Unpacking Leveraged Incentive Plans – Does Fortune Favour the Brave?

What is the issue?

In an ASX listed world where proxy advisors and investors favour incentives delivered in equity, not all types of equity awards are equal.

Whilst the majority of ASX 200 companies, being relatively mature or in relatively mature markets, adopt a conventional performance rights plan as a long-term incentive (LTI) and a mix of cash and restricted shares in the short-term incentive (STI), are there more powerful motivators for executives to execute on company goals and ultimately, deliver shareholder returns?

Uncontroversial in Australia, the use of performance rights and restricted shares are unlikely to ruffle feathers. However, for Boards looking to incentivise executive outperformance or a significant turnaround in a company’s fortunes, rights may be too conservative to attract, retain and motivate an all-star executive team due to the limited upside. Instead, a more highly leveraged plan with a more lucrative upside may be more enticing. However, it should be noted that there is an overarching caveat to the introduction of such plan, which is the prerequisite of being a company with a high growth profile.

When is the right time to introduce a leveraged plan?

Without going into the weeds, leveraged awards of the type outlined below provide higher upside for executives (where there is meaningful share price appreciation above the exercise price), albeit with greater risk (resulting in nil value if share prices flatline or decline) than performance rights.  

Whilst most would be familiar with option plans, a quick breakdown of other leveraged plans include:

• Share Appreciation Rights (SARs) – A SAR provides value for participants where the share price grows above the grant price, similar to an option. However, the participant is not required to pay any exercise price, increasing the attractiveness of SARs for participants.

• Loan plans – Similar to options, value is generated where the share price grows above the grant price, however, loan shares also enable the participant to benefit from dividend payments and a lower tax environment.

Whilst leveraged plans keep executives’ and investors’ eyes on the same prize – growing shareholder returns – they can garner increased scrutiny from proxy advisors if the odds are too far in the participant’s favour from the starting gun and have a high likelihood of vesting.

Introducing a leveraged plan isn’t a one-size-fits-all solution for all ASX companies and these types of plans are certainly not for low growth or highly volatile companies. ‘Out of the money’ awards will likely be demotivating for the executive team.

Instances which may support the introduction of a leveraged plan:

• High growth companies;

• Start-up-style companies;

• Junior miners in the exploration stage; or

• Undervalued companies looking to restore shareholder value.

What are the relevant considerations?

Whilst SARs, options and loan plans all require the company’s share price to grow above the grant price to be ‘in the money’, the following considerations will impact the type of leveraged plan selected:

• Is merely growing the share price above grant price sufficient or should a higher bar be set?

• Are the company's dividends a material factor in overall value and total shareholder return?

• Are you targeting immediate share ownership?

• Which is the most tax effective solution for participants?

Balancing internal and external stakeholder preferences is equally important, before Boards get stuck trying to sell the unsellable.

Playing ball with proxy advisors and investors

In general, proxy advisors and investors are supportive of the delivery of incentive plans in equity, however, when transitioning from performance rights to a leveraged plan, a spanner in the works may be:

• If a significantly higher number of instruments are granted (which may result in a significantly higher payout). This is particularly relevant where a company has seen its share price in freefall and a mechanistic application of option valuation models will result in a very low value;

• If the award is granted at a depressed share price (which may be viewed as opportunistic); and

• If there are no additional performance conditions which must be met for the award to vest (which may be viewed as insufficiently challenging – the old adage that a rising tide lifts all boats is often heard during bull markets).

Although it is commonly accepted that leveraged plans result in a greater number of instruments granted than performance rights plans, given the share price has to grow for any value to be generated for executives, what is the magic number? Executives will expect to be fairly compensated for the greater risk whilst proxy advisors will likely be critical of high quantum.  

For companies introducing leveraged plans when the share price is at historical lows (e.g. LendLease), directing the focus of executives on the delivery of shareholder value is commendable.

Despite the exercise price acting as a built-in share price hurdle, proxy advisors especially, are more likely to support awards with additional performance conditions. The ‘right’ performance conditions will be influenced by over the term of the award and whether the award is a one-off vs permanent award. Dexus’ FY25 option plan and IRESS’ FY24 SARs plan both have additional absolute TSR hurdles. Go too soft and external stakeholders’ eyes will widen, go too hard and executives’ enthusiasm will wane.

This is not for the faint-hearted. However, for Boards looking to challenge the status quo and dangle a larger carrot on a stick, a leveraged plan may provide the extra kick.