Performance Share Plans: Valuation, Optimal Design, and Empirical Tests
Craig W. Holden
Indiana University Bloomington - Department of Finance
Daniel Sungyeon Kim
Peking University HSBC Business School
May 11, 2013
Performance share plans are an increasingly important component of executive compensation. A performance share plan is an equity-based, long-term incentive plan where the number of shares to be awarded is a quasi-linear function of a performance result over a fixed time period. Closely related are performance-vested share plans, which provides a fixed number of shares whenever a performance result exceeds a threshold goal. We begin by documenting the size and importance of performance share plans and performance-vested share plans. Next, 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). Next, 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) and that performance-vested share plans are not optimal. Next, we compare the actual plan parameters to optimal parameters. We conclude that a standard principal-agent model cannot rationalize observed performance share plans or observed performance-vested share plans. Finally, we use our new valuation formulas to estimate the value of a sample of performance share plans and performance-vested share plans compared to reported values on proxy statements. We find that in most cases our new valuation formulas are statistically and economically different. The policy implication is that FASB should require that grant date fair value be estimated using valuation formulas such as ours.
Number of Pages in PDF File: 51
Keywords: Executive compensation, Performance share plan, Performance-vested share plan, Optimal design
JEL Classification: G34working papers series
Date posted: November 18, 2012 ; Last revised: July 12, 2013
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