Understanding Performance Awards

Your long-term incentives may hinge on some form of performance metric, now that companies have been issuing performance awards in increasing numbers. Issuance of performance awards nearly doubled between 2006 and 2010, fueled by stock market volatility and increasing shareholder interest in seeing equity compensation tied to long-term return to shareholders.

Performance awards are performance-based stock grants awarded to management. They vest contingent on meeting common performance targets. Vesting may be based on meeting such company goals as total shareholder return (TSR), earnings per share (EPS), sales, return on assets, return on equity, and levels of customer satisfaction. In some cases, the targets are based on company performance relative to its peers.

Though they look and seem similar to other stock awards, it is important to recognize how performance awards differ from ordinary common stock grants.

1. There are generally two major types of awards: Performance Share Awards (PSAs) or Performance Share Units (PSUs). PSAs are issued at the time of grant, although possession takes place after performance target is reached. PSUs are issued when they vest based on meeting performance targets.
2. Performance can make or break the award.

Performance Metrics
Performance equity plans may be based on two types of metrics: market conditions or internal performance conditions. Market conditions are metrics tied to company stock price, while company internal performance-based conditions may be tied to meeting performance targets such as division profitability or another internal measurement.

In either case, it is important to understand what is expected in order to merit performance compensation. Some performance targets used for Performance Equity Plans may include[1]:

Taxation

1. Performance shares do not result in any taxable income at grant. Subject to ordinary income when specified targets are reached and shares (or cash) are then either released or delivered.
2. When shares are sold, here’s how it works: 2,000 shares of performance stock that vested on April 25 (company has March 31 year-end), when the company certified that it reached specified targets and the shares were released. The market price was $42 per share ($84,000 total). More than one year later, the stock is sold at $60 per share, minus commissions and fees of $500 ($35,500 net sales proceeds). Tax basis is $84,000 (value at vesting), and on a long-term capital gain of $35,500 ($120,000 – $84,000).

This is an illustration and you should consult your tax advisor for further information.

Planning Considerations
Additional equity compensation may tip the scales in company stock and create concerns about lack of portfolio diversification. It is important to understand how performance awards are integrated with your other forms of equity, such as Stock Options, Restricted Stock, Stock Awards, and Restricted Stock Units.

Don’t forget that dividends or dividend equivalents are a very attractive feature during the vesting period.

Timing can be an important consideration. You may have a narrow window within which to sell Performance shares, subject to blackouts. We can help you track all the nuances of your long-term incentive compensation and help to organize your strategy for divesture. We welcome your questions and comments. Please give us a call.

Click here to access our report, 5 Reasons to Like Performance Share (and One Reason to Think Twice).

Mr. Steege is President of SFG Wealth Planning Services, Inc. (SFG), a fee-only financial planning firm. Founded 15 years ago, SFG is dedicated to assisting senior executives and their employees with their complex stock-based compensation and planning challenges.