Recently, we encountered more and more clients evaluating possibilities for employee participation in the company’s success. By doing this, companies generally aim at motivation and retention of their key personnel by providing additional incentives over and above the regular fixed salary. In the wake of the so-called “war for talents” this may become an ever more important topic to many employees and therefore also employers.
Another challenge especially for small and fast growing companies is to offer competitive remuneration to attract and retain high potentials, while at the same time preserving cash for necessary capital investment. One way of tackling these challenges is to implement a share based payment or stock option plan (SOP) plan.
But, implementing a SOP comes with many complexities. It starts with an adequate contractual design to achieve the desired incentive effects. A SOP that is designed in best intentions, but is not understood by the participants may even fail completely in providing any incentive. Next on the list are tax implications especially arising in a multinational environment that may lead to unexpected adverse effects that have not been properly evaluated beforehand. Last but not least, the accounting under IFRS and HGB has to be ensured making a valuation of the SOP inevitable.
Also an analysis of possible effects on KPIs and total resulting expenses are of interest for management purposes. In particular, operating profit, earnings per share or equity ratio are influenced by design parameters such as caps, performance hurdles, vesting periods or time-to-maturity and differ significantly between equity-settled and cash-settled plans. For now we will focus on the valuation, since we see that this is in most cases done by the Treasury Department.
Especially under IFRS 2, the fair value measurement of the granted instruments is driven by provisions of the accounting standard. These imply a split of the total personnel expense, i.e. the fair value of a grant, into a part corresponding to the expected number of instruments likely to be exercised (quantity of instruments) and the fair value of a single instrument. The total fair value of the personnel expense to be recognized is then the product of both components. Further, the standard distinguishes between four different types of vesting conditions
The top three types are to be considered when determining the expected number of options likely to be exercised and must not be considered in the fair value of a single instrument. The last type is only to be considered in the determination of the fair value of a single instrument.
The rationale behind the separation is that for the valuation of market performance conditions readily available option pricing models can be employed. Market performance condition may cause very different degrees of complexity for the valuation. It ranges from the simple application of the Black-Scholes formula for plain vanilla call options, to the necessity of complex Monte-Carlo or tree methods. The latter ones are often necessary when the instruments are exercisable at multiple times, reference is made to the average share price, or to a peer group baskets for relative outperformances conditions. Due to the high number of individual characteristics encountered in practice, these valuations can very often not be implemented within the standard software.
For the remaining conditions the modelling choice is not as clear cut. Good or bad leaver (service condition), i.e. employees leaving the company before the end of the vesting period, may be evaluated on historical statistical data of the company itself. Evaluating the achievement of non-market performance targets, e.g. reaching a certain EBIT within a certain time, poses another challenge. For all three types of conditions the available data and the modelling or forecasting processes have to be evaluated individually.
All these complexities incorporated in the determination of the total and the own capabilities to handle them are often taken into consideration too late in the process of setting up a SOP. Even worse they are often only detected when it comes to accounting and the valuations become essential.
As experts in the Finance and Treasury Management Team, we are glad supporting you with any questions arising from valuation and accounting of share-based payment programs. As part of the KPMG specialist network we can provide you with the whole range of services around equity based compensations, including tax, HR and further consulting services.
Source: KPMG Corporate Treasury News, Edition 54, April 2016
Author: Thomas Baureis, Manager, email@example.com
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