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Article | Executive Pay Memo North America

SEC pay versus performance equity valuation implications

It’s not just grant date valuations anymore.

By Stephen Zwicker , Mark Daniels , Steve Seelig and Heather Marshall | September 22, 2022

The new proxy disclosure rules will require companies to value in-flight awards. 
Governance Advisory Services |Executive Compensation
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On August 25, 2022, the Securities and Exchange Commission (SEC) adopted final rules implementing the pay versus performance (PVP) requirement in the Dodd-Frank Act. Please see our blog posting on September 7, 2022, for an overview of the new rules. This post focuses on the significant valuation implications for equity awards as they are defined within “compensation actually paid,” which must be reported on the new PVP table.

The final rules adopted a measure of “realizable pay” that includes the change in equity award fair values from one period to the next until the date of vesting. This was a significant departure from the proposed rules that would have required only reporting the value of equity vested for any given year, which would have been more akin to the W-2 values recognized by an executive for the year.

The main takeaway is that there is a lot of work to be done in a relatively short period of time, when many of the people who will be preparing these valuations are already busy with other year-end calculations. This is coupled with the need to make several strategic decisions about how footnotes that describe changes in assumptions from the original grant date will need to be crafted, whether companies will ask outside auditors to review the calculations and how companies will disclose changes in “probability” assumptions for performance-based equity awards.

Figure 1 is our synopsis of the categories and calculation methodologies for equity awards in the PVP table.

Figure 1. Categories and calculation methodologies for equity awards in the PVP table
Grant timing Vesting status Calculation methodology
1 Granted during the covered fiscal year Remains outstanding and unvested at the end of the covered fiscal year Add the fair value calculated as at the end of the covered fiscal year
2 Granted during the covered fiscal year Vested during the fiscal year Add the fair value as of the vesting date
3 Granted during any prior fiscal year Remains outstanding and unvested as of the end of the covered fiscal year Add the change in fair value as at the end of the covered fiscal year relative to the prior fiscal year (whether positive or negative)
4 Granted during any prior fiscal year Vested during the fiscal year Add the change in fair value as of the vesting date relative to the prior fiscal year value (whether positive or negative)
5 Fail to meet the applicable vesting conditions during the covered fiscal year Fail to meet the applicable vesting conditions during the covered fiscal year Subtract the amount equal to the fair value at the end of the prior fiscal year

What will make this new disclosure requirement so unique is that, except in limited circumstances (e.g., cash-settled awards, modified awards), companies have not been in the habit of re-valuing their equity awards after the initial date of grant. For corporate financial statement and proxy summary compensation table (SCT) reporting purposes, Accounting Standards Codification Topic No. 718 (ASC 718) requires stock-settled equity awards to be valued at the grant date. The resulting fair value creates a fixed amount of expense to be recognized and a fixed value to be captured in the SCT; therefore, valuations are prepared only once for most awards.

As shown in Figure 1, the new PVP rules will require companies to re-value outstanding equity awards through the date of vesting. This creates a number of new, and unexpected, challenges:

  • The number of valuations required each year to be prepared by internal or external valuation resources will significantly increase.
  • In-flight valuation of stock option awards will be required to reflect changes in assumptions that consider current fiscal year economic conditions and how much the options are in or out-of-the-money.
  • In-flight valuation of relative total shareholder return (RTSR) awards will be required to reflect changes in assumptions that consider current fiscal year economic conditions and actual TSR performance for the company and peers to date.
  • Other market-condition awards (e.g., stock price hurdle vesting) will face similar challenges.
  • Companies will be required to disclose changes in valuation assumptions between the grant date and the PVP measurement date.
  • For non-market-condition awards (e.g., awards subject to conditions tied to financial or non-financial goals), while complex valuation models will not be required, internal alignment will be needed on updated probability achievement factors and a shared understanding around the disclosure of this information in a new way.

Let’s look at some of the specific implications for stock option and RTSR awards, which are the awards that most frequently require measurement using valuation models.

Stock options

Grant date fair values for stock options are primarily prepared using either Black-Scholes or binomial lattice pricing models, with Black-Scholes being far and away the most commonly used model. We would expect companies to utilize a consistent model for PVP valuation purposes. Let’s look at the inputs (Figure 2).

Figure 2. Inputs for grant date fair values for stock options using Black-Scholes or binomial lattice models
Input ASC 718 grant date PVP measurement dates
Market price Company's stock price Company's stock price
Exercise price Price at which the executive can purchase shares; typically, equal to market price on the grant date Same as grant date exercise price; compared with PVP market price, this will inform how much the options are in or out-of-the-money
Stock price volatility Companies consider some combination of their actual historical volatility and a market-based implied volatility measure. Historical volatility is typically calculated over a period consistent with the expected life if Black-Scholes is used or contractual term if binomial lattice is used. Implied volatility is typically derived from the current pricing of exchange-traded stock options. Companies select a methodology of how much weight to apply to each measure.

