Performance shares

What Are Performance Shares?

Performance shares are a form of equity compensation granted to employees, typically executives, that only vest and convert into actual company stock if specific, pre-determined financial performance goals are achieved over a defined period. These awards fall under the broader category of executive compensation and are designed to align the interests of the employee with the long-term shareholder value of the company. Unlike traditional stock options or time-based restricted stock units, performance shares directly tie the payout to measurable operational or market achievements.

History and Origin

The concept of linking executive pay more directly to company results gained traction over time, evolving from simpler salary and bonus structures. Performance shares were introduced in the early 1970s as an innovative form of incentive compensation. These early awards were often tied to targets such as cumulative growth in earnings per share over a multi-year period, commonly three years. Their emergence reflected a growing desire among companies to provide executives with a stake in the business that was contingent on demonstrated success, particularly during periods when traditional stock options might not have yielded significant value due to market conditions.⁶

Key Takeaways

• Performance shares are a type of equity compensation that grants company stock based on the achievement of specific performance goals.
• They are designed to align management's interests directly with the company's financial and strategic objectives.
• Common performance metrics include revenue growth, earnings per share, return on equity, or total shareholder return relative to peers.
• If performance targets are not met, the shares may not vest, or may vest at a reduced percentage.
• Performance shares are a prevalent component of modern executive compensation packages.

Interpreting Performance Shares

Interpreting performance shares involves understanding the specific metrics chosen by the company's board of directors and its compensation committee, the weight given to each metric, and the associated vesting schedule. A company might, for instance, set a target for a certain percentage increase in revenue over three years. If the company exceeds that target, executives might receive a maximum payout, while failing to meet a minimum threshold could result in no shares vesting.

The Securities and Exchange Commission (SEC) has increasingly emphasized the disclosure of the relationship between executive compensation and a company's financial performance. New rules adopted in 2022 require companies to clearly disclose how compensation paid to executives relates to the company's performance, including its total shareholder return and that of its peers. This aims to provide investors with better insight into whether executive compensation aligns with company results.⁵

Hypothetical Example

Consider "TechGrowth Inc.," a publicly traded software company. Its board of directors grants its CEO, Sarah Chen, 100,000 performance shares with a three-year performance period. The vesting conditions are tied to two equally weighted metrics:

1. Revenue Growth: Achieve a cumulative 30% revenue growth over three years.
2. Product Launch Success: Successfully launch and scale a new flagship product line, evidenced by achieving 500,000 active users within 18 months of launch.

The payout structure is as follows:

• Threshold (50% payout): 20% cumulative revenue growth AND 250,000 active users.
• Target (100% payout): 30% cumulative revenue growth AND 500,000 active users.
• Maximum (150% payout): 40% cumulative revenue growth AND 750,000 active users.

At the end of three years, TechGrowth Inc. achieves 32% cumulative revenue growth and reaches 550,000 active users for the new product. Based on these results, Sarah Chen would typically receive shares somewhere between the target and maximum payout levels, as defined by a pro-rata calculation within the company's equity plan documentation. If the company had only achieved 15% revenue growth and 100,000 users, no performance shares would vest, underscoring the risk/reward nature of these awards.

Practical Applications

Performance shares are widely used in modern corporate governance as a key component of long-term incentive compensation plans. They are particularly common for senior executives and key employees in public companies, often surpassing stock options in prevalence for executive grants.⁴ Companies use performance shares to:

• Align Interests: Directly tie executive compensation to the achievement of strategic and financial objectives, fostering a shared interest in the company's success.
• Motivate Long-Term Performance: Encourage executives to focus on sustainable growth and profitability over short-term gains, as the vesting period typically spans several years.
• Retain Talent: Provide a powerful retention tool, as the value of the award is realized over time and upon meeting specific goals, encouraging executives to remain with the company.
• Address Investor Concerns: Demonstrate to shareholders that executive pay is contingent on actual company performance, addressing criticisms of compensation that is perceived as excessive or unrelated to results.

These awards are often disclosed in public company filings with the SEC, subject to stringent accounting standards and transparency requirements.³

Limitations and Criticisms

Despite their intended benefits, performance shares, and performance-based pay in general, face several limitations and criticisms:

• Gaming Metrics: Executives may be incentivized to focus solely on the specific metrics tied to their performance shares, potentially leading to short-sighted decisions or even manipulation of financial reporting to meet targets. Research suggests that linking pay to specific, short-term targets can lead to unintended consequences, such as cutting spending on research and development or advertising to boost immediate profits, which can negatively affect long-term shareholder value.²
• External Factors: A company's financial performance can be influenced by broader economic conditions or industry trends outside of management's control. While some plans incorporate relative performance metrics (e.g., comparing against a peer group), significant market downturns can still result in no payout even if management performed well relative to adverse circumstances.
• Complexity: Designing and administering performance share plans can be complex, requiring careful selection of metrics, setting appropriate targets, and robust measurement systems. Changes in business strategy or unexpected market events can render pre-established targets inappropriate or unachievable.
• Discouraging Innovation: For non-routine tasks that require creativity or deep analysis, research indicates that performance-related incentives can sometimes be detrimental, potentially leading to a focus on hitting numbers rather than fostering true innovation.¹

Performance Shares vs. Restricted Stock Units

Performance shares and restricted stock units (RSUs) are both forms of equity compensation, but they differ primarily in their vesting conditions.

While RSUs provide value to the employee even if the stock price remains flat or declines (assuming it's above zero), performance shares require active achievement of defined objectives for any value to be realized. This distinction often leads companies to use performance shares for their most senior leaders to foster a direct link between executive compensation and measurable corporate success.

FAQs

How do performance shares align with executive compensation?

Performance shares align with executive compensation by making a significant portion of an executive's potential pay contingent on the company achieving specific strategic or financial performance targets. This incentivizes executives to make decisions that directly contribute to the company's success and, by extension, shareholder value.

What types of metrics are typically used for performance shares?

Common metrics for performance shares include financial measures such as revenue growth, earnings per share, return on equity, free cash flow, or profitability targets. Market-based metrics like total shareholder return (TSR), either absolute or relative to a peer group, are also frequently used. Operational metrics tailored to specific business goals, like customer acquisition or product development milestones, can also be incorporated.

Are performance shares taxed when granted?

Generally, performance shares are not taxed at the time they are granted. Instead, they are typically taxed when they vest and are delivered to the employee. At that point, the fair market value of the shares received is usually treated as ordinary income to the employee.

Can performance shares have a zero payout?

Yes, performance shares can result in a zero payout if the company or individual performance targets set by the board of directors are not met, or if they fall below a pre-defined "threshold" level. This risk is a key characteristic that differentiates them from time-based restricted stock units.