By Jon Burg. The use of mandatory post-vest holding requirements on restricted stock awards and restricted stock units (“RSUs”) is increasingly prevalent as companies search for ways to strengthen the link between compensation and shareholder interests. Mandatory holding periods typically prevent employees from selling vested equity until additional requirements are met— usually “owning” shares for one, two or three years following the original vesting date. And in some cases, holding periods can stretch until retirement. By virtue of obliging employees to hold vested equity, companies can achieve a number of governance benefits, including the following:
- Explicitly Define a Pathway for Meeting Ownership Guidelines Most C-level executives are required to maintain corporate equity holdings valued at between 2x and 5x of their annual base salary. Mandatory post-vest holding requirements, when designed correctly, can directly contribute to and accelerate the achievement of required ownership levels. Once the ownership guidelines have been met, older shares can be sold for liquidity if newer ones are subject to the hold.
- Improve Your Governance Ratings with Proxy Advisory Firms Institutional Shareholder Services (ISS) recently updated its equity plan evaluation methodology to include positive scoring for mandatory holding periods. Additionally, ISS views the use of holding periods as a risk-mitigating pay practice for its say-on-pay evaluations. Similarly, Glass Lewis & Co. also rates the presence of equity holding periods positively in their equity plan evaluation framework.
- Create a Mechanism for the Recovery of Awards via a Claw-back In light of forthcoming Dodd-Frank requirements, the adoption of claw-back policies, designed to recover compensation in the event of governance or financial failings, is on the rise. Mandatory post-vest holding requirements for vested equity awards provide one of the few practical mechanisms to recover incentive payouts in the event a claw-back is triggered.
- Improve Tax Positions for Executives Mandatory post-vest holding requirements can also help executives improve their tax qualification status for Incentive Stock Options (ISOs) and Employee Stock Purchase Plans (ESPPs) under IRC Section 423. In both cases, the period of time that vested awards are held impacts tax treatments.
Mandatory holding periods after equity awards vest is on the rise thanks to the variety of governance aims being satisfied. However, holding periods also carry significant additional value that most companies do not fully realize. Specifically, these post-vest holding periods can significantly reduce expense under ASC 718.Current accounting requirements in the US and abroad require companies to reflect post-vesting conditions (i.e., mandatory holding periods) in the initial grant date valuation of awards. Applying a discount for illiquidity to award valuations is a common technique with both empirical and theoretical backing that companies can use to reduce compensation expense. There are several theoretical valuation models that can be used to calculate the impact that illiquidity periods have on an asset’s value (e.g., a stock award), with two very prominent techniques (Chaffe and Finnerty models). Both of these models conclude that mandatory holding periods lower the value of an award, with the degree of the discount varying based on the length of the restriction period, a company’s volatility assumption, and prevailing interest rates. For example, a moderately volatile company (40% to 50%) with a one-year holding restriction could take a discount of approximately 10% to 15% from the fair value. An RSU issued without a restriction that has a fair value of $10.00 would be between $8.50 and $9.00 with a 1-year restriction.Given the current corporate governance environment and strong institutional investor preferences in favor of mandatory holding requirements for vested equity awards, we expect post-vest holding periods to grow in prevalence significantly over the next three to five years. The accounting fair value discount for illiquidity is simply icing on the cake. For more resources on post-vest holding requirements, please visit Aon Hewitt or contact the author directly.