Value Creation Plans – genuine attempts at designing executive LTIPs or too complex to explain?
Some years ago, I attended the AGM of one of the UK’s biggest supermarkets. A shareholder asked a question about the proposed new executive LTIP. After a pause, one of the non-executives stood up and replied “it is too complex to explain”. I was reminded of this recently when MM&K inherited two Value Creation Plans (VCPs) adopted by clients who had recently appointed us.
In both cases, the client had been advised by the same firm and there was an apparent lack of appreciation among the Board and shareholders about the details of how the plans worked or the financial/economic consequences of having adopted them.
The VCP concept is simple – in essence VCP’s are stock appreciation rights settled in shares (or nil-cost options):
Stage 1: Award notional performance units to participants
• Performance units are not equivalent to shares; they define an allocation of future value created
Stage 2: Units convert into nil-cost options according to the value created
• TSR is calculated at a designated future date or dates
• If TSR exceeds a threshold compound annual growth rate, some or all of the units convert into nil-cost options
• The number of shares into which units convert is a function of the number of units awarded, the company’s TSR performance above the threshold and the market price of a share in the company on the conversion date
Stage 3: Nil-cost options vest and become exercisable
• Nil-cost options are held until a vesting date or dates
• On each vesting date, nil-cost options vest and become exercisable if the company’s TSR/share price growth has exceeded a specified minimum acceptable rate
• Post-vesting, options remain exercisable up to 10 years after the award of units
The above outlines the general principle but plans may vary in detail. For example, if units fail to convert (because TSR performance at the relevant date fails to exceed the threshold) VCP rules may provide for re-testing at a subsequent date. Re-testing performance and adopting LTIPs linked exclusively to TSR (share price growth, if there are no dividends) with no financial or operational targets are not the flavour of the month with investors in listed companies.
As ever, the devil is in the detail and there was a lot of impenetrable detail in the plan rules we inherited. However, the purpose of this piece is not to dwell on this or that form of words or complex formula. Our inherited VCPs were almost identical, clearly hewn from the same block, and yet they had been adopted by two very different companies in terms of size, activity and market positioning. There are good reasons for standardisation and “working smarter” but an incentive should be tailored to the business for which it is being designed. Corporate governance now has a much higher profile in relation to executive pay than hitherto. Incentive plans must be technically sound, work for the business and take account of applicable good governance principles.
But the most striking feature of our VCP inheritance has been the lack of appreciation about how the plans operate and potential outcomes. This emphasises the need for clear explanation. It also underlines the essential value of modelling a wide range of potential outcomes to minimise the risk of future surprises which might cause companies and their shareholders to regret their decision to adopt a VCP in the first place and there is the prospect of adverse publicity if payments are more generous that had been expected.
As a concept, VCPs tick the box of aligning executives with shareholders, insofar as they are linked to TSR or share price growth. Added features such as awards of notional performance units, complex conversion formulae and consequentially impenetrable rules are not necessary. It is, however, critical that companies, their shareholders and remuneration committees fully appreciate the plan which they have adopted – and its potential consequences.
As VCP’s attract no special tax advantages, it is hard to see what the added complexity brings to the table, when a similar result can be achieved with a much simpler share plan.
Paul Norris, Chief Executive
MM & K Limited