Editor's Note: Joseph Bachelder is special counsel in the Tax, Employee Benefits & Private Clients practice group at McCarter & English, LLP. The following post is based on an article by Mr. Bachelder, with assistance from Andy Tsang, which first appeared in the New York Law Journal. Research from the Program on Corporate Governance on long-term incentive pay includes Paying for Long-Term Performance by Lucian Bebchuk and Jesse Fried (discussed on the Forum here).

There is an important difference between the price paid for a business enterprise and the intrinsic value of that enterprise. As Benjamin Graham said, "Price is what you pay; value is what you get." Warren Buffett has made himself and many others wealthy by understanding this difference and making investments accordingly.

Part I of this post looks briefly at the intrinsic value versus the market price (sometimes the latter is referred to as market value or market cap) of a publicly traded corporation. Part II looks at current design of long-term incentives awarded to the management of such corporations. These awards tend to be tied to short-term increase in the market price of the corporation's stock. Part III suggests a way in which long-term incentive awards might be tied more to generators of long-term value of the corporations awarding them.

Click here to read the complete post...

" /> Editor's Note: Joseph Bachelder is special counsel in the Tax, Employee Benefits & Private Clients practice group at McCarter & English, LLP. The following post is based on an article by Mr. Bachelder, with assistance from Andy Tsang, which first appeared in the New York Law Journal. Research from the Program on Corporate Governance on long-term incentive pay includes Paying for Long-Term Performance by Lucian Bebchuk and Jesse Fried (discussed on the Forum here).

There is an important difference between the price paid for a business enterprise and the intrinsic value of that enterprise. As Benjamin Graham said, "Price is what you pay; value is what you get." Warren Buffett has made himself and many others wealthy by understanding this difference and making investments accordingly.

Part I of this post looks briefly at the intrinsic value versus the market price (sometimes the latter is referred to as market value or market cap) of a publicly traded corporation. Part II looks at current design of long-term incentives awarded to the management of such corporations. These awards tend to be tied to short-term increase in the market price of the corporation's stock. Part III suggests a way in which long-term incentive awards might be tied more to generators of long-term value of the corporations awarding them.

Click here to read the complete post...

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Tying Incentives of Executives to Long-Term Value Creation

Joseph Bachelder is special counsel in the Tax, Employee Benefits & Private Clients practice group at McCarter & English, LLP. The following post is based on an article by Mr. Bachelder, with assistance from Andy Tsang, which first appeared in the New York Law Journal. Research from the Program on Corporate Governance on long-term incentive pay includes Paying for Long-Term Performance by Lucian Bebchuk and Jesse Fried (discussed on the Forum here).

There is an important difference between the price paid for a business enterprise and the intrinsic value of that enterprise. As Benjamin Graham said, “Price is what you pay; value is what you get.” Warren Buffett has made himself and many others wealthy by understanding this difference and making investments accordingly.

Part I of this post looks briefly at the intrinsic value versus the market price (sometimes the latter is referred to as market value or market cap) of a publicly traded corporation. Part II looks at current design of long-term incentives awarded to the management of such corporations. These awards tend to be tied to short-term increase in the market price of the corporation’s stock. Part III suggests a way in which long-term incentive awards might be tied more to generators of long-term value of the corporations awarding them.

I. Intrinsic Value Versus Market Price

The Meaning of Intrinsic Value

For purposes of the following discussion, an enterprise’s “intrinsic value” means its inherent value as an ongoing business. A financially based definition could be expressed as the present value of the enterprise’s estimated “free” cash flow over a period, for example, of 10 years (or even longer). As stated by Buffett, “It is the discounted value of the cash that can be taken out of a business during its remaining life.” In some cases it may be appropriate to add to this value the value of certain current assets.

However one defines it, “intrinsic value,” as used in the following discussion, means “what you’ve got” value and not the price at which an enterprise might sell if all the owners decided to sell.

Price of Publicly Traded Stock

The price of a publicly traded stock reflects many factors in the minds of buyers and sellers. Stock price of a publicly traded corporation fluctuates, sometimes dramatically, often based on circumstances unrelated to the intrinsic value of the enterprise itself. These circumstances may include the state of the economy, price levels generally in the stock markets, the state of the industry of which the enterprise is a part, events in other parts of the world and many other factors…most of these generally outside the control of management of the enterprise.

Share ownership in a publicly traded corporation is in constant turnover. (The average length of time a share of stock listed on the New York Stock Exchange is held is measured in months—and this excludes high-frequency traders). This makes it very difficult, in the case of most public companies, to identify the future profile of its ownership over a meaningful period of time. Not only is future price of stock subject to variables that are unforeseeable and beyond the control of management but, in addition, the profile of the ownership that will be willing to support and grow the price of the stock in the future is uncertain.

