5 TSR Implementation Mistakes to Avoid

Over the last decade, relative TSR has become a routine metric in performance awards. Whether standalone or as a modifier, an enthusiastic embrace or a begrudging addition at shareholders’ behest, the majority of public companies now use TSR as part of their incentive compensation program.

Despite its ubiquity, however, implementing TSR is not without risks. Through our work valuing hundreds of these awards every year, we’ve discovered a number of pitfalls that companies can avoid with proper care and foresight. Here are the top five.

1. Not taking the time to get the design details right

TSR awards have a lot of seemingly mundane details, mostly wrapped in legalese, but they can matter greatly. In some cases, payouts will be different from intended or cause an unforeseen jump in payouts.  In other cases, not providing specific definitions may result in disputes about the amount to be paid at the end of the performance period.

Some simple examples include:

• Failing to define how the percentile ranks will be calculated
• Benchmarking against an index, but failing to incorporate the returns from dividends in the index’s performance
• Using incorrect tickers for peer companies, especially when dealing with different exchanges or historical ticker changes
• Failing to mimic the exact payout calculation in the valuation, such as not applying linear interpolation for performance between stated bands if doing so is specified in the award agreement
• Failing to specify what happens to companies that go bankrupt, are dropped from an index or exchange, or get acquired
• Misunderstanding whether a settlement feature causes the award to be liability-classified instead of equity-classified

Obviously, the list can go on and on. Problems and errors can arise from a number of root causes, ranging from the award design details not being appropriately translated into the valuation model to fundamental misunderstandings of how those details should impact the valuation framework.

In any event, the best practice is to convene a cross-functional team to study the award agreement closely before the grant is finalized. The team should include internal executive compensation personnel in addition to the outside professionals performing the valuation.

Details are most likely to be overlooked when the valuation starts before a formal award agreement has been drafted. As a result, it’s critical for management to make sure the valuation reflects the final terms in the completed award agreement.

2. Cutting corners in the valuation model

Valuation for TSR awards requires Monte Carlo simulation, a fairly sophisticated modeling technique.  An appropriate valuation takes into account the structure of the award. It also reflects how the company and all the peers have moved during the performance period through the valuation date, in addition to how they may move in the future. The model needs to consider how large stock price fluctuations will be (volatility), as well as how much they tend to move together (correlation).

Companies with experience in stock options may have relied on websites with versions of Black-Scholes or even lattice models for their modeling. Unfortunately, Monte Carlo simulations are too complex for such calculators to be effective. The answers they produce are usually very different from a formal valuation. The reason is simple: ASC 718 requires a custom model linked to the exact terms and conditions of the award.

Our firm is often engaged to correct valuations performed by other vendors. Some errors spring from a misunderstanding of how to appropriately model a particular award feature. Others result from crude model functionality that breaks down in more complex cases. Some of the more common errors to look for include:

• Failing to incorporate actual returns in between the performance start date and grant date
• Ignoring available data, such as updated dividend or interest rate information
• Neglecting that the number of shares earned depends on the stock price, giving these shares an option-like leveraged payout
• Modeling derived service periods
• Mishandling the interaction between a market condition (requiring Monte Carlo simulation) and one or more performance conditions (not embedded in the model)
• Incorrectly calculating correlations among peer firms, or failing to even try to model correlated return movements

Any of these modeling errors can—and likely will—result in drastic differences between the expected and actual fair value of the awards, resulting in more costs from providers and auditors down the road.

3. Failing to set expectations between finance and compensation

Typical TSR award designs generally yield a fair value in excess of the face value of the stock, and values also tend to be relatively volatile year over year based on actual performance up to the time of grant. This single fact has led to countless occasions when the compensation committee and executive recipients plan for a particular grant amount, only to be shocked when the actual amount is much higher or lower.

If the intent is to grant an executive $1,000,000 in TSR awards and the assumption is that each award is worth the current stock price of $100, then expectations are tied to a grant of 10,000 units. If the value turns out to be $130, then either fewer units need to be granted or more compensation will need to be reflected in the proxy. Either outcome can result in frustration within the organization.

There are two available solutions. One is to model the value multiple times before the actual grant date. During this pre-grant planning phase, educate stakeholders about the spectrum of potential values that are possible under different market performance scenarios. A valuation firm can provide a range of “what-if” analyses to show what the impact could be. Then, weeks before the grant, refresh those estimates to see what has changed. This helps minimize surprises and thus allows for better planning.

Second, if the results of pre-grant modeling raise concerns, explore design changes that lower the fair value without altering the award incentives. These design changes may include adding an absolute TSR hurdle, changing the performance start date or time window, introducing a post-vest holding period, adjusting the payout matrix, or pulling any other number of levers. Again, working with a team that has valued many awards in the past will provide a good feel for what changes may have the most impact while preserving key features of the award.

