We’re entering the annual reporting season when executive pay comes under scrutiny. Large payouts are normally fuelled by company share awards, but how they’re managed behind the scenes receives little attention. Here’s a brief overview.
Share awards are most appropriate for companies with stable, rather than volatile, share prices. Options are a different beast, and we’ll save them for another day, but the intention is the same – to pay participants by providing them with company shares in a few years’ time. Where do these shares come from? They could be new ones issued by the company. Or they could either be recycled – shares bought back and held by the company itself – or ones bought and held in an employee benefit trust (EBT).
We’ll assume that an executive is awarded 1,000 shares for delivery in three years’ time. If the share price is £1 when the award is made, and the company decides to fund it in full, it could pay £1,000 into the EBT. The trust then buys the shares in the market and sits on them for three years, at the end of which it transfers the shares to the employee. We’re looking at high pay, so if the share price has gone up to, say, £1.70, the award will be worth £1,700. What the company has done is minimise risk by hedging the share price – the pay element was £1,000 and the £700 share price gain will have been funded not by the company, but by the market. More companies are now making this distinction in their annual reports.
But HMRC sees things differently. Since it would be inequitable to demand tax before people receive the means to pay for it, the 'taxable event' occurs when the shares can be sold. This approach was adopted when defining the 'Single Figure of Total Remuneration' published in annual reports. Both would regard pay here not as £1,000, but as £1,700.
Companies don’t tend to show the impact of income tax and national insurance. Factor these in, and the executive will receive shares worth 70 per cent (or £879.75) of the £1,255.85 cost to the company. This is much more efficient than if a £1,000 cash bonus had been paid instead – the executive would then have received only 45 per cent (£517.50) of the £1,115.50 outlay. Corporation tax also strengthens the business case, but this too tends to be overlooked – because within companies, internal budgets are pre-tax, and in the UK, the external focus tends to be on pre-tax profit, rather than earnings.
Even if the share price falls, awards can still be better value than paying cash upfront. Why? Because, in practice, they normally have a service condition attached, typically that executives lose their award if they resign before they receive the shares. And some inevitably will. The share awards of classic long-term incentive plans (LTIPs) carry additional conditions based on the company performance. Chances are that this won’t turn out to be good enough to enable all the shares to be transferred, so what happens to those that end up remaining in the EBT? The trust deed prevents them from being returned to the company, but they can be put towards the next award, which reduces the cash needed to fund it.
This means that, unlike with immediate payments, the company effectively gets part of its money back – the award has insured it against another risk: that of worse-than-expected outcomes. What’s more, the number of resignations is fairly predictable. And provided that performance conditions are reasonably challenging, only some of the LTIP shares will vest. Both of these can be estimated in advance, so fewer shares need to be bought in the first place, which saves on funding costs while still allowing awards to be hedged in full.
There are quirks. The expenses recorded for share awards depend on factors such as the type of performance condition, and they don’t necessarily match the cash cost. That can distort profit and loss account reconciliations. And the published number of shares in issue might omit those in the EBT – on the grounds that the EBT is a separate legal entity, run by independent trustees.
Share plans straddle several disciplines (such as pay, company law, accounting and financing, personal tax and corporate tax) and within companies, professions with internal clout such as finance, company legal, and human resources often regard them as peripheral. This lack of champions causes problems. Some directors (including those on remuneration committees) seem to have only a superficial understanding of how they operate – as evidenced by those who adjust out the cost of share plans from underlying earnings figures, even though such costs are incurred every year.
The example above outlines the most prudent way of funding awards – how companies actually go about this can make a significant difference. If annual reports went into more detail, we’d know more about management attitudes – and the benefits of share awards might become better appreciated.