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August 21, 2023

Share-based remuneration – what is there to be scared of? Part 1

In this blog, and two following, we consider share-based remuneration (SBR).  SBR is generally talked about as if it were a dark art; best left alone unless it is fully understood. In truth, it is not anywhere near as complex or dangerous as some would have us believe.

The purpose of this blog is to help demystify SBR and consider how it should be analysed from a practical standpoint.  A second blog (Share-based remuneration – what is there to be scared of? Part 2) will examine just how big an issue it actually is and how relevant it is on a macro and micro scale. And in a final blog, we will look at the issue in the context of UK small caps.

What is it?

SBR comes in two main (and broad) forms – share options and share grants – typically, but not necessarily, dependent on certain performance criteria being met.  While there are some differences, the basic issues and challenges with regard to reporting and analysis are for all intents and purposes the same.

Why use SBR?

SBR is used for two reasons, and they are worth recapping.

The first is that it is a means to pay for something, using shares or options as a currency.  After all, companies typically use shares to buy other companies, so why not do that to pay for someone’s time and commitment. It can even be seen as a financing decision, along the lines of the company paying all cash and taking on some debt or paying some shares and not taking on debt.

The second reason, or rather set of reasons, relates to incentivisation and alignment of employee, shareholder, company and management interests.  Quite how effective this is has been the subject of much debate and research; suffice to say it does appear to work but not necessarily in every case.

Is it a cost?

It is now almost universally accepted that SBR is a cost that should be reflected in some way in the income statement.  It was introduced on that basis into International Accounting Standards with IFRS2 in 2004 and into US GAAP with FAS 123R in 2006.

At the base level, employees take share options or other share-based remuneration with the intention of obtaining the benefit after they vest or become exercisable. This issuance of shares is a cost to shareholders because they are diluted; even though no cash has moved or changed hands, the proportion of future profits that can be attributed to a single share has diminished.

Even if no shares are actually created, the fact that the company has made a commitment to undertake certain actions is a cost.  To look at it another way, consider the idea that instead of providing an employee with an option the company could create that option and sell it to someone else. We could take that money and give it to the employee, although this would lose the employee incentivisation element of the process.

How is it calculated and accounted for?

The calculation of the cost of SBR is a complex matter, and not entirely accurate.  It is typically based around somewhat esoteric formulae and methodologies (including binomial models, Monte Carlo simulations and formula such as the Black-Scholes-Merton model), with assumptions that are open to criticism. In general, the price of the option goes up with the time to vest and the volatility of the underlying asset (share). There is broad agreement that these approaches produce a tolerable outcome. As with much in the world of financial accounting and analysis, this broad acceptance is possibly not matched by broad understanding.

The cost is calculated on the issue of the initial instrument/agreement and is spread across the period until the vesting date, even if the share price collapses and the vesting or exercise of the instrument becomes a remote possibility.  The cost is not recalculated.

Much of the value in options on issuance is due to uncertainty, and in the end the actual cost depends to a considerable extent on the final share price.  It is therefore unsurprising that the final realised cost to the shareholders of delivering X shares after Y years does not equal the estimated market value of the options at issuance in year 0.  In fact, it would be surprising if it ever did.

If share prices fall and the options don’t get exercised, there has been an accounting charge but no actual impact.  If the share price rises dramatically, the cost to wider shareholders from the new share issuance is likely to be considerably more than the cost of the options – because their shares have gone up in value, the amount of value delivered to employees by shareholders has increased.

If it is only an estimate, can I rely on it?

The argument sometimes surfaces that SBR is an estimate, so can or should be ignored; this is fallacious.   Plenty of other costs and value movements are reflected in the balance sheet and income statement. From work in progress, to pension costs, to warranties, to foreign currency exposures, the accounts are awash with judgements and shifting of income and expenditures across period ends.

The error doesn’t matter! (that much)

It is easy to get lost with this error.  It could well be argued that the actual cost should be better reflected or disclosed with recalculation of the cost over the vesting period or after the shares have been issued. However, it is important to keep focus on what we are actually trying to achieve with the analysis.

If we are looking at business performance (margins, returns on capital etc.), then we have to think in terms of what was required to achieve the outcome – this included the SBR priced at market value when given to the employee in return for their employment.  If we were to ask management to repeat the performance, ceteris paribus they would have to pay the staff the same total value – regardless of whether our end result has been an over- or under-calculation.  There could be some debate as to whether the value of the share-based payments is the same in the eyes of the payee and the payor, but that is not a debate that progresses our understanding any further here.

If we are looking at valuation, then we should be thinking in terms of what will be required to achieve the performance again.  Where the actual cost has been lower than the original calculation, we can’t base a valuation on a partial cost of labour – staff will demand the full market rate whether that is paid in cash or options, or private health care and company cars.  Where the actual cost has been higher, looking forward we should only assume the costs/rewards required to make the employees do the work, not the historical amount that they have actually received.

