Since Egan Associates first raised the issue in 2013 of using fair value to allocate equity under incentive plans, many companies have switched from fair value to face value for equity allocation purposes. Yet some are continuing the practice.
If a company uses face value (market value) to allocate equity, if they want to grant an executive $100,000 worth of performance rights and the share price is $1, the executive will receive 100,000 performance rights. (Number of performance rights to be granted = Value to be granted / market value of a share).
If a company uses fair value to allocate equity, if they want to grant an executive $100,000 worth of performance rights, they will calculate a value for each right based on assumptions. If the probability that the performance hurdles will not be met is taken into account, this value may be significantly lower than the market value. If the company wants to grant an executive $100,000 performance rights and the fair value of a right is $0.5, the executive will receive 200,000 performance rights. (Number of performance rights to be granted = Value to be granted / fair value of a share).
To investigate how transparently companies are disclosing the value of LTI grants, Egan Associates examined Australia’s top 200 listed companies, charting the difference between:
- the market value at grant date of equity granted to the CEO under an LTI plan
- the CEO’s LTI opportunity that companies disclosed in their annual report as part of the remuneration mix
for the most recent year where data was available in the annual report. Where a CEO started part way through the year, contract information and director interest notices were used. Companies that did not make a grant to their CEO or disclose the maximum (or target) LTI opportunity were excluded. Companies granting options were also excluded.
The resulting percentage difference between the stated opportunity and actual grant was as follows:
Three points emerge from this graphic:
- The median company granted their CEO almost exactly what they stated as their LTI opportunity. The value of just under 40% of grants is within 10% of the stated LTI opportunity.
- Outside those 40% of grants there is a large variation between actual grant value and stated LTI opportunity. A certain level of variation is to be expected, especially where share prices are volatile, because:
- The grant date (used to obtain the LTI grant value for our analysis) may not be the same date as that used to determine the allocation share price
- A VWAP over a long time period (even up to a year) may be used to determine the allocation share price
- There is a small, but still significant, percentage of companies which grant their CEO a far higher value of equity than they have stated. Over 15% of the companies examined had grant values that exceeded the stated LTI opportunity by over 50%.
Some of these companies were merely experiencing share price volatility. However, a large proportion of them were using fair value to price equity for allocation, or were disclosing the LTI opportunity based on fair value within the remuneration mix.
Egan Associates has previously noted that companies may find it necessary to grant large long term incentive awards to executives in a competitive market. This is perfectly appropriate if disclosure is transparent. However, when the use of fair value for allocation purposes makes an LTI grant well in excess of expectation, companies are deceiving shareholders.
Particularly concerning is where companies highlight their use of face value to allocate equity but then use the fair value of the award to construct a remuneration mix diagram. The face value of the LTI opportunity may be disclosed elsewhere, but may not be as prominent, making it less likely that the real value of the intended LTI opportunity is understood.
Confusing the message is the use of the phrase “target” remuneration package to justify the inclusion of a fair value in the remuneration mix, especially given that when some companies use target, they really mean maximum. It is the latter that will be most easily understood by shareholders for long term incentives, not the former.
Although Egan Associates has been pleased by the migration from the use of fair value to face value for allocating equity, shareholders would be well advised to
- ensure they vigorously question the validity of any reasons provided for maintaining a fair value methodology – the difference in grant values can be significant
- check that companies really have abandoned their use of fair value, and not just changed their disclosure to make it seem that way