For companies without sufficient trading history to rely upon, peer group volatility may be substituted.
Historical and implied volatility measures will need to be updated at each measurement date, based on current market conditions. We would expect the weighting of each measure to be applied consistently from one valuation to the next unless the company has changed its methodology during the interim.

For the PVP valuations, there will be a range of remaining expected lives and contractual terms at each measurement date due to the various vintages of options being valued. Companies will need to evaluate whether their historical volatility measures should consider these differences or if one consistent measure of historical volatility should be used. We would typically recommend having a single measure of expected stock price volatility that applies to all stock option valuations. Otherwise, a company is effectively creating a term structure of expected volatility, which can be more difficult to support.
Expected life (Black-Scholes)/exercise rates (binomial lattice) Companies review historical exercise patterns in order to determine how long a new at-the-money option grant is expected to be held prior to exercise (Black-Scholes), or at what gain levels and time the new option grant is expected to be exercised at (binomial lattice).

Separate assumptions may or may not apply to the executive population based on differences in historical behavior (e.g., actual data on how long individuals hold vested options prior to exercise may support a longer expected life assumption for executives).

For companies without sufficient historical exercises, the SEC simplified methodology (midpoint of average vesting and expiration) may be used for Black-Scholes.
Adjustments to the grant date expectations will need to be made to reflect changes in remaining vesting periods, remaining expiration periods and option gain levels.
For binomial lattice valuations, the model will automatically reflect these changes because exercise assumptions are already mapped to time and gain factors. For Black-Scholes, companies will need to develop a methodology to adjust for these factors. This will likely include full adjustments for time elapsed (i.e., subtract one year from expected life for each one year elapsed since grant) and partial adjustments for gain factors (e.g., subtract/add X% of a year from expected life for the options being Y% in/out-of-the-money).
Dividend yield Companies typically set based on either their current dividend yield (e.g., most recent annualized payment divided by market price) or a trailing average dividend yield. The dividend yield will need to be updated at each measurement date based on current market conditions. We would expect the same methodology to be used as for the grant date valuation unless the company has changed its methodology during the interim.
Risk-free interest rates Risk-free rates are based on U.S. Treasury yields with a term commensurate with the expected life (Black-Scholes) or contractual term (binomial lattice). The risk-free rates will need to be updated at each measurement date based on current market conditions and the updated expected life assumptions and remaining contractual periods.
Relative total shareholder return awards

Grant date fair values for RTSR awards are prepared using a Monte Carlo simulation model. This same model will be required for PVP valuation purposes until the end of the performance measurement period. At that date, the actual relative TSR performance and the current market price will be the basis for the fair value. Let’s look at the Monte Carlo inputs (Figure 3).

Figure 3. Inputs for grant date fair values for RTSR awards using a Monte Carlo model
Input ASC 718 grant date PVP measurement dates
Market price Company's stock price Company's stock price
Stock price volatility Companies typically use historical volatility for themselves and each company in the peer group. Implied volatility is much less commonly used for RTSR valuation purposes. Historical volatility is typically calculated over a period consistent with the performance period of the awards (generally three years).

For companies without sufficient trading history to rely on, peer group volatility may be substituted.
Historical measures will need to be updated at each measurement date, based on current market conditions.

For the PVP valuations, there will be a range of remaining performance periods at each measurement date due to the various vintages of RTSR awards being valued. Companies will need to evaluate whether their historical volatility measures should consider these differences or if one consistent measure of historical volatility should be used. We would typically recommend having a single measure of expected stock price volatility that applies to all RTSR award valuations. Otherwise, a company is effectively creating a term structure of expected volatility, which can be more difficult to support.
Actual TSR performance Often, the grant date is after the beginning of the performance measurement period. The grant date fair value is required to reflect actual TSR performance that has been experienced by the company and the peers between the start of the performance measurement period and the date of grant. The PVP valuations will require updated inputs for actual TSR performance for the company and the peers as of the PVP measurement date. In addition, a careful review of any changes to the peer group will need to be considered (e.g., M&A activity, changes to index constituents, bankruptcies).
Dividend yield Companies typically set based on either their current dividend yield (e.g., most recent annualized payment divided by market price) or a trailing average dividend yield.

If the TSR definition includes re-invested dividends (normal) and the RTSR awards accrue dividend equivalents, then the dividend yield input may be set to 0% because it does not impact the valuation.
The dividend yield will need to be updated at each measurement date based on current market conditions. We would expect the same methodology to be used as for the grant date valuation unless the company has changed its methodology during the interim.

