Restricted stock: the case for total shareholder return; Companies that adopt market-based and performance-based vesting conditions under FAS 123(R) can better reward high-level employees and create shareholder value--without increasing accounting costs--say three professionals.

• Author: Abrams, Daniel
• Position: Executive compensation - Financial Accounting Standards

In the wake of adopting FAS 123(R), some companies have shifted away from exclusively granting stock options toward exclusive use of restricted shares or a combination of the two. From 2003 to 2005, the prevalence of S & P 500 CEOs receiving both stock options and restricted share awards increased from 33.5 percent to 42.2 percent, according to an Equilar Inc. survey.

Clearly, companies are searching to improve equity plans by looking at a combination of options and restricted shares. However, for many senior executives there are better vehicles than simply a combination of these two familiar alternatives. Companies that design awards with market-based and performance-based vesting conditions under FAS 123(R) can better reward high-level employees and create shareholder value without increasing accounting costs.

In particular, under the former standard, APB 25, shares that vest based on market conditions ("market-based" awards) were subject in the U.S. to variable accounting. FAS 123(R) has eliminated this unfavorable accounting treatment. As a result, U.S.-based companies are joining those in the U.K. and Continental Europe in recognizing the advantages of market-based awards over service-based awards.

Companies like Time Warner Inc., Pfizer Inc., Campbell Soup Co., Duke Energy Corp. and Viacom Inc., among many others, are awarding or will be awarding market-based shares as part of long-term incentive plans to senior executives. The number of companies granting market-based and performance-based shares is expected to grow dramatically as companies seek to better align executive compensation to shareholder returns.

Equity-based compensation strategy usually involves six considerations: keeping accounting costs under control; minimizing the variability of accounting costs; providing perceived value to employees; retaining employees; creating incentives for employees to increase share value; and limiting the complexity of plan administration. The following analyzes why market-based shares--as a key component of long-term compensation to high-level employees--can further these objectives.

Market-based Share Awards

The two most common market-based share awards have the following structure:

Absolute awards, for which vesting depends on a company's own stock price or total shareholder return. This is usually structured as a price or return target or hurdle.

Relative awards, for which vesting depends on a company's total shareholder return (TSR) rank relative to a set of pre-defined peers, or an index of companies in a relevant industry or broader market. TSR is defined as the return on the company's stock, assuming reinvestment of dividends.

An example of an absolute award is one where shares are granted when the stock price is $20, and vest immediately upon the stock price averaging $25 for 30 consecutive trading days at any time within two years.

A relative award, in contrast, might vest at the end of two years, with the number of vested shares depending on the company's TSR rank among its peers as follows: beginning with a fixed target of 10,000 shares, if the company TSR as compared to the TSR of its peers is below the 25th percentile, then no shares vest; above the 25th percentile, an interpolated amount vests beginning at 50 percent of the target and capping out at 200 percent of target. Table 1 on this page shows the payout schedule using 15 peer companies.

With a relative TSR award, the number of shares that the employee will receive varies, depending on actual relative performance; however, the...