Executive Summary
Given the broad prevalence of TSR-based PSUs in the market(1), a key question is whether to determine the number of PSUs to grant based on the Monte Carlo value (“MCV”) or grant date stock price.
While TSR-based PSUs must be expensed and disclosed based on MCV, companies can choose whether to determine the number of TSR-based PSUs to grant based on MCV or grant date stock price.Therefore, companies must ask the question: to MCV or not to MCV?
The Monte Carlo model is a widely accepted financial model similar to the Black-Scholes model, however it applies to TSR-based PSUs while Black-Scholes applies to time-vested stock options. When determining how many TSR-based PSUs to grant, companies must choose between the following:
- Monte Carlo Value Approach: Use Monte Carlo value per share, similar to how companies use the Black-Scholes value to determine the number of stock options to grant. The Monte Carlo value per share may be a premium or discount to grant date stock price, depending on the award design (and is most often a premium to grant date stock price given typical TSR-based PSU designs in the market)
- Grant Date Stock Price Approach: Use stock price on the date of grant (or a recent average closing price), similar to how companies determine the number of shares to grant for other full value awards (e.g., RSUs or PSUs tied to non-market-based metrics such as revenue or earnings)
| Approach |
Key Takeaways |
Monte Carlo Value Approach
(Used by ~1/3 of companies(2)) |
- Aligns intended grant value with both proxy-disclosed grant date fair value and accounting expense (as proxy-disclosed/accounting values must be based on the number of shares granted multiplied by the MCV per share)
- Results in granting fewer shares (if MCV is a premium to grant date stock price) or more shares (if value is a discount) vs. using grant date stock price
|
Grant Date Stock Price Approach
(Used by ~2/3 of companies(2)) |
- Number of shares to grant determined by grant date stock price, but results in difference between intended target grant value and disclosed/accounting value given disclosed/accounting value must be based on MCV
- Consistent with share determination approach used for time-vested RSUs and PSUs tied to non-market-based measures, thus number of shares granted is equivalent to such awards when intended grant value is also equivalent (e.g., 50/50 split between RSUs and PSUs)
|
Given the selected approach can affect both the number of shares granted and the grant date fair value, it is important that boards and management consider the trade-offs associated with each approach. This CLEARthinking article outlines the implications and pros/cons of both methods.
1) 55% of mid-cap and 70% of large-cap companies used relative TSR as a performance metric in their 2023 LTI plan, based on The ClearBridge 200: Long-Term Incentive Plan Report (2023)
2) Source: The 2022 NASPP Equity Administration Survey, 2022
Considerations of Share Determination Approaches
| Approach / Implications(1) |
Pros |
Cons |
Monte Carlo Value Approach
- Number of shares to grant increases when MCV is a discount to grant date stock price, and decreases when MCV is a premium
- Grant value disclosed in the proxy compensation tables and accounting expense is equal to the intended grant value
|
- Monte Carlo considers the range of possible award outcomes and probability of achieving the range, resulting in a more precise estimate of the value of the award
- Aligns intended grant value with proxy-disclosed grant date fair value and accounting expense, avoiding potential external scrutiny in situations where the disclosed fair value may be greater than the disclosed target value*
- Aligns with typical approach for determining the number of stock options to grant (i.e., BlackScholes value)
|
- May be difficult for participants to understand, diminishing perceived award value:
- For example, when using relative TSR, MCV is typically a premium over grant date stock price; results in fewer shares granted vs. RSU awards with the same intended value
- Award design may become overly complex if desire is to narrow gap between Monte Carlo value and grant date stock price (see next page)
|
Grant Date Stock Price Approach
- Number of shares to grant does not fluctuate based on MCV
- Grant value disclosed in proxy and accounting expense is greater than intended grant value when MCV is a premium to grant date stock price, and lower when MCV is a discount
|
- Aligns with approach for determining number of shares to grant for full value awards that do not use a market condition (e.g., RSUs); number of shares to grant is equivalent to such an award with the same intended value
- Easy to communicate to plan participants
|
- Inconsistency between intended grant value and proxy-disclosed fair value and accounting expense
- Typically results in higher proxydisclosed grant value/accounting expense (given MCV is typically a premium to the grant date stock price) which may lead to greater shareholder scrutiny*
|
*Shareholder Scrutiny Case Study: In 2023, Apple faced a shareholder lawsuit because the grant values disclosed in the Summary Compensation Table (which must incorporate Monte Carlo) were higher than the intended grant values described in the CD&A: Apple had used the Grant Date Stock Price Approach to determine the number of TSR shares to grant. A shareholder claimed Apple had therefore overpaid its NEOs. While the lawsuit was dismissed, it emphasizes the importance of understanding share determination approaches and the need for clear rationale / disclosure.
