Whether to use determinate or indeterminate rights in long term variable remuneration (LTVR) plans for senior executives remains a challenge for many boards.  Indeterminate rights are far more flexible and have wider application, yet market practice is divided.

GRG Remuneration Insight 168

by James Bourchier & Denis Godfrey
31 October 2024

Whether to use determinate or indeterminate rights in long term variable remuneration (LTVR) plans for senior executives remains a challenging decision for many boards.  Indeterminate rights are far more flexible and have wider application than determinate rights, yet market practice is largely evenly divided in their use as indicated by the following table, copied from the 2024 GRG Variable Remuneration Guide.

Indeterminate vs Determinate LTVR Instrument Breakdown

This GRG Remuneration Insight discusses the main matters that may be relevant to Boards in reviewing the use of determinate and indeterminate rights.

What are Determinate and Indeterminate Rights?

In this context the term “right” covers four main types of instruments that provide for different entitlements and obligations on exercise.  They are:

Determinate or Indeterminate Instrument Obligation and Entitlement on Exercise
Determinate Share Rights Nil exercise price.
On exercise the holder is entitled to receive a share, only.
Indeterminate Right Nil exercise price.
On exercise the holder is entitled to receive either a share and/or cash equal to the value of a share, as determined by the Board at the time of exercise/settlement.
Determinate Option Exercise price needs to be paid by option holder.
On exercise the holder is entitled to receive a share, only.
Indeterminate Share Appreciation Right (SAR) Nil exercise price.
On exercise the holder is entitled to receive in relation to the parcel of SARs being exercised either, as determined by the Board:
a) Whole shares equal in value to the excess of the value of one share for each right being exercised over the notional exercise price of each SAR, or
b) cash equal in value to the excess of the value of one share for each right being exercised over the notional exercise price of each SAR.
Note: SARs are considered indeterminate whether or not the cash settlement aspect is present, as they do not have a 1:1 relationship between the number of Rights held and the number of Shares that may be received.

Illustration and Discussion

Assumptions

The following table presents various aspects relevant to consideration of the use of determinate and indeterminate instruments.  The examples referred to in the table are based on the following assumptions:

  1. Share Price at grant $1.00,
  2. Share Price at exercise $1.50,
  3. Value of option or SAR at grant $0.25,
  4. Value of Rights at grant $1.00,
  5. Remuneration Value of grants $100,
  6. The equity plan satisfies the requirements for tax deferral, and
  7. An employee share trust (EST) that satisfies the sole activities test is operated to receive contributions from the company and apply those contributions to acquire shares either by on-market purchase or subscription to a new issue,
    1. Scenario 1: Contributions to the EST at the time of grant of the instruments are applied to purchase shares at that time on-market,
    2. Scenario 2: Contributions to the EST at the time of exercise of the instruments are applied to purchase shares at that time by subscription to a new issue.

For many years indeterminate instruments were preferred as they enabled the incorporation of features in plan designs that helped address taxation that arose on cessation of employment, Corporations Act termination benefit limits that apply when higher amounts have not been approved by shareholders and taxation at grant for executives who hold or control the voting of more than 10% of issued shares.  Taxation on cessation of employment has been removed so this consideration is no longer relevant.  Situations where a single executive holds or controls the voting of more than 10% of issued shares are uncommon.  Thus, there is less need to use indeterminate instruments than was previously the case, although the need for them to be used for substantial shareholder participants persists.

Whether to use unleveraged (share rights & Rights) or leveraged (options & SARs) instruments tends to be influenced by the Board’s expectations in relation to future share price growth.  Leveraged instruments tend to offer the potential of higher benefits when share price growth significantly exceeds market median growth. Unleveraged instruments tend to be preferred when share price growth is expected to be not significantly more than the market median, or if instability in the share price is expected (nil priced Rights do not end up “under water”).

Discussion

The following discusses the implication of various instruments and approaches to share acquisitions.

Instruments and Share Acquisition

Commentary on each of the foregoing scenarios follows:

Row Comments
1 This alternative may be selected by a company that is prepared to forego a future larger tax deduction so as to minimise the cost of purchasing shares and not issue new shares. Possibly a company undertaking share buy-backs or with a major shareholder who does not wish to have their ownership of the company diluted. This company would also be prepared to take on the added administration that is involved when shares are purchased by the EST well before the instruments are exercised.  If the company pays dividends then it would also be prepared to accept the tax inefficiency involved when the EST is taxed on dividends at a penal tax rate, currently 47%.
2 This alternative has the advantages of tax deduction maximisation, minimum EST administration and no tax on dividends within the EST.
3 This is similar to Row 1, except that the deduction for contributions to the EST is not known until the instrument is settled in shares, not cash.  The entitlement to a tax deduction in respect of the contributions means that the company’s accounts and tax return for the year of the grant of the instrument need to be amended.
4 This is the same as Row 2.
5 This alternative involves higher cash outflow and higher accounting expense than the alternatives.
6 This alternative is more complex than the “on exercise” alternative because at the time of grant of the options it will not be possible to accurately predict the number of shares that need to be funded by the company (amount equal in value to the growth in value of the shares subject to the options), noting that the exercise price to be paid by the option holder will fund the purchase of some of the shares. Comments in relation to Row 1, also apply.
7 Comments in relation to Row 2, apply.
8 Comments in relation to Rows 6 and 3, apply.
9 Comments in relation to Row 5, apply.

Clearly, whether to use determinate or indeterminate instruments will depend upon each company’s circumstances and the views of the Board.  However, as a broad comment it may be observed that indeterminate instruments offer more flexibility if the company is prepared to issue new shares when instruments are exercised (and not to acquire equity prior to exercise and settlement).  That aside, it should also be recognised that many companies do not need that additional flexibility.

Conclusion

Unless the company is:

  1. looking to capitalise on leverage using SARs instead of options (options should generally not be used under current regulatory frameworks), or
  2. it is unlisted and needs to be able to provide cash at settlement to assist employees to pay tax, or
  3. has participants that own or control the voting of or more than 10% of the Company’s Shares,

Indeterminate Rights are unlikely to be optimal going forward. This is because they limit the ability of the company to claim a tax deduction for equity acquired ahead of exercises, and result in accounting, reporting and tax complication if that occurs (especially for listed companies). That said, acquiring equity prior to exercise and settlement is a practice that GRG and most trustees recommend against, therefore if the trust and acquisition of shares is operated as generally recommended (shares are only acquired at the time the company has an obligation to settle in shares), there should be no particular disadvantage.

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