 

 

Death spirals of share issuance?

One rabbit hole that investors should avoid – although it seems one particularly attractive to UK investors – is that a falling share price just leads to companies issuing more shares.  Some schemes are set up like this; most aren’t.  Typically, when the share price collapses, the shares end up not being issued, and the merit for management in issuing more vaporises as staff do not attribute value to new ones.

We believe that this is often seen as an issue because of senior executive schemes topping up to ensure management ‘get what they deserve’.  The frequency and impact of such situations might not be as great as some fear, but they do remind us that SBR is as much an indication of a wider problem as anything else.

We are looking here at share-based remuneration rather than share-based payments.  There is, however, a major, and justifiable, concern when considering share-based payments for acquisitions – when companies commit to a specific value paid in shares, only to see the number of shares to be issued spiral up as the share price spirals down over the weeks, months and years following the deal.

It is worth noting that ‘share based’ does not necessarily mean ‘share paid’, and where the payment is made in cash based on the value of shares or there is an element of optionality in payment, the US and International standards diverge.  For UK investors, the key point is that, under IFRS, where cash is the means of payment the balance sheet impact is seen in the liabilities rather than the equity.

There are also differences between the US and international standards in the way that tax – in effect deferred tax – is dealt with. Over the time to vesting, this affects the accounting tax charge but not the tax paid, as this is determined by share prices et al at the time of exercise. Suffice to say, rightly or wrongly, deferred tax is generally where most institutional investors’ interest tapers to insignificance.

What should I do?

Having reached the conclusion that SBR is both relevant and, to a greater or lesser extent, reliable, we can consider how to deal with it in our analysis.

It is easy to assume that having accounted for SBR in the income statement, our work is done.

It is not.

SBR in the income statement is a measure of the impact of shares currently in their vesting period, spread over the vesting period.  It does not reflect the share dilution for those shares that still could be issued and for which options/conditional grants were created in the time before.

How should we capture ALL the cost?

Prior to IFRS2 and FAS123R (now ASC718), the recognition of SBR was not through the income statement but through the dilution to shares in issue.  This does not capture the option value or the opportunity cost in the share-based payments where the options or grants were not in the money or where performance or other such criteria may have yet to be met, even though that may be the likely outcome.

Should we recognise the cost of SBR in the numerator or the denominator? Or both?  It may seem odd to take the hit twice but there is sense in this.  The dilution on the shares principally reflects the historical dilution – the number of existing claims.  The post-SBR income reflects the impact of options and awards etc granted in the year.

The problem now lies with the fact that the diluted shares figure may reflect some of the dilution from the year just gone, and that, because the SBR charge is calculated when the scheme is established and then that charge spread, this figure includes some charge for costs incurred in prior years.

It would appear that either way we look at it, we are wrong. But then again, we should remember that the charge itself is only an estimate – like so many other items in the financial statements.

It has become commonplace for share-based payments to be adjusted out of EBITDA, EBIT and earnings per share figures.  It is also the most significant overall adjustment in public company accounts.

However, the dominance of electronic data feeds, such as Bloomberg, Refinitiv, FactSet and S&P, as the source of information for professional investors and the way that analysts receive guidance from companies have together meant that the figures that are most widely discussed are the ‘adjusted’ figures, not the ‘reported’ figures. This proves problematic not only in directly assessing the performance and value of a company with SBR, but also in making comparisons between companies.

However, for all the finger wagging that comes from commentators, most analysts would prefer to have their own adjusted, adjusted figures, but the practicalities and fractured economics of investment research stand in their way. There is nothing to stop investors adjusting the adjustments for themselves.

Do I have to?

SBR is a cost to shareholders, so is technically relevant to any shareholder.  Its measurement and accounting are far from precise, but it is but one of many estimates in the financial statements and we are better to be roughly right than precisely wrong.  Hopefully this blog will have made clear that, for the most part, SBR is not as complex or as challenging a matter as many make it out to be.

So we no longer have to worry about whether we can deal with it correctly, but must still consider what there is to deal with.  This is the subject of our next blog.

Ian Robertson

irobertson@progressive-research.com

 

This communication is provided for information purposes only, and is not a solicitation or inducement to buy, sell, subscribe, or underwrite securities or units. Investors should seek advice from an Independent Financial Adviser or regulated stockbroker before making any investment decisions. Progressive Equity Research Ltd (“PERL”) does not make investment recommendations.

Opinions contained in this communication represent those of PERL and/or our affiliates at the time of publication and PERL does not undertake to provide updates to any opinions or views expressed. PERL does not hold any positions in the securities mentioned in this communication, however, PERL’s directors, officers, employees, contractors and affiliates may hold a position,  and/or may perform services or solicit business from, any of the companies or related securities mentioned.

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