Modeling Equity Compensation under Accounting Contingencies

Abstract

Of late, both U.S. and International firms have increased the granting of performance-contingent equity awards to their executive officers. Beyond simple stock options, these awards frequently include accounting-based performance targets. Failure to meet or exceed these targets causes award forfeiture. While now a common component in executive pay, little is known about how to value these instruments. In this paper, we model the expected payoff from an equity award with accounting-based payout conditions. The model incorporates numerous characteristics of awards seen in practice, including the coupling of stock price and accounting targets, multiple accounting targets, sliding payout schedules, and the adoption of both “and” and “or” conditions that trigger payout. We also translate the expected payoff into an approximate present value. Given the growing prevalence of performance-contingent features in executive pay, this exercise is important to academics, board members and shareholders, along with other market participants and regulators.