Do you understand the quantitative effects?
Shareholders and investors view forms of share-based payment as an opportunity to harmonise the interests of executive boards/management with their own. In this regard, the economic sense and any quantitative effects on the balance sheet and income statement strongly depend on the individual design of such remuneration models.
Share-based payment within the meaning of IFRS 2 always applies if settlement for goods or services received is rendered in company shares or the amount of any cash payment is linked to the performance of company shares. The structure of a variable remuneration programme enables corporate management to incentivise long-term corporate goals, to tie senior staff individually to the company and also to lift the attraction of the company as employer through the use of financial incentives. Diverse options to structure such programmes can nevertheless lead to very complex contract structures. For instance, performance conditions such as limit or threshold values regarding share price development can have a significant impact on the fair value of the instruments issued to the beneficiaries. For the relevant proper measurement of such instruments, an understanding of simulation methods and the application of option pricing models (for instance Black-Scholes, Cox-Ross-Rubinstein) is often required in addition to access to market data in order for this task to be routinely assumed by Corporate Treasury. Further, it may also be the task of Treasury to develop possible hedging strategies for share-based payment programmes, to anticipate any effects from such programmes on corporate liquidity and to maintain the necessary funds to match due dates.
A KPMG in-house assessment of the DAX 30 shows that each of the groups represented rewards parts of its workforce with at least one form of share-based payment. Of the companies considered, more than EUR 1.9 billion was recorded as (personnel) expenses for share-based payment programmes in the period under review, with EUR 0.8 billion attributable to cash settlement and EUR 1.1 billion to equity settlement programmes using own shares. At the individual company level, it was possible to observe the effects on earnings; this extended from income of EUR 270 million through to expenses of more than EUR 600 million.
DAX 30 companies currently mostly use share-based payment programmes in the form of a cash settlement (62%). This means that the beneficiaries have the prospect of a cash settlement that depends on the share price. The increased use of this structure is not least due to the currently high level of free liquidity. It is therefore not surprising that the balance of provisions recognised for cash-settled share-based payments amounted to approx. EUR 2.6 billion as of financial year-end 2018.
In contrast to equity settlement, the decision in favour of a cash-based structure nevertheless results in the need to determine the fair value of the instruments issued at each reporting date, thus entailing potentially greater earnings volatility over the entire period. Further, according to company disclosures the most frequently used vesting condition is a market condition (market-based vesting condition), which must be directly taken into account in the fair value modelling (44%) according to the requirements of IFRS 2 Share-based payments. Generally, these terms are structured as relative performance targets meaning that the company's own share price, or alternatively total shareholder return (TSR), must outperform a specifically selected peer group of competitors or a selected equity market index over a predefined period.
In addition to linking to market conditions, companies also have the option to link the value of issued instruments to company-specific performance indicators such as revenue, EBITDA or qualitative targets such as sustainability indices using non-market performance conditions (non-market vesting condition). DAX 30 companies use this option intensively and incorporate up to four such performance indicators into each programme.
Through the implementation of share-based payment programmes, the intention is to relay the individual intentions and strategies of the group to staff using financial incentives. Nevertheless, the goal of increasing company value over the long-term, which has to be considered the primary goal from the shareholder viewpoint, offers plenty of scope for economic misinterpretation. For a start, market conditions are rarely economically structured. Ever more frequently one sees targets that are not linked to the cost of capital of the company (instruments issued are already at the money or even in the money at issue), so that even negative company performance can result in an entitlement to additional compensation for the beneficiaries.
Where rational owners might assume such incentives to be misaligned, the HR department may be tracking other targets. The long-term commitment and motivation of staff and their identification with the company may be paramount. It is therefore all the more important for the interest groups involved (particularly the divisions concerned and shareholders) to deal with the quantitative effects of the envisaged structure in advance, thus avoiding conflicting incentives.
Source: KPMG Corporate Treasury News, Edition 96, November 2019
© 2020 KPMG AG Wirtschaftsprüfungsgesellschaft, ein Mitglied des KPMG-Netzwerks unabhängiger Mitgliedsfirmen, die KPMG International Cooperative (“KPMG International”), einer juristischen Person schweizerischen Rechts, angeschlossen sind. Alle Rechte vorbehalten.