Restricted stock units, Performance stock units and Employee stock options – What is the right choice for a long term incentive plan?

 

Long-term incentives (LTIs) are a valuable part of total compensation packages that help in delivering rewards while enabling employees to focus on desired future objectives. There are varying types of LTIs — cash based or equity based — that work as strategic compensation vehicles to promote long-term retention and alignment with company goals. In this article, we focus on the prevalence and trends of the three equity-based instruments; namely, restricted stock units (RSUs), performance stock units (PSUs) and employee stock options (ESOPs).

 

A quick look at the definitions:

  • RSUs are typically time-based restricted stocks/units, granted at face value, which vest based on a predetermined length of time, with certain conditions, such as continued employment.
  • PSUs are just like RSUs, with an exercise price equal to the face value of the stock, but they have an added condition of vesting linked to achieving company or other business performance targets (in addition to continued service).
  • ESOPs, on the other hand, allow for the purchase of stock at a fixed price over a specified period. The exercise price (the price an employee has to pay to convert the option into a share) is typically equal to the market price on the date of grant but may be less than (with discount) or greater than (with premium) the market price on the date of grant.

Instrument prevalence over the years

RSUs continue to be the most prevalent LTI instrument used by listed companies. Mercer’s All-Industry Compensation Survey results indicate that approximately 59% of the companies that have an LTI plan use RSUs. RSUs offer a significant discount to employees compared with the prevailing market value of the shares. And unlike an appreciation-based award, a restricted stock will still have value upon vesting even if the per-stock value decreases. This makes RSUs the most favourable retention instrument from both employee and employer perspectives as they guarantee some reward to employees and do not result in much dilution. (Companies can offer a similar value of reward with a relatively fewer number of shares.)

Given this premise, when we compare the last five years of data, the decrease in usage of RSUs may come as a surprise. (Figure 1 below indicates a marked decline in the use of RSUs — from 65% in 2018 to 59% in 2021.)

 

Figure 1. Prevalence of RSUs over the years

Fig 1

Source: Mercer’s India Total Remuneration Surveys.

No. of responses (N): 256 (2021), 296 (2020), 290 (2019) and 290 (2018)

 

One of the main drivers of this trend is the strong reservations from proxy advisors, institutional investors and shareholders, who aren’t thrilled with the idea of employees — particularly executives — receiving LTIs without significant pay at risk. This is leading companies to explore PSUs and ESOPs for their executives.

 

Demystifying PSUs

PSUs are limited mostly to executive and senior management levels, as can be seen in Figure 2. The performance criteria set are usually those at company level, which senior management employees can influence. A few common performance metrics include relative total shareholder return, revenue and EBIDTA. Although some companies have an all-or-nothing approach for vesting, others have a minimum threshold below which no grants vest. Once the threshold is met, vesting increases proportionately up to a maximum defined cap.

 

Figure 2. Prevalence of PSUs across levels

Fig 2

Source: Mercer’s 2021 India Total Remuneration Survey.

N: 134 (heads of organizations), 227 (executives), 164 (management) and 88 (professionals)

 

From a shareholder perspective, companies must seek approval on the maximum number of units that will be granted upon vesting under the LTI plan. Companies that define PSU grant plans as a “maximum award” must set expectations clearly as employees might feel they’ve received less than what has been communicated. (Since most of the time, the achievement will be less than the maximum.)

 

PSUs typically have cliff vesting rather than instalment vesting, as shown in Figure 3. This reduces their attractiveness for yearly earning potential. Hence, some companies grant RSUs in addition to PSUs to support retention and ensure predictable annual wealth creation.

 

For companies that have instalment vesting of PSUs, the number of vested units in a year are typically computed based on the target achievement of the previous year. Therefore, an annual grant plan for instalment-based vesting is quite unlikely in a PSU scenario. In a single year in which grants of multiple years vest, there could be confusion regarding the criteria being used to compute the vested number of grants.

 

Figure 3. Types of vesting

Fig 3

Source: Mercer’s 2021 India Total Remuneration Survey.

N: 80 (PSUs), 146 (RSUs) and 52 (ESOPs)

 

In India, currently, there is still some scepticism regarding PSUs in the minds of proxy advisors, shareholders and employees. The main reason for this could be the lack of clear visibility into the performance criteria being set or the belief that the targets aren’t aggressive enough. As more companies explore the PSU route, clearly outlining performance metrics will be a key requirement from shareholders and employees alike.

 

Comprehending ESOPs

ESOPs are much easier to understand because the earning potential is linked to the stock appreciation. ESOPs are also viewed positively by investors and shareholders as employees have “skin in the game”, and there is an element of pay at risk. However, it requires significant investment from employees exercising these options, making it less attractive at junior levels.

 

At times, even after exercising, executives may be reluctant to hold onto the stock for long. They may choose to sell their options with marginal upside to meet other financial obligations, to repay loans they took to exercise the stocks or simply because the market is too volatile due to other macroeconomic factors. This defeats the purpose of executives having skin in the game, as the goal would be for employees to continue holding the stock for relatively longer periods of time.

 

There is also the risk of stock options going underwater (that is, the market price at the time of exercise becomes lower than the exercise price, which would make purchasing the stock via secondary market cheaper than exercising the option). We saw this following the global financial crisis in 2008, when ESOP plans of many listed companies went underwater and did not result in any wealth creation.

 

Having a longer exercise period, post vesting, allows some of these risks to be managed effectively in an ESOP plan. Employees have enough time to be able to arrange for funds, and stocks can bounce back to higher prices. (Stocks that hit their lowest-ever prices at the beginning of the COVID-19 pandemic have bounced back within the past two years, and some have reached all-time highs.)

 

Conclusion

Although each instrument has its advantages and disadvantages, the best instrument or mix of instruments to use will depend on proper employee segmentation, effective communication and transparency. Ultimately, the appropriateness of an LTI vehicle will vary from company to company and will also depend on which stage a company is in (as illustrated in Figure 4 below). No LTI vehicle is superior to another, and it typically requires an overall assessment of culture, company strategy and goals to select the right mix, amounts and vesting mechanics.

 

Figure 4. LTI vehicles vary based on business life cycle

Fig 4

 

Like what you read and want to know more? Please reach out to Debasmita Das | debasmita.das@mercer.com  or Vinayak Vayuvegula | vinayak.vayuvegula@mercer.com


Authors

 

Vinayak Vayuvegula

Senior Associate | Executive Compensation & Rewards Design

Mercer India

 

Debasmita Das

Principal | Executive Compensation & Rewards Design Practice Leader
Mercer India


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