What Executives Need to Know About Performance Awards

A performance award is a grant of company stock or stock units, typically tied to a pre-determined metric or goal that is specific to the recipient or award itself. More often than not, the recipient is an executive. Interchangeably referred to as performance awards, performance shares, or performance units, similarities among performance stock awards (PSAs) can vary greatly from there.[1] Some act more like restricted stock, others are more like restricted stock units (RSUs). In fact, performance metrics can be tied to actual RSUs, and some are a breed of their own.

Bottom line, if you’re granted a PSA package, it’s especially important to read the fine print, and understand what must occur before you’ll vest in your award. Each award can be highly customized, so you’d do well to consult with an independent advisor or attorney skilled at deciphering performance award terminology.

Unpacking Performance Shares

Broadly speaking, performance shares are awarded to executives as part of a compensation package. Similar to other forms of equity compensation such as RSUs and stock options, PSAs offer executives the ability to personally profit from company stock, while also creating a stronger link between pay and performance.

PSAs differ, however. In lieu of a typical time-based vesting schedule that often only requires you to stay employed to receive the financial benefit, your PSA may require additional criteria be met. This is because PSAs, and the financial windfall that may follow, are often tailored to your role at the firm or the firm’s overall success. And PSAs may require you to meet or exceed specific business targets, such as Total Shareholder Return, EBITDA, EPS, sales, revenue, explicit industry or peer benchmarks, etc. If you do meet or exceed said targets, PSAs can result in a full, extra, or partial pay-off, depending on how well you’ve performed.

Beyond understanding your particular metrics, you’ll also want to read and understand what happens once you meet or exceed them, assuming you do. For example, how many shares will you receive, and when? Also, as we’ll cover further down, delivery isn’t always when you might assume, which can impact your tax planning if you’re caught unaware.

Why Do Companies Use Performance Awards?

Before we dive into the details, let’s talk about higher purposes for PSAs. Suffice it to say, performance shares and performance units can be more complicated and varied than your basic equity incentive program. So, why bother? Why not simply offer incentives to every employee, and move on?

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Simply stated, PSAs are meant to reward executives based on their contributions to a company’s objectives and overall progress in a measurable and congruent way. The more deliberately a company can structure its executives’ performance share metrics, the better it can align executive incentives with its particular values and vision. If the executives rise to the occasion, the business should thrive along with its share price, and everyone should win: shareholders, executives, the company, and its clients.

Thus, while typical RSUs and stock options can contribute to a company’s success, a well-designed PSA program can potentially drive success and efforts in a way other forms of equity cannot.

What Might a Performance Award Grant Look Like?

Next, let’s cover some of the logistics of PSAs. Again, there can be variations on every offer, so always read the fine print, which is more likely to be found in your grant agreement and notice than in the stock plan itself. But a performance award is generally issued with a target number of shares, an achievement timeline, its metric(s), and a minimum and maximum award. Minimum/maximum awards are typically based on how effectively you meet your metrics, such as whether you reach 0%, 50%, 100%, 150%, or 200% of your target within the designated timeline.

For example, a simple illustration may look like this:

• Target Shares: 5,000
• Timeline: 3 Years
• Performance Metric: Net Revenue
• Payout Thresholds
  • Minimum: 0% of Target
  • Maximum: 200% of Target

Following this example, if the net revenue target is reached within the 3-year timeframe, the executive will be awarded 5,000 shares of stock (or subject to the plan document, the cash value of the award). If the company’s net revenue meets or exceeds the maximum, the executive receives 200% of the target, or 10,000 shares. Alternatively, if the minimum threshold is not reached, no shares will be awarded.

What if you reach the end of the timeline without meeting your performance metric(s)? Some grants include a secondary, time-based vesting clause, similar to a standard RSU. Otherwise, the award expires and is deemed worthless. Once again, it’s worth checking your agreement to understand the terms.

How Are Performance Shares Taxed?

