The selection, design, and implementation of a successful equity compensation plan can be a complex undertaking. There are two fundamental types of equity compensation instruments that can be issued to a participant: time-based and performance-based instruments. Performance-based awards and performance-based options are a trend that continues to be on the rise, not only among public companies, but even within privately owned companies.
A company who wants to include a performance-based equity program should spend some time to scope out the right performance target and the right equity vehicle to issue to the participants. The target should be realistic and achievable. If the target is too hard it might discourage the participants, if it too easy it will fail to align participants with shareholders. Further, consideration should be given not only to the difficulty of attainment, but also the difficulty of measuring the performance itself. Simpler is often better.
Performance awards are earned over a performance period with vesting contingent upon a pre-set target. The final number of shares vesting is conditional upon the achievement of the performance metric(s). In some cases, the participant has the potential to earn additional shares if the final performance exceeds expectations. Conversely, the participant can receive fewer or no shares if the goal falls below expectations or the target is not achieved.
At the end of the performance period (or when a performance milestone is met if allowed to be sooner), the company will determine the final performance payout. This goes back to the earlier statement that careful consideration should be applied when designing and adopting a performance-based plan. We recommend limiting targets that are too broad or too vague that might cause the performance period to be "undefined". For example, performance targets tied to achieving FDA approval, raising the next round of capital, or other broader milestones may create additional challenges and layers of complexities not only in the administration, but also with the expensing and financial reporting of the grants. Also, if participants feel that they cannot directly impact the goal, grants might be perceived negatively rather than as an incentive.
The design of the plan differs from company to company. One thing to keep in mind is that there cannot be shortcuts and there is no "one size fits all" plan.
Some of the most underestimated key issues when designing a performance-based plan are:
Do not underestimate plan communications to your participants. Be clear about the program's objectives, terms, and how the performance awards play into the overall mix of incentives granted to your company's participants. It will helpful to give an example or "what if" scenario to illustrate the potential of the final outcome.
Learn more about equity compensation and contact Armanino's team of experts with any questions you have.