This process should be a collaboration among finance, compensation, and the outside valuation specialist so that each party understands the tradeoffs and the most important risks to manage.

4. Misunderstanding the interaction between a TSR metric and other non-TSR metrics in the same award

More and more companies are folding multiple metrics into their performance-based long-term incentive grants. Sometimes they add TSR as an independent metric weighted alongside some other financial (non-TSR) metrics. Other times, TSR serves as a modifier of those other metrics. Either way, a TSR metric adds risk since ASC 718 treats market conditions differently from performance conditions.

The simplest case is where TSR is a standalone (independent) metric. In this event, the award is functionally split up into separate awards for each metric and expensed at the metric level. For example, if TSR is given a 40% weight, EPS is given a 30% weight, and ROIC is given a 30% weight, then the award is treated as if it were three separate grants. The TSR portion, assuming equity treatment, is valued using Monte Carlo simulation and that value is expensed on a fixed capacity, adjusted only for forfeitures. Meanwhile, the two other conditions are treated as vesting conditions and have variable accruals throughout the performance period.

A TSR modifier requires extra care. In the simplest case, a Monte Carlo simulation is performed to value the impact of the TSR modifier. Then that value is applied when expensing the core performance conditions in the award. However, sometimes the impact of the TSR metric differs depending on the probable performance outcome on the performance conditions. For example, if the award is subject to an absolute cap, excellent EBITDA performance may prevent the TSR metric from adding more shares. In that event, multiple TSR fair values may need to be calculated and the value of the TSR condition may change from period to period.

In short, when dealing with multiple metrics, slow down and take time to iron out a clear accounting policy that considers how the market condition (TSR) interacts with the performance condition(s) (all non-TSR metrics). Document the policy and make sure those charged with performing the actual expensing and EPS reporting understand how it works. Finally, confirm with your valuation team how they intend to deal with any downstream changes, and whether they should produce all the values upfront or make changes later as needed.

5. Inadequate controls across the full process

The requirement for advanced Monte Carlo simulation methods to calculate the fair value of a TSR award can put a lot of emphasis on the model itself. In some cases that have gone sideways, we find the problem is not with the core valuation model but with a lack of holistic process controls. Such controls are necessary for both the upfront valuation and the ongoing tracking of relative TSR performance.

Upfront valuation. These valuations often hinge on hundreds (or thousands) of input assumptions in the form of capital markets data based on thousands (or millions) of historical stock prices. Data feeds such as Capital IQ or Bloomberg need to connect into the models and feed these values into the model in the right place and at the right time. Another risk in the upfront valuation is change management, since award terms often change or get interpreted in a new way, prompting adjustments to the model.

Ongoing performance tracking. ASC 260 requires companies to estimate the award payout at each reporting period date as though the end of the performance period were the end of that reporting period. This means there must be some way to continuously track the issuing company’s actual performance relative to peers—no Monte Carlo simulation, just actual performance. What makes this tricky and complex is that peer firms are bought, go bankrupt, split up, change their ticker, and so on. Add foreign peers or large numbers of peer companies to the mix, and tracking can become quite the hassle.

So internal process controls are critical. We rely on extensive automation, a software tool called AwardTraq that helps companies handle their ongoing performance tracking, and a Service Organization Control 1 (SOC 1) report with a Big Four public accounting firm. We’re especially surprised that many valuation specialists lack a SOC 1 surrounding their control environment for tracking TSR during the performance period, given how much this specific processing leans on reliable systems, timely data feeds, and ongoing change management procedures.

In short, it’s critical to invest considerable energy into stress-testing the models being used, carefully review the treatment of companies undergoing corporate events, and periodically update processes to keep pace with evolutions in award designs and market best practices.

Getting TSR Right

Overall, TSR is becoming a way of life for public companies. It’s likely to stay around even as new metrics come to the forefront. The reason is simple: It’s the only design we know of that focuses on stock performance yet removes the impact of broad market fluctuation to align shareholder and executive interest. With that said, TSR also presents a hornet’s nest of potential challenges. And with the growing popularity of hybrid awards, complexity is increasing.

But an experienced team of HR, legal, and valuation professionals can help you see these challenges coming. Therefore, when evaluating a valuation provider, don’t hesitate to ask the following questions:

• How long have they been working with relative TSR awards?
• Can they explain the Monte Carlo simulation model in a way your team can understand it?
• Will they look at your award agreement in advance to alert you of any pitfalls?
• What processes do they have in place to help assure accuracy of the results?
• Do they have a SOC 1 supporting the internal control environment?
• How will they help you track the award in the future?
• Does your auditor’s valuation specialist know and trust the team?

In summary, the best way to avoid TSR implementation mistakes is to work with people who know what can go wrong, and what needs to be in place to keep it from happening again.