Portfolio Company Compensation Equity Plans: The Details Matter

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When equity based incentive compensation plans are set up, some level of compensation expense is virtually unavoidable. Proactive accounting, however, can help to mitigate future compensation charges and earnings surprises.

Listen in to the latest episode of Deloitte Insights to learn more about designing compensation plans.

Guests

Matt Himmelman, Partner, Merger & Acquisition practice, Deloitte & Touche LLP
Kevin Masse, Partner, Merger & Acquisition practice, Deloitte & Touche LLP

Transcript

Sean O’Grady, Host, Deloitte Insights: Hello, and welcome to Deloitte Insights. Today, we are discussing equity-based incentive compensation plans and how proactive accounting during such a plan’s formation can help to mitigate future compensation charges and earning surprises. Joining us by phone to discuss this topic are Matt Himmelman and Kevin Masse, both partners in the Merger & Acquisition practice at Deloitte &Touche LLP. Gentlemen, thank you both for joining us today on Insights. Matt, I would like to begin with you. So, obviously, if you set up a compensation plan, you’re probably going to have some level of compensation expense, but what are some of the key considerations in mitigating those future charges and potential earning surprises, Matt?

Matthew Himmelman: Thanks Sean, and first off, thanks for having us. When you talk about compensation charges and earning surprises, I think the first consideration always has to be whether or not the plan is going to receive liability treatment or equity treatment. Now, in terms of why that’s important, you have to realize that if the plan gets equity treatment, you would fair value the award on day one and then that fair value remains fixed over the life of the award. Compare and contrast that to liability accounting, in liability accounting, you also fair value the award on day one, but then you have to re-measure that each and every period until the end of the award, and obviously, when you introduce the concept of re-measurement, you are also introducing the concept of volatility and that’s usually something that people try to avoid.

Sean: Thanks for that, Matt. Kevin, I would like to turn my attention over to you. I understand if the grantor is a public company, but do private companies really care about these types of charges?

Kevin Masse: Thanks Sean. Yes, they should care. Many portfolio companies have aspirations at some point of being public one day. So, although the expenses associated with equity awards are generally identified by investors as non-cash and that’s something that gets thrown around on a pretty regular basis, people need to keep in mind that the charge still has an impact on both your GAAP EPS as well as your GAAP reported earnings. So, what happens is the stock-based comp or the equity award compensation charges create a potential drag or even volatility depending on the accounting treatment between liability or equity award on the GAAP earnings that would need to be addressed by management at some point as they’re reporting to the street. So, in a perfect world, you would want to avoid this layer of potential complexity around the financial story of the business to the extent you have got lots of volatility coming about simply because of how you are accounting for your equity awards.

Putting aside an IPO, equity compensation charges could also impact an exit of a portfolio company – even if it involves a sale to another strategic buyer. Equity awards and the related expense that comes about with the awards may be considered by a buyer when they’re looking a total compensation expense for the company and the overall structure of the company pertaining to salaries and benefits. This could impact a buyer’s valuation as well as their integration plans for the business. The bottom line is that investors need to be focused on the structures of these equity awards and the issues related to liability accounting for these awards to minimize volatility and any surprises in their GAAP results. All which may impact valuation on exit.

Sean: Thanks for that, Kevin. Matt, back over to you, how does one go about avoiding liability accounting and getting fixed equity accounting?

Matthew: It’s a good question. There are actually a number of considerations, but at the risk of oversimplifying, I am going to focus on just two items, Sean. First and foremost, I think the company has to grant a substantive class of equity to the employee, and when you think about a substantive class of equity, I guess you think about some of the characteristics that go with equities. So, does it legally qualify as equity, does it have dividend rights, does it have voting rights, does it give the employee rights and liquidation. Those are just some of the considerations that you might look at there. And while you don’t necessary need to have all of those considerations, you do need to have a preponderance of those and may be even some other things that you might consider, such that when somebody steps back, they say that really is a substantive equity award as opposed to some sort of a bonus arrangement or a profit-sharing plan. And the second item is that once the individual gets an award with respect to their stock-based compensation they have to be exposed to the risks and rewards of ownership for a reasonable period of time. Now, for accounting purposes, a reasonable period of time is defined as six months and a day, and that doesn’t necessarily mean that the employees can’t sell it to a third party within that period, but really what they’re focused on are cash settlement provisions between the company and the employee within that period of time. And really what we are looking for is a period of time where the employee is exposed to movements in the share price of the stock such that if it goes up, they benefit, and if it goes down, they do not to the extent that that period is not there. Then the plan starts to look more like, again, just some sort of a cash bonus or profit-sharing award that will lend itself more towards the liability treatment.

