This article discusses how to determine the fairness of an equity-based compensation plan. Fairness, as discussed in this article, is established from a financial point of view. It requires an analysis of the value of the equity-based compensation awarded and measurement of its impact on shareholder value using quantitative and qualitative methods.
Fairness is a consideration in the implementation of a new plan, capital transactions, mergers & acquisitions, plan modifications, restructuring, or shareholder disputes. Evaluating the fairness of a plan assists in design, improves effectiveness, supports legal requirements, and helps avoid other problems.
The importance of fairness
Fairness is an important issue for any equity-based compensation plan. The award of equity compensation represents a transaction, in which equity interests in a company are “sold” and payment is made in the form of services from participants. As with any sale of an equity interest, an analysis of the associated economic costs and benefits is required to determine the overall fairness of the transaction. Additionally, with an equity compensation plan, the need exists for an assessment of the reasonableness of the equity awarded, taking into account the overall compensation structure, participants’ positions and responsibilities, industry practices, market conditions, and other factors.
The definition fairness from a financial point of view
The fairness of an equity-based compensation plan is established from a financial point of view. This means determining if the value of the equity provided to participants, and impact on shareholder value, is fair and reasonable. Ideally, in exchange for granting the equity-based compensation, shareholders would expect to receive an equivalent or greater value in return. The plan could be designed to reduce costs, lower risk, or address other factors that would have a positive impact on shareholder value. Equity compensation plans are frequently implemented to provide both shareholders and participants the opportunity to share in and achieve a higher equity value than could otherwise have been achieved without a plan.
Under a typical equity compensation plan, the company provides a share of its equity value to participants in exchange for services. These services could range from continued employment to the accomplishment of specific business performance goals. This exchange of value between the company and the participants is a primary focus of a fairness analysis. In addition, an evaluation of the plan terms, contingency features, types of equity granted, and other design elements are also factored into the fairness analysis.
Ultimately, fairness is a question of perspective, namely “fair to whom?” While an equity compensation plan is established for the participants, fairness is an issue that is principally focused on the impact of the plan to the equity interests of existing shareholders.
How is fairness determined?
Fairness can be determined using several approaches, including measures based on objective (quantitative) and subjective (qualitative) analysis.
Objective measures are the primary basis for determining fairness. Objective measures use data and analysis to evaluate the financial characteristics of the plan and determine the relative value exchanged between shareholders and participants. Objective measures also incorporate analysis of market or industry benchmarks and comparisons. Objective measures consider the impact of the specific terms and features of the equity granted and can provide an evaluation of the overall reasonableness of the compensation levels of participants.
Qualitative measures are a secondary basis for determining fairness and can be used to support quantitative measures. Qualitative measures include individual or collective perceptions of the plan, expected fit with company culture and operations, levels of equity awarded, or participation requirements. Qualitative measures can also include an assessment of the expected effectiveness of the plan or its potential for accomplishing the intended goals.
Objective (quantitative) measures of fairness
Objective measures of fairness address the potential change in existing shareholder interests created by an equity compensation plan. This change can result in either dilution (a reduction) or accretion (an increase) to shareholder interests. Most plans are expected to reduce shareholder interests, although there can also be the potential for accretion. For purposes of this article, the change in shareholder interests resulting from an equity compensation plan is referred to as dilution.
Dilution is expressed as either a percentage or value amount. Percentage dilution and value dilution can be, and usually are, different. For example, an equity plan might represent a certain change in percentage ownership and could result in a different percentage change in value.
Percentage dilution results from the fact that if a certain number of equity compensation units are issued, they reduce the percentage ownership held by existing shareholders. For example, if 1,000 shares are outstanding, and 100 new shares are awarded in an equity compensation plan, the percentage ownership of the existing shareholders declines from 100 to 91 percent. With equity compensation plans, percentage dilution is usually expressed on an “as if, fully converted basis” which is based on the premise that all units will be issued and converted to their corresponding share equivalents.
Value dilution relates to the potential change in value per share resulting from an equity compensation plan. For example, if the value of equity in a company is $10 per share and an equity compensation plan is implemented with a value of $1 per share, then shareholder equity value declines by 10 percent to $9 per share.