II. Long-Term Incentives Versus Long-Term Value Creation

The distinction between intrinsic value and market price of an enterprise raises a number of questions regarding long-term pay of executives:

  • Do current long-term incentive compensation programs of public corporations award their senior management for taking steps to increase the intrinsic value of those corporations? Or do these programs instead motivate management to optimize the enterprise’s stock price without taking into account the impact of their performance on the intrinsic value of the enterprise?
  • Can long-term incentive compensation be designed to take into account not only growth in stock price but also those factors that generate growth in intrinsic value?
  • What should be the time horizon for the earn-out of long-term incentives?

Formulas Used in Long-Term Incentives

Market Price

Today, the long-term incentives awarded to senior executives of publicly traded corporations are, to a substantial extent, tied to the market price of the employer’s stock. This, of course, is true of stock options which without increase in the stock price from date of grant (assuming exercise price is grant date price) will produce no value for the holder. A significant portion of performance shares today are tied to performance targets based on increase in stock price. A performance standard frequently used today for performance shares is total shareholder return (TSR). TSR measures the difference in market price of a share of stock between two points in time, generally, and adds to that the value of dividends paid during that period (sometimes the calculation of TSR assumes that the dividends are reinvested in the stock).

Financial Metrics

In contrast to the price-driven incentives noted above, less than half of long-term incentives awarded to senior executives of publicly traded corporations are tied to growth in financial metrics, which are generators of intrinsic value. Such metrics include profit-based metrics (e.g., net income and earnings per share (adjusted)) and capital efficiency metrics (e.g., return on equity and return on capital (“capital” in this context takes into account both equity and long-term debt)). Growth in revenue also may support growth in intrinsic value provided it does not negatively impact on profitability.

In a letter to Berkshire Hathaway’s shareholders, contained in the 2010 Annual Report, Buffett said, “Market price and intrinsic value often follow very different paths—sometimes for extended periods—” and then he added, “but eventually they meet.” The author of this column agrees with the first part of Buffett’s statement but has a question as to the meaning of “eventually they meet.” Over an extended period of time the market price for an enterprise’s stock and the intrinsic value of the enterprise may be very different. Even if they meet at certain points in time, they will diverge again (unless convergence coincides with a merger or other acquisition of the enterprise). We don’t know when (or whether) (or for how long) they will converge (before diverging again). To the extent stock price and intrinsic value converge, it is because intrinsic value, among other factors, is driving price, and not vice versa. Accordingly, long-term award systems should be tied to financial metrics more than they are today. [1]

Earn-Out Periods for Long-Term Incentives

A second crucial feature of a long-term incentive award is the period of time over which it is earned out. Most performance share awards in public corporations today are tied to relatively short performance periods (the majority are three years or less). [2] Stock options generally have terms of 10 years (although some have shorter terms). These options typically are earned out (i.e., vest and become exercisable) over periods of much less than 10 years (a three- or four-year earn-out period is typical).

Conclusion as to Design and Earn-Out in Current Long-Term Incentive Practices

Thus, most long-term incentive awards do not have targets that encourage growth in intrinsic value of the enterprise and very few of them contain an earn-out period that extends for more than a fraction of the period needed to measure whether long-term value has been created in the enterprise. Stock price is a reflector of many factors, not a generator of long-term value. Two observations in this regard:

  • growth in intrinsic value is a generator, over the long term, of market price growth; and
  • growth in market price itself is not a generator of intrinsic value. The one begets the other but not vice versa.

Following is a plan designed to tie the award earn-out to growth in intrinsic value for a period coincident with long-term value creation.

III. A Long-Term Performance Plan Tied to Long-Term Value Creation

An example of such a plan would be one under which “Career Performance Credits” are awarded each year to participating executives based on the achievement for that year of specified financial performance targets. These targets, which would be set at the beginning of each year, might be based on: (i) growth in net income; (ii) growth in return on capital; and (iii) growth in revenue (without negative impact on profitability).

Achievement of one of these targets for a given year would result in a Career Performance Credit equal to one percentage point to be applied as described in the next paragraph. Achievement of all three targets in a given year would result in credits totaling three percentage points. [3]

The Career Performance Credits would be applied to provide a life-time annuity to the executive, with fixed annual income to be determined as follows. The Career Performance Credits (each a percentage point) would be totaled and the executive’s Covered Compensation would be multiplied by the percentage represented by the accumulated credits. The executive’s Covered Compensation would be his or her average annual cash compensation (salary plus annual bonus) over the period of his or her participation in the plan. Following is an illustration of how this would work.

Assume a 50-year-old chief executive officer is paid $1.5 million in current cash compensation (salary plus annual bonus) and that such compensation grows at the rate of 3.5 percent a year. If all three targets were achieved each year over a period of 10 years, the executive would have accumulated 30 Career Performance Credits. The executive’s Covered Compensation for that 10-year period would be approximately $1.76 million. The start date for the executive’s receiving the lifetime annuity would be at age 60. The annuity, in this example, would provide a fixed annual payment of approximately $528,000 (30 percent of $1.76 million ). (A joint-and-survivor annuity could be elected, in which event the fixed annual payment for the joint lives would be reduced to an actuarially equivalent amount.)

