Performance shares

From CEOpedia | Management online

Performance shares are the shares given to top management of company as a reward for reaching performance criteria, e.g. earnings, market share. Examples of many companies have shown that managers are more interested in company results if they own part of it. Therefore, performance shares should motivate managers to reach higher results[1].They are recognized as an additional benefit while the company is performing well or better that it was assumed. In most of the cases they are issued while some specific regulations are met (for example performance target, sales, earning for shares, EBIT, ROE, EPS). They are issue at the end of performance period. The expanse is adjusted to equal the value of the shares that actually vest. Performance shares are determined by stock market performance (for example stock price change or TSR). They are mostly valued with the use of lattice model or Monte Carlo simulation [2].

Downside of performance shares

There are many examples showing that wrong set of targets for managers associated with performance shares can lead to better short time results, but then lead into decline or even crisis. Some managers try to reach targets quickly, at a cost of sustainable growth, obtain their shares, sell them and then leave company before the crisis occurs[3].

Therefore, it is very important to set proper targets, not only short time, but also long time ones.

Lattice model

In finance lattice model is recognized as a technique applied to the valuation of derivatives, where a discrete time model is required. Such structure employs a binomial tree in order to show different paths the price of the underlying asset may take over the derivative's life. It means that each variable may change many times over different time periods during the life of the option (it doesn't remain constant). A lattice formula can change[4]:

  • the dividend rate each quarter/year based on future dividend policy
  • the risk-free interest rate over the time if rates are expected to change
  • the volatility for company specific factors that will cause it to change
  • the expected exercise behavior of the employees based on a host of variables such as their employment termination rate

Monte Carlo simulation

Monte Carlo simulation is a technique used to see the impact of risk and unreliability in financial, project management, cost, and other forecasting models. A Monte Carlo simulator helps to visualize most or all of the potential outcomes to have a better idea regarding the risk of a decision. Monte Carlo simulation conducts risk analysis with a use of building models of possible results by involving a range of values—a probability distribution—for any component that has inherent uncertainty. Then it calculates results each time using a different set of random values from the probability functions[5] .

Taxation of performane shares

Regarding to normal federal tax rules, an employee receiving a performance award is not taxed at the time of the grant. However, the employee is taxed at vesting, unless the plan allows for the employee to defer receipt of the cash or shares.

Examples of Performance shares

  • Apple Inc.’s Performance Shares: Apple Inc. offers performance shares to its executive officers. These performance shares are based on performance criteria such as total shareholder return, the company’s operating performance, and the officer’s individual performance. If the performance criteria are met, the executive officer will receive the performance shares over a three-year period.
  • Microsoft Corporation’s Performance Shares: Microsoft Corporation also offers performance shares to its executive officers. These performance shares are based on a combination of performance criteria such as the company’s operating performance, the officer’s individual performance, and total shareholder return. If the performance criteria are met, the executive officer will receive the performance shares over a three-year period.
  • Amazon.com’s Performance Shares: Amazon.com offers performance shares to its executive officers. These performance shares are based on performance criteria such as total shareholder return, the company’s operating performance, and the officer’s individual performance. If the performance criteria are met, the executive officer will receive the performance shares over a five-year period.
  • JPMorgan Chase’s Performance Shares: JPMorgan Chase also offers performance shares to its executive officers. These performance shares are based on performance criteria such as the company’s operating performance, the officer’s individual performance, and total shareholder return. If the performance criteria are met, the executive officer will receive the performance shares over a three-year period.

Advantages of Performance shares

Performance shares have several advantages that make them attractive to companies and their executives. These include:

  • Improved motivation - Performance shares can be used as an incentive for executives to perform better and help the company reach its goals. By tying executive compensation to performance, executives are more likely to make decisions that increase the value of the company.
  • Increased loyalty - Performance shares can help build loyalty among executives, as they know that their performance will help increase their share of the company. This can help retain key executives and prevent them from leaving.
  • Reduced employee turnover - Performance shares can also help reduce employee turnover, as employees are more likely to stay with a company that rewards excellent performance.
  • Alignment of interests - Performance shares also help to align the interests of the executives and the company. By having a financial stake in the company, executives are more likely to make decisions that benefit the company as a whole, rather than their own interests.

Limitations of Performance shares

Performance shares can be a great incentive and motivator for managers, however they are not without limitations. The following are some of the limitations associated with performance shares:

  • Poorly designed performance criteria can lead to managers focusing on short-term goals rather than long-term stability, as they only receive rewards when performance criteria is met.
  • Performance shares can create a conflict of interests, as managers may be more interested in gaining rewards than achieving company goals.
  • Performance shares are often a costly incentive, and can be difficult to track and administer within the company.
  • Performance shares can also be difficult to determine fairly, as the criteria used to determine payouts can be subjective.
  • Finally, performance shares can be difficult to align with the goals of the company, as managers may be seeking rewards for individual performance instead of a collective effort.

Other approaches related to Performance shares

The following are other approaches to motivating managers to reach higher results:

  • Bonuses: Bonuses are rewards given to managers for reaching certain goals or performance criteria. These rewards can be in the form of cash payments, stock options, or other forms of compensation.
  • Equity grants: Equity grants are another form of reward given to managers for achieving certain performance criteria. Equity grants are usually given in the form of stock or options, and they can be either restricted or unrestricted.
  • Long-term incentives: Long-term incentives are rewards given to managers for achieving goals over a long period of time. These incentives are typically granted in the form of stock options or restricted stock units, and they are designed to incentivize managers to stay with the company for the long-term.
  • Profit sharing: Profit sharing is a type of reward given to managers based on the profits earned by the company. This reward can be in the form of cash, stock, or other forms of compensation.

In summary, Performance shares are one approach to motivating managers to reach higher results, but there are other options such as bonuses, equity grants, long-term incentives, and profit sharing. Each approach has its own advantages and disadvantages, so it is important to consider all options when deciding which incentive structure to implement.

Footnotes

  1. ↑ Mehran H (1995)
  2. ↑ Director S (2013)
  3. ↑ Kolb R (2012)
  4. ↑ Cantrell C (2009)
  5. ↑ DeFusco R (2015)


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References

Author: Weronika Włodarska

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