Share-based payment plans are an increasingly relevant feature of attractive employee remuneration and serve as an instrument for recruiting staff.
As the settlement of share-based payments (such as share options) occurs in the future, they are accounted for by measuring their fair value (FV). While a closed-form Black-Scholes formula is often sufficient for payment plans with only a few conditions, there are plan conditions that typically require a pathwise simulation and therefore entail the implementation of a Monte-Carlo simulation. [This is the case particularly for asymmetric payment profiles.]
Performance condition: peer group ranking
- So far, total shareholder return (TSR) conditions have dominated the market, in which the company's own share price development over the performance period was compared with the overall share price development of a defined peer group (e.g. the company's own share against an index such as the DAX or MDAX).
- More and more frequently, however, we observe that target achievement is based on the ranking within the peer group. The company's share price development over the performance period is compared for example with the price development of each MDAX 60 company and the ranking is then derived from that. Target achievement is then defined depending on the ranking and could, for example, look as follows:
- zero for a ranking below the first quartile
- 0.5 for a ranking between the first and second quartile
- 1.0 for a ranking between the second and third quartile
- 2.0 for a ranking above the third quartile
What are the challenges for FV measurement?
- An asymmetric payment profile requires a pathwise simulation. Special expertise is therefore required for implementing a Monte-Carlo simulation.
- Large volumes of market data are required for all peer group companies, which are time-consuming to prepare and analyse. Taking the dividends paid during the performance period into account is particularly challenging, which may need to be done during the final TSR determination, depending on the plan's structure.
- In particular, the correlations to be taken into account between the share prices of the companies to be included in the ranking lead to performance problems of spreadsheet programs for commercially available notebooks even with a small number of paths
Replacing the many MS Excel formulas with programming code in Visual Basic for Applications (VBA) leads to very good performance in terms of computing power, however requires special programming knowledge.
Non-market performance conditions: total compensation and sustainability components
- Share-based payment for which target achievement depends on several components, such as total shareholder return, EBITDA, ESG (environmental, social and governance), strike price, share price on the exercise date, etc., often involves a 'total cap'. This means that overall target achievement (total compensation) is limited to a maximum, for example five times the initially offered target amount.
As the cap is included in fair value measurement, non-market performance conditions such as ESG components must also be included in modelling.
- For sustainability components (ESG), estimating the transition matrix is particularly challenging, i.e. the expectation of a future 'change' from the current sustainability level to another. External providers are therefore frequently used for measuring the achievement of ESG targets.
Modelling liquidation preferences:
- For companies not listed on the capital market, commitments under share-based payment plans are usually subordinate to the liquidity preferences arising from the share classes of various financing rounds. Moreover, the IFRS 2 plans are frequently only exercisable upon occurrence of a triggering event (such as an IPO). The development of the company's value (corporate performance) at this point in time can be modelled by a Monte-Carlo simulation of the geometric Brownian motion. Using the simulated values, the fair values of option plans can be determined by means of a waterfall structure that reflects the liquidation preferences of the individual share classes.
- Apart from the precise reflection of the liquidity preferences, estimating a suitable volatility for the development of the company's value presents another challenge. This frequently requires resorting to market data of peer group companies, on the one hand, and also adjusting these for the respective leverage ratio, on the other.
These three examples illustrate the classic challenges of proper measurement of share-based payment plans:
- Determining volatilities for the company and peer group companies as well as their correlations based on historical share prices
- Implementing a Monte-Carlo simulation to reflect complex individual payoff structures and/or liquidity preferences. Using VBA can greatly improve performance through a greater number of simulation paths, smaller file size and much shorter calculation times.
- Preparation of the results for external and internal users, such as the accounting department, board, auditors, etc.
No matter how complex your IFRS 2 plan may be, we have many years of experience, the right tools for your company and the financial mathematics expertise to develop a customised solution for you, to simulate developments or to assist you with their presentation in the financial statements.
Source: KPMG Corporate Treasury News, Edition 113, July/August 2021
Authors: Ralph Schilling, Partner, Finanz- und Treasury- Mangement, KPMG AG; Sebastian Gammisch, Senior Manager, Finanz- und Treasury-Mangement, KPMG AG