Performance Share Plans: Valuation and Optimal Design

Abstract:     
Performance share plans are an increasingly important component of executive compensation packages. A performance share plan is an equity-based, long-term incentive plan where the number of shares to be awarded is quasi-linear function of a performance measure over a fixed time period. A special case is a performance-vested share plan, which provides a fixed number of shares whenever a performance measure exceeds a threshold goal. We derive closed-form formulas for the value of a performance share plan or a performance-vested share plan when the performance measure is: (1) a non-traded measure following an Arithmetic Brownian Motion (e.g., earnings per share), (2) a non-traded measure following a Geometric Brownian Motion (e.g., revenue), or (3) the price of a traded asset following a Geometric Brownian Motion (e.g., a stock price). In a principal-agent setting, we solve for the optimal design of a performance share plan that maximizes outside shareholder wealth while accounting for the incentive effect on executive effort. We find that the optimal performance share plan is uncapped (has no upper bound), that the optimal slope of the payoff function balances the marginal incentive effect against marginal cost, and that performance-vested share plans are not optimal.

Number of Pages in PDF File: 48

Keywords: Executive compensation, Performance share plan, Performance-vested share plan, Optimal design

JEL Classification: G34

working papers series