Sean: Well, thank you for that, Matt. Kevin, in your view, is that hard to accomplish?

Kevin: It is not hard, but the challenge exists when you are trying to balance the objectives of two key constituents, the employees receiving the awards and the investors making the awards, and that ultimately are being diluted as a result of the equity awards. Some of the concepts that Matt just outlined have the potential to place the employee’s objectives at odds with the investor’s objectives. For example, in a private company scenario, management will want the option to achieve liquidity via a put feature; however, investors would prefer only a call feature on the equity to avoid potential equity repurchase commitments or other unexpected cash flow requirements.

As Matt highlighted, both of these features if not structured correctly can result on a liability treatment, accounting answer, for either one of those types of attributes included in an equity award. You would also think that granting a substantive class of equity should be easy, but when investors start to utilize instruments aimed at guaranteeing a certain level of ROI to the investor, such as a waterfall calculation, or include minimum return thresholds, the equity awards start to take on the look and feel of a profits interest. Now, profits interest, unlike a share of stock or an option, is much more complex instrument that requires attention when assessing whether it is a substantive form of equity. If the substance of the instrument is more like for a profit-sharing arrangement, then you run the risk of accounting for the award using liability accounting. This is both where the investor and the management need to evaluate the nature of the award, and they need to keep in mind the key concepts that Matt just stepped through when thinking about the ultimate accounting conclusion relating to the nature of the award.

Sean: All right, thank you for that. Gentlemen, is there anything else that an organization needs to consider when designing these types of plans?

Matthew: Sean, I can leave you with two thoughts there. First one would be with respect to the vesting conditions and looking at those. I think in most of these instances, a plan has a set of vesting conditions that are tied to service and that means the employee has to work for some period of time in order to vest in the award. But above and beyond that, typically, people try to layer in what’s referred to as either performance conditions or market conditions, and it is important to understand the distinction on the accounting between those two.

With respect to our performance condition, those performance conditions are things that are tied to the performance of the company. So, for example, might be something like an EBITDA hurdle or revenue target or perhaps the successful completion of an IPO. And when it comes to fair valuing the award however, you do not include the probability of hitting those hurdles in your day one fair value. Rather, that affects how much compensation you book and you only book compensation when it becomes probable that one of those hurdles is actually going to be met.

If you compare and contrast that to a market condition and those are the ones that are tied to movements in the price of the share of the stock, in those situations, you actually do have to factor in the probability of hitting that share price on day one that drives down the overall fair value of the award. But then on the downside, you have to book that compensation expense irrespective of whether or not the hurdle is ultimately hit. And so I think that is an important distinction for people to look at as they layer in performance conditions and market conditions. Are you look for a lower charge that you are going to take for sure or would you rather have perhaps a larger charge that you’re only going to book when and if certain hurdles are met.

And I guess a closing thought would be with respect to the use of clawbacks. I think this is something that we are going to see more of in terms of use in these plans. And a clawback just allows a company to claw back a vested award that’s already been earned by an employee in the event that some negative event occurs. Let’s say, for example, there is a restatement in the company’s earnings or the employee leaves to go work for a competitor or breaches a confidentiality clause. The beauty of the clawback provision is that it allows the company to claw back that compensation that they granted to the employee, but it doesn’t really affect any of the underlying accounting that we have talked about so far. Rather you typically account for a clawback provision at the point in time that it is triggered and essentially you end up with a pickup of compensation expenses and again don’t have any negative consequences in terms of the upfront accounting.

Sean O’Grady: It is time for Insights, a production of Deloitte LLP. Now, here’s your host, Sean O’Grady.
Sean O’Grady: Hello and welcome to Insights. We have been listening to Matt Himmelman and Kevin Masse, both partners in the Merger and Acquisition practice at Deloitte & Touche LLP. If you would like to learn more about Matt, Kevin, or any of the topics we discussed on this program, you can find that information and much more by visiting our web site, deloitte.com/insightsus. For all the good folks here at Insights, I’m Sean O’Grady. We’ll see you next time.

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