Reducing the Gap Between Monte Carlo Value & Grant Date Stock Price
Certain variables can significantly influence the Monte Carlo valuation (shown below), and several can be adjusted through award design features to bring the MCV closer to the grant date stock price.
| Variable |
Impact on Monte Carlo Valuation |
Adjustment Opportunity |
| Stock Price Volatility
|
- Higher volatility (magnitude of stock price movements) generally results in a higher Monte Carlo valuation given high-volatility stocks carry the possibility of higher returns
|
- None, outside of company’s direct control
|
| Stock Price Correlation (for relative TSR only)
|
- Higher correlation (e.g., the company’s TSR is projected to move in tandem with comparators) lowers the Monte Carlo valuation given outperformance is more difficult when a company’s TSR is high if the comparator group’s TSR is also high
|
- Can indirectly reduce gap between MCV and grant date stock price through selected comparator group (e.g., use custom group with higher stock price correlation)
|
| Award Payout Leverage |
- Higher payout leverage (e.g., max at 200% of target vs. 150% and/or minimum at 75% of target vs. 50%) increases the Monte Carlo valuation given the increased potential payout; can increase valuation even further for highvolatility companies
|
- To reduce gap between MCV and grant date stock price, can reduce max payout opportunity
- Similar impact with minimum payout (i.e., can reduce gap by reducing minimum payout)
|
| Performance Goals |
- The more rigorous the goals (i.e., the more difficult they are to achieve), the lower the Monte Carlo valuation given it’s less likely the performance requirements will be met
|
- To reduce gap between MCV and grant date stock price, can set performance goals that are harder to achieve (e.g., max goal at 90thpercentile of comparator group vs. 75th
|
Companies can also consider other design features to reduce the gap between MCV and grant date stock price (e.g., implement a post-vest holding period, which introduces a liquidity discount and thereby lowers the fair value of the award). Nevertheless, any design decisions made to impact the MCV should also be assessed relative to a company’s business/compensation objectives (e.g., reducing the max payout to 150% of target may reduce the MCV, but may also reduce the perceived value of the award).
What about ISS Voting Policies? ISS does not have a specific policy or viewpoint on the share determination approach used. However, when valuing performance shares for the pay-for-performance tests, ISS will use the target number of performance shares multiplied by the stock price at grant to determine the grant value of the award. Therefore, a company’s selected share determination approach can indirectly impact ISS’ say-on-pay evaluation, given it impacts the target number of TSR-based performance shares.
Which Grant Approach Should Companies Use?
Using the MCV approach for determining the number of shares to grant ensures that the intended grant value aligns with the fair value and accounting expense of the award. At the same time, it often results in granting fewer shares than the grant date stock price approach (if MCV is a premium to the grant date stock price), and can therefore diminish the perceived award value and be more difficult for plan participants to understand.
Thus, when deciding on the share determination method, companies should balance the following:
- The desire for the award value to align with the intended target value, and the impact on the accounting expense and potential for external scrutiny when the fair value of the award is different from - and possibly higher than - the intended grant value
- The desire for simplicity and complete internal understanding of the share determination approach
Ultimately, boards and management have to decide what is more important when granting TSR-based PSUs: to have a grant that more accurately reflects the intended value, or to have a more straightforward grant that participants will more easily understand.
