Though relative Total Shareholder Return ("TSR") programs offer no direct line of sight for the executive to chase the business goal, such programs continue to remain the most common metric within an issuer's performance-based equity program.  In designing these programs, a common question is how payouts could be adjusted if the issuer's stockholders realize negative returns and lose money during the measurement period.  The answer to that question is this "Tip of the Week."

Background

• Generally.  TSR measures the return a stockholder would receive if he or she bought one share of stock at the beginning of the measurement period, accumulated dividends throughout the measurement period, and then sold the common stock at the end of the measurement period (i.e., the "measurement period" is typically a 3-year period).  There are two types of TSR formulas: absolute and relative.
• Absolute TSR Formula.  An absolute TSR formula is calculated as follows: TSR = [(Ending Price - Beginning Price) + Dividends]/Beginning Price.  Whether an absolute TSR award pays out depends upon a comparison of the issuer's absolute TSR to predetermined goals.  For example, if the issuer's absolute TSR equals or exceeds x%, then the percentage of the target award earned would equal y%.
• Relative TSR Formula.  A relative TSR formula is initially calculated the same as an absolute TSR formula, except that whether a payout occurs under a relative TSR program is a function of the issuer's TSR ranking or ratio compared to the TSR ranking or ratio of the issuer's peer group.  Consider the below as an example.  If the issuer's TSR rank relative to its peer group is at the 91st percentile, then the payout would be 200% of the target shares subject to the award.

Issue with Negative Returns

Should management be rewarded when absolute TSR is high but relative TSR is low (i.e., a reward to reflect gains realized by the stockholders even though the issuer's stock price did not outperform the issuer's peer group)?  Should management be rewarded when absolute TSR is low but relative TSR is high (i.e., a reward to reflect the issuer's stock price outperforming the issuer's peer group even though the issuer's stockholders lost value, in other words, it could have been worse but for the management team's skill and efforts).

Addressing Negative Returns

There are a variety of ways to address negative returns within a relative TSR program, including:

• Elimination.  Eliminate payouts when absolute TSR is negative over the measurement period (consider whether the reverse should apply - trigger a payout when absolute TSR is high but relative TSR is low).
• Cap the Opportunity.  Implement a cap to the payout opportunity when absolute TSR is negative over the measurement period (consider whether the reverse should apply - same as above).  When absolute TSR is negative, a cap would typically limit the payout at the target level.
• Downward Adjust the Payout.  A modifier could be implemented to downward adjust the payout when absolute TSR is negative (consider whether the reverse should apply - trigger an upward adjustment to the payout when absolute TSR is positive).

Closing Point

It is common for compensation committees to initially denominate an executive's award in dollars (e.g., the executive is awarded a target TSR equal to $300,000 as of the date of grant), and then convert that dollar amount into a number of shares covered by the relative TSR award.  A design issue is whether the dollar amount should be converted into shares on the basis of grant date stock price or grant date "fair value" (the latter determined using a Monte Carlo simulation).  If the conversion is based upon grant date "fair value," then keep in mind that implementing any of the above design considerations will decrease the "fair value" of the award, thus having the direct result of increasing the number of shares subject to the award (i.e., using the above example, a lower fair value will require more shares to equal $300,000).