receive less overall value because no dividend equivalents are given, this must be factored into the Monte Carlo valuation. Be sure to document the exact mechanics and rules for handling the dividend equivalent units so that the Monte Carlo valuation is compliant with ASC 718. While you’re at it, state whether dividends are paid on the entire payout, only on target, or none of the shares. Finally, even if your company has no immediate plans to pay a dividend, it’s still a good idea to specify how dividend equivalent units will be handled. The reason is that you may eventually begin paying a dividend over the award period or, if not then, long before you revisit the wording of your agreements.

2. Omitting key details about the peer list

It’s not enough to just list the companies in the peer group. Add their tickers and exchanges to minimize the risk of confusion between those calculating the ending payouts and participants. If you use an entire index as the peer group, specify the reference date. All this information becomes even more important when the peer group includes foreign peers because you may end up dealing with ADRs and dual listings that may have similar (but not the same) returns on stock prices. The objective is to clear up any misconceptions about the exact listings to use in determining the group’s returns.

3. Failing to anticipate changes in the peer list

The length of the performance period means some peer changes will likely occur, especially if the peer group is larger. That’s why it’s important to articulate exactly how you’ll handle any peer transactions in the final calculation. Failure to do so can lead to a painful reconciliation of the final payout at the conclusion of the performance period. It might even upset participants if the peer changes are detrimental to the final payout. To avoid this, explain what will happen in the wake of events such as:

• A peer going bankrupt
• A peer being acquired—by a member or a non-member of the peer group
• A peer delisting or move to a different exchange
• Companies entering or leaving the peer index

A good rule of thumb is to back-test the award, select what the peer group would have been several years ago, and guarantee that there’ll be no doubts about how to handle any changes that occurred over that performance period, regardless of who calculated the payout. Thoughtfulness is crucial, especially if the peer group is small. For example, we’ve seen bankrupt peer companies removed from the group altogether, thus lowering the payout of the target company awards. Especially frustrating, this has happened even though the bankruptcy happened only in the last week of the performance period, causing concern and confusion among recipients.

4. Avoiding misunderstandings about the TSR calculation

It’s one thing to share how you calculate the total shareholder return for each company. It’s another thing altogether to remove any potential ambiguity about it. Laying out the exact mechanics of the TSR calculation can head off mistakes and turmoil at the conclusion of the performance period.

When defining the TSR calculation, ask yourself:

• Is the averaging period a particular period (e.g., the month of December) or a specified number of days (e.g., 20 days)?
• Are those days calendar days or trading days?
• Does the averaging period precede the performance start date, or does it start on the performance start date?
• Is the first day of the performance period included or does the averaging period end before the performance start date?
• If a divided is paid during the averaging period, how is that treated?
• If an index is using a peer company, are you specifying a return that incorporates dividends?

Another important consideration is how dividends paid during the performance period will be factored in to the TSR calculation. Typically, dividends are either assumed to be reinvested or cumulatively accrued over the performance period.

5. Being unclear about how the award pays out

Some potential errors are due to math itself. In 2019, an internet debate erupted about the problem 8/2(2+2), a hazard of a lack of consistency in how we were taught to apply orders of operations. Some readers may see this as 8/(2*4)=1, while others may read it as (8/2)*4=16.[1] Percentiles can differ based on a few factors, the most important being whether you include or exclude your subject company, and different programs may have different outputs. In this case, some award agreements actually include specific Excel formulas to be used in the calculation.

In other cases, the payout is defined, but the results aren’t always as intended. Consider an award that reaches its maximum payout if the return is more than double that of the peer group average. If the peer group returns 10%, clearly the hurdle is 20%. But what if the peer group returns -30%—does a return of -59% guarantee full payout? It may, if the award doesn’t specify how to treat negative returns.

One final scenario worth highlighting is when a hybrid award is being issued. With a hybrid award, two or more metrics interact with each other to determine the final payout. A common example is an internal performance metric that has its overall payout modified by a TSR metric.

The important clarification to make in your award agreement is exactly how one payout modifies the other. Generally, the modifier can be applied in either an additive or a multiplicative way. In an additive framework, the payouts of each metric are simply added together. For example, if the performance metric earned a payout of 150% and the TSR modifier provides a modifier of +50%, the total payout would be 200%. Under a multiplicative framework, the adjustment is applied to all shares earned. Using the same example, you would instead multiply 150% by a factor of 1.5, leading to a payout of 225%—quite a difference!

Clearing the way to a successful grant

There you have it—five key areas where we see companies trip up. Previously we discussed principles of a successful grant, and avoiding these pitfalls is key to a getting the details right and avoiding arguments about the payout when the time comes.

As you can see, it pays to have a clear and objective framework for calculating your awards payout. To test its effectiveness, try using data from a prior award cycle and calculating the outcome. If performing the calculations reveals anything ambiguous, the award agreement likely needs more clarity.

A well-written award agreement should enable any reader to calculate the same results consistently and easily. Of course, you can always go over your award with a valuation professional. We value hundreds of these awards annually and are familiar with what it takes to help stakeholders understand every part of an award design.

[1] We contend that the answer to this is clearly 16 as multiplication and division should go from left to right. For the internet savvy, we acknowledge there is still some disagreement among us on the color of “The Dress.”