From a fairness perspective, dilution in value is the primary consideration. Value dilution measures the actual economic impact of the plan to shareholder value; in an equity compensation plan, it’s usually a stronger measure of fairness than the percentage change in ownership.
Quantitative methods used To determine fairness
There are several quantitative methods that can be used to analyze the fairness of an equity compensation plan. The methods used will depend upon the specific facts and circumstances of a particular situation. However, a list of some of the methods that may be used in a fairness analysis is summarized below:
- Net present value
With this method, an equity compensation plan is evaluated on a financial basis as a business investment. The cost, time period, potential benefits, risk, and expected return associated with the plan are analyzed. The net present value of the plan, taking into account these factors, is calculated. The present value resulting from that calculation is used to determine shareholder dilution for the plan.
- Returns analysis
Another method is to evaluate the expected percentage rate of return (also referred to as the internal rate of return or IRR) from the equity compensation plan. This is similar to the net present value method described above; however, the result of the returns analysis is the expected percentage return on investment resulting from the plan.
- Differential analysis
Under this method, the value per share is determined (a) on an “as is” or “status quo” basis without the plan and (b) a “pro forma” basis with the plan in place. Changes in the terms of the plan could also be evaluated. This approach is often referred to as the “with and without” method. This method is particularly useful when the plan includes performance and vesting requirements designed to change business performance. The difference between the “as is” and the “pro forma” value becomes the measure of dilution to shareholder value.
Comparative analysis is another method for evaluating an equity compensation plan. With this approach, features of the plan are compared with a peer or industry group of similar companies. Items compared could be percentage and value dilution, levels of participation, types of equity compensation granted, total compensation levels, or other factors.
Qualitative measures of fairness
Qualitative factors can be important to the overall success of a plan and can support quantitative measures of fairness. Qualitative measures vary depending upon the situation and could include items such as surveys, market research, competitor analysis, interviews, or benchmarking. The goal of qualitative methods is to develop conclusions regarding issues such as:
- Is it the right type of plan for the culture of the company?
- Can it help accomplish intended goals?
- Will employees and shareholders support the plan?
- How well is it coordinated with other compensation and benefit plans?
- What process was used to develop the plan?
- Is there a reasonable sharing of the risks and rewards between shareholders and participants?
- Is this the right time to implement the plan?
- Is it the best alternative to achieve the intended goals?
A plan that’s not designed to address these and other qualitative measures of fairness might not achieve its objectives and result in unfavorable levels of dilution by creating a cost with no benefit to shareholders.
Ways to manage dilution and fairness in an equity compensation plan
In an equity compensation plan, there are a number of items that can be used to manage dilution to shareholder value and fairness, including:
- Vesting Requirements
Service, performance, or market vesting requirements can reduce dilution and enhance fairness. Service vesting enhances shareholder value by reducing the cost of employee turnover. Performance vesting tied to achieving objectives relating to improvement in value drivers such as growth, financial performance, or risk would be expected to increase shareholder value. Vesting based on market returns helps manage dilution by setting threshold targets for increases in shareholder value.
- Design Features
The specific type, terms, and features of equity compensation granted impact value, dilution, and fairness. The variety of equity compensation that can be awarded is broad and can range from stock options and restricted stock to phantom shares, profits interests, and appreciation rights or other instruments. The specific effect on value will depend upon the design of the plan and is beyond the intended scope of this article.
- Sharing of Risk/Rewards
A basic principal of fairness in an equity compensation plan is that both participants and shareholders have risks and rewards. This means the participants have a potential risk of loss of and opportunity for reward from the equity value. This is generally an implicit feature in the nature of an equity compensation plan and is also addressed through the type of equity compensation provided, contingency features such as vesting, and other plan design factors.
Fairness, from a financial point of view, is a key issue in any equity based compensation plan. Careful analysis is required to determine the dilution created by the plan, and the evaluate the impact on shareholder value. An accurate assessment, using concepts and methods presented in this article, will help support plan and establish the potential to accomplish its intended goals.