A growing number of companies are making stock grants that base your profit on more than just your continued employment or an increase in the company's stock price. As companies take a portfolio approach to stock compensation, particularly at the executive level, you can expect grants of "performance shares" along with standard restricted stock (or RSUs) and stock options.

The common feature of performance share grants is a specified goal or metric that must be achieved.

These grants come in a much greater variety than stock options or time-vested restricted stock. The structure and details of these grants are so flexible and vary so much that your grant will almost certainly be different in some way than the grants of your friends at other companies. While the structure (and even the definition) of performance share grants can vary, the common feature is a specified goal or metric that must be achieved before you can profit from the grant.

Usually, more details appear in your grant agreement than in your stock plan. To maximize the value of performance shares, you need to explore these details of the grant's structure more than you do with standard time-vested restricted stock or stock options.

Alert: The potential upside of these grants can be more generous than it is often believed to be. As noted by an article in the magazine workspan, with the use of realistic stock-price increases and holding periods, payouts from performance-based grants at target levels can be a "better deal" than options for executives (i.e. the performance grants can have a higher after-tax value).

How Performance Shares Differ From Restricted Stock

In grants of restricted stock, shares are issued up front at grant, but you do not own them outright until the restrictions lapse at vesting, and thus you cannot sell or transfer the shares until then. Standard restricted stock units (RSUs) are similar, except that the shares are not issued into your actual possession until the vesting occurs. Under both restricted stock and RSUs, vesting usually happens after a specified length of employment (in this article series, the phrase "restricted stock" includes RSUs unless RSUs are specified as well).

Performance shares are not issued up front and are usually part of a long-term performance or incentive plan (LTIP). You earn the payout in shares by meeting targets that are either absolute or relative to the performance of your company's peers. Technically, these grants can be in the form of performance stock awards (PSAs), which are similar to restricted stock, or performance stock units (PSUs), which are similar to restricted stock units. Both vest or deliver the shares upon the meeting of performance goals. Often these grants are called simply performance shares or performance awards without a differentiation between PSAs or PSUs. When in the form of performance units, each unit has a designated dollar value, with payment in stock, cash, or a combination of both. This article series focuses on performance share plans that pay out or vest shares of company stock.

These performance plans may have other design features that are structured to meet company strategic plans, such as a measurement period (e.g. a three-year cycle). Even after the shares are paid out for meeting the pre-established performance goals, the shares can then include time-vesting rules that require continued employment. As explained below, common performance targets are based on the stock market or on other company goals, such as total shareholder return (TSR), earnings per share (EPS), sales, return on assets, return on equity, and levels of customer satisfaction.

Example: Instead of granting you 2,000 shares of restricted stock that vest 25% a year on the anniversary of the date when your employment started, your company grants you 2,000 performance shares that will result in 2,000 shares if the earnings per share (EPS) of your company grow by 10% per year or cumulatively by 30% after three years.

It has become common for performance share grants to have multiple goals and a sliding scale for share payout. The following example shows results in shares at the end of a three-year cycle with two separate metrics, based on (1) earnings per share growth and (2) relative TSR:

Table of PSU award targets

Restricted Stock Can Be Performance Shares

Not every company clearly distinguishes between true performance shares and restricted stock that is contingent on performance. Restricted stock and RSUs can have vesting features that are similar to targets for paying out performance shares. With performance-vested or performance-contingent restricted stock, the shares are issued up front, giving you voting rights and dividends (but not with RSUs). The shares are held in escrow until the reaching of the target triggers vesting.

With performance-accelerated restricted stock, the shares will vest after a certain time, but they can vest earlier if specific targets are met. For these grants, the goals can be highly customized and are sometimes based on internal milestones in product development and sales. For example, at Vertex Pharmaceuticals, the vesting of restricted stock is accelerated upon the achievement of goals linked to market approval for a new drug, aggregate net sales on a different drug, and the start of clinical trials for another drug. (See page 26 of their 2011 proxy statement to read a detailed breakdown of goals for what the company calls performance-based restricted stock.)

Grant Terminology Varies

Companies also refer to restricted stock with performance vesting features as "performance shares." In company disclosures and communications, the line between these types of grants is often blurred. Companies sometimes create their own unique terminology. One example of this is in the excerpt below from the proxy statement of a technology company (boldface is our emphasis):

The compensation committee granted restricted stock to members of senior management that vest only if a specified performance goal is achieved. We refer to these grants as "performance shares." The number of performance shares that vest depends on the percentage of achievement of a three-year cumulative EPS target. We refer to these as "target performance shares." An additional number of performance shares (equal to 25% of the target performances shares) will vest if at least 106% of the performance goal is achieved and the named executive officer remains employed by the company through January 2019. We refer to these as the "overachievement performance shares."

Why These Grants Are Becoming More Common

Your company's stock price may not always accurately reflect business performance. Investors want equity compensation to be earned for reasons beyond just higher stock prices or your continued employment. Though stock options lead to profit only when the stock price rises, you still receive the gains if the stock price has failed to outperform the market index or the stock performance of competitors. With standard restricted stock, even if the stock price goes down, the grants still have value as long as you're still working at the company when they vest.

Performance shares both make investors happy and create a stronger link between pay and performance.

While stock options and restricted stock remain important for corporate recruitment, retention, and motivation, performance shares both make investors happy and create a stronger link between pay and performance. In fact, for senior executives they have become almost mandatory as a sign that the company is trying to improve the alignment of pay, performance, and long-term shareholder value. Now companies are starting to grant performances shares beyond a narrow group of key executives who steer a company's long-term success. Outside the US (e.g., in the UK), these grants have been popular and fairly common for a while. (For studies on changes in stock grant practices inside the US, see a related FAQ.)

The accounting for performance shares has also "improved" from the company's perspective under FAS No. 123(R). Your company takes a fixed earnings charge for the value of any stock grant, at the time of grant, spread out over the performance period. Variable accounting no longer applies to these awards as it did under the old accounting rule APB 25. When the performance conditions are based on company metrics (e.g., revenues or return on assets, though not total shareholder return or other goals linked to stock price) but these are not met, the accrued expense of these grants is reversed when the performance period ends (for details, see an FAQ on accounting).

Next Article: Grant Structure, Expiration, & Termination

Part 2 explains the structure of performance share grants, presents the concept of expiration, and considers the treatment when employment ends (e.g, layoff, retirement, disability, death).

Bruce Brumberg is the Editor-in-Chief of myStockOptions.com.