There is no taxable event when performance shares are granted. A taxable event occurs once you meet a performance metric and shares are delivered to you. This often occurs after the board meets to certify the attainment of said goal. At that time, the value of the delivered shares is taxed as ordinary income subject to Social Security and Medicare tax.

Using our example, let’s assume you have 5,000 target shares and achieved the maximum performance payout of 200%. Let’s also assume, when the performance metric is confirmed and your shares are delivered, the stock price is $50 per share. In this example, the taxable income is:

• Shares Earned: 5,000 shares x 200% = 10,000 shares
• Taxable Income: $50 per share x 10,000 shares = $500,000

If we assume a statutory Federal income tax withholding of 22% and Medicare withholding of 1.45%, that’s a total of 23.45%. (We’ve omitted Social Security, assuming you’ll exceed the annual limits.)

• Withholding Requirement: 23.45% x $500,000 = $117,250
• Shares Withheld to Cover Tax = $117,250 / $50 = 2,345 shares
• Shares Deposited into Your Investment Account: 10,000 – 2,345 = 7,655 x $50/share = $382,750

Watch the Withholdings: Similar to RSUs, just because there’s been a tax withholding, doesn’t mean it will cover the full taxes due on the income. The statutory withholding may not be enough, given your personal financial circumstances. Consult with a tax professional as you go, and if more taxes are due, consider selling additional shares immediately upon receipt.

About That Delivery Date: Compared to RSUs, the timeline for delivering performance shares can be less predictable. With RSUs, there’s usually a clear vesting and delivery schedule you can count on for estimating taxes and engaging in financial planning. With performance award delivery, it may take time for your company to verify whether you’ve met your metrics. This may delay the delivery, and push your taxable event into the calendar year following the year you met your metric(s). The uncertainty makes planning for the tax hit a bit more difficult.

Performance Shares and Personal Financial Planning

Performance awards can be an attractive executive benefit that allows you to profit handsomely. Maybe even more important, they may be tied to business metric(s) over which you have more direct control, such as EBITA or EPS, versus less manageable factors such as stock price.

PSAs may also be combined with more traditional RSUs and/or stock options that vest over time, to round out a robust executive compensation package. This can offer an executive the unique combination of greater certainty from RSUs as well as additional upside from performance shares.

At the same time, PSAs may warrant a higher level of upfront and ongoing financial planning and investment management. For example:

• 10b5-1 Plan Considerations: Advance planning for executives with PSAs includes understanding the terms of the grant, and considering whether to add future delivered PSAs to a 10b5-1 plan. Adding shares to a 10b5-1 plan can mitigate the risk that shares will be delivered during an executive black-out period where the executive may not be able to sell.
• Tax Payments: It’s important to complete tax planning at delivery, and to cover any additional taxes due beyond the statutory withholding.
• Concentration Risks: You may want to consider whether/how to sell shares out of an overly concentrated position, to mitigate portfolio-wide investment risk. This can trigger additional tax planning.
• Tax Management: If you’re in a high-income year in the year PSAs vest, you might take additional tax-mitigation steps, such as exercising and holding ISOs (versus selling them), or bunching charitable contributions into a donor-advised fund (perhaps donating in-kind appreciated shares).

You and Your Performance Shares

There’s considerably more we could cover here, but we’ve touched on the highlights of performance shares and why they can result in a financial windfall in the right environment. Besides being a financial boon for the executive, they can align your executive interests with those of your company, your fellow shareholders, and your customer base. It may also give you a little extra incentive to do what already comes naturally to you as a key executive: deliver your best efforts to another job well done.

While you focus on that, please let us know if we can answer additional questions about your company’s performance stock awards.

[1] The terms “performance shares” and “performance awards” are often used interchangeably. While the nuances may differ, we will assume in this article that performance awards and performance shares mean the same thing.

This material is intended for informational/educational purposes only and should not be construed as investment, tax, or legal advice, a solicitation, or a recommendation to buy or sell any security or investment product. The information contained herein is taken from sources believed to be reliable, however accuracy or completeness cannot be guaranteed. Please contact your financial, tax, and legal professionals for more information specific to your situation.