A series of regulatory and corporate governance developments, combined with
the refinement of a key design feature, have breathed new life into the use
of restricted stock in long-term incentive programs. Restricted stock – long
favored by recipients, but sometimes resisted by investors – has shown a
resurgence in popularity in recent years.
Traditional Practice. Executives who receive restricted stock are
granted the right to shares of company stock, usually without cost, once
prescribed terms and conditions are satisfied. In traditional practice,
“terms and conditions” were limited to time-based vesting. Stay on the job
for, say five years, and the stock becomes yours, either ratably over time
or all at once (cliff vesting) at the end of the restriction period. During
the interim, you may be a beneficial owner which means you receive dividends
and can vote shares.
All in all, a good deal for the executive: the downside is limited
(restricted stock does not go “underwater”) and the cost cannot be beat (by
contrast, an executive must pay to exercise an option). Once restrictions
lapse, the executive may sell shares or use cash to pay the resulting taxes,
at regular rates.
From the viewpoint of investors and shareholders, however, this practice is
often viewed as too good of a deal. They want to see more executive “skin in
the game” and performance hurdles more robust than merely staying employed.
Growing Practice. In recent years, the use of restricted stock has
surged due to a combination of reasons. First, FAS 123(R) eliminated a
compelling advantage held by stock options by requiring companies to
recognize a charge to earnings on fixed option grants at fair market value.
This heavily-debated action put other compensatory equity-based programs on
a par with stock options from an accounting perspective. Second, publicly
traded companies became concerned about the excessive dilution that resulted
when the majority of long-term incentives were granted in options.
Restricted stock helps conserve shares since companies typically obtain more
mileage out of the full value of a restricted share than the fair value of
an option. Understandably, restricted stock carries greater perceived value
than an option in the eye of the recipient.
Most notably, an increasing number of restricted stock grants now contain a
previously uncommon feature – performance goals – that responds in some
measure to critics. One estimate is that over the past four years,
performance-based restricted stock increased in usage by twenty-five
percent.How They Work. Restricted stock plans offer companies
considerable design flexibility. Generally, here is how they work:
First, a company (usually the board’s compensation committee) establishes a
measurement period, usually three to seven years.
Second, the company selects the goals it expects an executive to achieve
during the measurement period.
- Goals are typically limited to one or two in number, enabling the
company to focus on performance drivers considered most likely to create
value, particularly in capital markets.
- Goals may be performance-based, meaning they are derived from
company performance, or market-based, indicating their reliance on
company stock price.
- Performance-based measures currently in use include net income,
earnings per share, return on equity, return on assets, and cash
flow.
- Total shareholder return is the predominant market-based
measure.
- Goals may be stated in absolute terms based on historical
performance and forward-looking business plans, or relative terms when
compared to a peer group, or both.
- Goals are typically established on a high-to-low performance
continuum that strikes the desired balance between achievability and
stretch.
Third, as goals are achieved during their respective measurement periods,
recipients vest in the shares and assume actual (not merely beneficial)
ownership.
Accounting and Tax Considerations. The impact on a company’s
financial statements often affects the types of incentive compensation that
it provides to executives. Tax considerations (from the perspective of both
the employer and the executive) also can be critical. Outlined below are key
accounting and tax considerations that may affect awards of
performance-based restricted stock.
Tax Impact to Company
-
Company receives
deduction when executive recognizes income.
-
Withholding is
required.
-
IRC section 409A:
potentially applicable, but can avoid its conditions
if award paid immediately upon vesting or within 2 ˝
months after fiscal year-end in which vesting
occurs.
-
IRC section 162(m):
should qualify as a performance-based award; hence,
does not apply against $1 million cap on deductible
compensation.
Tax Impact to Executive
- Taxed under IRC section 83.
- No tax at time of transfer.
-- Within 30 days of grant, executive may make a
Section 83(b) election
-- Section 83(b) election triggers a taxable event,
at which time grant is taxed as ordinary income.
-- Subsequent appreciation/loss taxed as capital
gain/loss.
- If no section 83(b) election,
executive taxed at ordinary income rates when
shares vest or are no longer subject to substantial
risk of forfeiture.
- Assuming goals are set with
reasonable stretch, executive would likely refrain
from making an 83(b) election since recouping taxes
(if goals are not achieved) is limited to capital
losses.
Accounting Impact
- Company expense equal to grant
date fair value of equity awards spread over the
requisite service period for awards expected to
vest, i.e., performance condition, is probable of
being satisfied.
-- Generally, “target” performance is assumed at
beginning of measurement period.
-- Because payouts are not guaranteed, companies may
record a figure lower than share value on grant
date.
-- Initial expense estimate may require revision if
subsequent data points to a different outcome.
-- Performance awards can result in earnings
volatility.
- Where executive fails to satisfy
requisite service period prior to vesting, or where
measurement is performance-based, and goals are not
met, accrued expense may be reversed.
- Where measurement is
market-based, expense may not be reversed for
non-performance.
The Penicle Group has been providing executive compensation consulting
services to clients (both publicly traded and privately held) since 1988.
Restricted Stock is but one of several long-term incentive vehicles used for
executives, and may be “simulated” when equity dilution is an issue. Please
let us know if we can be of service to your organization.
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