Forfeiture. The Career Performance Credits made to the account of a participant would be subject to forfeiture if the executive were terminated by the employer for cause or voluntarily left without good reason. Following a termination of employment, forfeiture also would occur if the executive violated restrictive covenants such as confidentiality, non-competition and non-solicitation of employees or customers of the employer. Confidentiality generally is a lifetime covenant. The other covenants typically continue for a stated period of time (time periods vary; they generally are in the range of six months to two years).

Taxation. If the Career Performance Credit plan is not a funded plan the credits to the accounts of participants would not be taxable to them. Participants would be taxable on receipt of the annuity payments. What if the plan is funded by an irrevocable trust? It still would not result in taxability to a participant until the annuity payments are received by the participant if either of the following two circumstances applies:

  • The assets are held in a trust that constitutes a “rabbi trust” for tax purposes; this means the assets of the trust are subject to the claims of the employer’s general creditors; [4] or
  • The assets in the trust are not subject to the claims of the employer’s general creditors (such a trust often is referred to as a “secular trust” to distinguish it from a rabbi trust), but the participant’s Career Participation Credits (and claim to trust assets) are subject to a substantial risk of forfeiture within the meaning of Internal Revenue Code section 83(c)(1). For example, the conditions listed in the paragraph above headed “Forfeiture,” taken together, likely would constitute a “substantial risk of forfeiture” within the meaning of Code section 83(c)(1)). On the other hand, at some point the aggregate risks of forfeiture may diminish to just one or two that do not longer constitute a substantial risk for this purpose. (For example, if the only remaining risk of forfeiture was a violation of a covenant to preserve confidentiality, it is unlikely that this risk alone would constitute a substantial risk of forfeiture under Code section 83(c)(1).) [5]

The trust funding the Career Performance Credits could provide that if and when the principal in the account held for the participant becomes taxable to the participant (that is, taxable prior to the participant’s receipt of the annuity payments) there would be a distribution of an amount equal to the taxes to the participant in respect of such principal amount. [6]

Conclusion

Today, practices under long-term incentive plans favor stock price as the determinant of what participants realize under such awards. In using price as the determinant, long-term incentive plans are using a reflector (price) instead of the real generators of long-term value. Further limiting the impact of such awards on the creation of long-term value in the enterprise is the earn-out period for such awards, typically not more than three or four years.

The column suggests a form of long-term incentive award that would be directly tied to long-term value creation. It is, of course, only one example. There are many ways in which long-term incentives can be tied more directly to creation of long-term value than they are under current practices.

Endnotes:

[1] TSR is sometimes used as a modifier in a formula in which financial performance is the primary metric (when so used, TSR often is “relative TSR,” meaning the employer’s TSR compared with the TSR of a comparative group of companies). It is noted that stock price is always embedded in a stock award since increase (or decrease) in the stock price impacts on the ultimate value of the award.
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[2] In contrast, there are incentive plans such as plans adopted by Goldman Sachs and by Exxon Mobil that are for longer periods. The original grant of restricted stock units to Timothy Cook at Apple, when he became CEO, was composed of two earn-out periods; one being for five years and the other for 10 years. (This award was subsequently modified and the earn-out periods were significantly shortened.)
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[3] If one or more of the three targets was not achieved in a given year, there could be a “make- up” opportunity for that target. Such “make-up” opportunity could be realized if, for example, cumulative growth over a stated period (such as five years or 10 years) turned out to be at least equal to what the growth would have been if each annual target had been achieved in each year over the period.
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[4] The rabbi trust has been a popular funding vehicle for non-qualified deferred compensation plans since the IRS ruled in the early 1980s that an irrevocable trust established by a congregation for its rabbi did not result in immediate federal income tax consequences because the trust’s assets were subject to the claims of the congregation’s general creditors. Under the ruling, the assets in the irrevocable trust continued to be treated as part of the general assets of the congregation. See PLR 8113107 (Dec. 31, 1980). In Revenue Procedure 92-64, 1992-33 I.R.B. 11 (Aug. 17, 1992) the IRS issued guidance as to a model trust for use as a rabbi trust.
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[5] Taxability to the participant of the employer’s contributions to the secular trust is determined under Code sections 402(b) and 83 (cross-referenced in section 402(b)). Treasury Regulation section 1.83-3(c) contains the IRS’s more detailed definition, with examples, of what constitutes a “substantial risk of forfeiture.”
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[6] If the executive were taxed on the principal amount in the account, the executive would receive subsequent annuities tax-free to the extent attributable to principal previously taxed. In such circumstance, under Code section 72, annuity payments would be treated as partly a non- taxable return to the executive to the extent attributable to principal previously taxed to the executive. See Code section 72(b)(1) and regulations thereunder.
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