For RTSR awards that accrue dividend equivalents, the value of the previously accrued dividends as of the PVP re-measurement date should be included in the fair value.
Risk-free interest rates Risk-free rates are based on U.S. Treasury yields with a term commensurate with the remaining performance period. The risk-free rates will need to be updated at each measurement date based on current market conditions and updated remaining performance periods.
Other valuation issues

While we expect stock options and RTSR awards will generate most of the valuation issues associated with the new PVP disclosure requirements, there are other issues to keep in mind:

  • Time-vested restricted stock and unit awards. The market price at the PVP measurement date should be discounted by the dividend yield if dividend equivalents are not provided. If dividend equivalents are provided, the value of the previously accrued dividends as of the PVP re-measurement date should be included in the total fair value of awards outstanding.
  • Performance-vested restricted stock and unit awards with non-market conditions. An updated expectation of the performance outcome will need to be reflected (and disclosed) at each PVP re-measurement date. At the grant date, it is common to assume target performance, which is reflected in the SCT. For the PVP calculations, however, a company will need to show the impact of changing expectations of performance over time, something that has never needed to be disclosed before. The same dividend equivalent issue as for time-vested restricted stock and unit awards applies.
  • Post-performance service period. An executive may be required to continue in service between the end of the performance period and the performance certification date in order to earn the award. This is an additional service vesting period. The PVP disclosures will need to reflect the change in market price between these dates. For example, a “must be present to win” provision that requires the executive to be employed as of March 15 following the end of a calendar year, or the date the goals are certified, if earlier, would require that portion of the award to be disclosed for the following calendar year.
  • Employee stock purchase plan. Although not a large component of executive pay, the change in the value of those awards will also need to be included. For completed periods, it will be the value of the shares earned. For outstanding periods as of the PVP re-measurement dates, a new valuation will be required.
Potential number of valuations required — an example

The PVP transition rules require disclosure of compensation for the past three fiscal years. Let’s consider a December 31 fiscal year-end company that grants the following awards each year on March 1:

  • Stock options with four-year graded vesting
  • Relative TSR performance stock units with a three-year performance period, running from January 1 to December 31 and a March 1 service vesting date

For the 2023 proxy disclosure statement, the valuations shown in Figure 4 will need to be prepared.

Plan - Stock options
Grant date Measurement dates Vesting tranches
requiring valuation
March 1, 2016 December 31, 2019 Tranche 4
March 1, 2020 Tranche 4
March 1, 2017 December 31, 2019 Tranches 3 - 4
March 1, 2020 Tranche 3
December 31, 2020 Tranche 4
March 1, 2021 Tranche 4
March 1, 2018 December 31, 2019 Tranches 2 - 4
March 1, 2020 Tranche 2
December 31, 2020 Tranches 3 - 4
March 1, 2021 Tranche 3
December 31, 2021 Tranche 4
March 1, 2022 Tranche 4
March 1, 2019 December 31, 2019 Tranches 1 - 4
March 1, 2020 Tranche 1
December 31, 2020 Tranches 2 - 4
March 1, 2021 Tranche 2
December 31, 2021 Tranches 3 - 4
March 1, 2022 Tranche 3
December 31, 2022 Tranche 4
March 1, 2020 December 31, 2020 Tranches 1 - 4
March 1, 2021 Tranche 1
December 31, 2021 Tranches 2 - 4
March 1, 2022 Tranche 2
December 31, 2022 Tranche 3 - 4
March 1, 2021 December 31, 2021 Tranches 1 - 4
March 1, 2022 Tranche 1
December 31, 2022 Tranches 2 - 4
March 1, 2022 December 31, 2022 Tranches 1 - 4

Plan - RTSR awards
Figure 4. Valuations required for the 2023 proxy disclosure statement
Grant date Measurement dates Valuation type
March 1, 2017 December 31, 2019 Actual performance and stock price
March 1, 2020 Actual performance and stock price
March 1, 2018 December 31, 2019 Monte Carlo
December 31, 2020 Actual performance and stock price
March 1, 2021 Actual performance and stock price
March 1, 2019 December 31, 2019 Monte Carlo
December 31, 2020 Monte Carlo
December 31, 2021 Actual performance and stock price
March 1, 2022 Actual performance and stock price
March 1, 2020 December 31, 2020 Monte Carlo
December 31, 2021 Monte Carlo
December 31, 2022 Actual performance and stock price
March 1, 2021 December 31, 2021 Monte Carlo
December 31, 2022 Monte Carlo
March 1, 2022 December 31, 2022 Monte Carlo

Given the significant number of valuations that potentially need to be prepared, we strongly suggest starting to figure out who will be able to perform these analyses and how they will be done, as soon as possible. A finite amount of time will be available to perform these calculations after year-end and at a time when the valuation resources are already busy working on other things, including valuations of new grants for the current year. Valuations for prior measurement dates should be prepared now to reduce the burden after year-end. These earlier valuations will also allow companies to establish processes to prepare the valuations at year-end.

A version of this article appeared in Workspan on September 15, 2022. All rights reserved, reprinted with permission.

Authors

Senior Director, Retirement

Director, Retirement

Senior Director, Executive Compensation

Senior Director, Executive Compensation and Board Advisory (New York)

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