Executives often hold a significant number of shares in the companies for which they work as the result of their participation in both long and short term incentive schemes. In such cases, dividends from those shares can become a substantial stream of income.
Most shareholders would not begrudge such inflows as the shares generating the dividends were generally the executives’ reward for past performance. However, what would investors think about executives (or indeed any individual) receiving the benefit of dividends without owning the shares?
It is likely they would not approve. Indeed, history proves they would not. Up until four or five years ago, a number of companies were openly paying dividends to executives on unvested rights or shares granted under long term incentive plans. The practice was phased out after protest from investors and stakeholders.
Yet, many companies are now (and in many cases have been for a long time) giving executives a level of benefit from dividends to be paid during the performance period through the way they calculate how much equity to grant to executives under incentive plans – that is by dividing the reward amount by the equity’s fair value instead of its market value.
For remuneration purposes, fair value formulas are used to estimate the value of equity grants that may or may not vest to the executive at a future date. The value will be discounted on a number of factors including the likelihood that the equity will vest given the performance conditions which apply and expected dividends. This value is used to provide an estimate of the accounting expense associated with offering the incentive opportunity. It is also considered to determine the current award value of the share subject to future service and company performance to the executive, leading some companies to use the fair value to determine the amount of equity to grant and hence inflating the amount of equity granted under incentive plans.
Egan Associates does not agree with this practice: as noted by Credit Suisse in 2014, there is a fault in the logic of adjusting the value of performance rights downwards to compensate for the risk of not meeting performance hurdles when long term incentives are intended to be a risk-based reward.
Discounting to account for dividends is more of a grey area.
The reasoning behind accounting for the dividends is that the share price generally drops by around the amount of the dividend when the share goes ex-dividend as the company’s asset value is reduced. The argument continues that it is necessary to use a discounted value for shares that accounts for this potential initial decline in share price when allocating equity for incentive plans.
Yet, in Egan Associates’ view, at grant date the executive is only receiving entry into the incentive plan, with the terms under which they may enter the plan defined on that date. These terms are defined by the market at that point, not when equity vests in the future.
In addition, fair value calculations are complex and many shareholders do not grasp how much executives are receiving under incentive plans.
Egan Associates believes companies should simply use the volume weighted average share price over an appropriate time period before the grant date to allocate equity under a long term incentive plan. It is simple for shareholders to understand and motivates executives to increase the share price.
What about short term incentives?
If deferred short term incentive awards are granted in a form of equity at the end of the performance period, as is the case in most organisations, the recipient should earn any dividends payable on the earned incentive which is mandatorily deferred. If rights have been granted, the number of rights to be granted may be adjusted to take into account the dividends paid over the deferral period. This is appropriate because the executive has already earned the right to the underlying share and its benefits.