What are Retention Awards, When and Why are they Used?
Retention awards tend to arise when a company is concerned that key talent is at risk of loss due to the disruption caused by exposure to a takeover, or particular individuals or groups of employees being targeted by competitors for recruitment. They can also arise when external factors have unsettled employees to the extent that they are likely to seek alternative employment opportunities. Recently, pressures around tightening of budgets due to economic uncertainty, competition in increasingly limited talent pools, and the rising cost of living has led to equity-retention awards being considered higher cash fixed pay might otherwise have been the norm. For companies competing with peers that have deeper pockets, equity retention awards are often the only viable choice.
Retention awards are generally not a good solution when excessive turnover is being caused by other factors such as poor working conditions or terms of employment that may be addressed via direct specific action.
An example of a retention award is when an employee is offered 20% of their Fixed Pay in the form of Service Rights, which vests in two equal portions at the end of the next two financial years, if they remain employed by the company at each of those two testing dates (with full forfeiture of each tranche if they leave before). The rationale for this approach is generally that a competitor is unlikely to be offering such a remuneration component, equity can offer significant upside on a tax effective basis, and the conditions are directly linked to the employee staying with the company while involving lesser ongoing cost than increasing Fixed Pay.
What are Sign-on Awards, When and Why are they Used?
Sign-on awards arise as part of recruitment and tend to be provided so as to either offer a “sweetener” for a high calibre candidate to make the switch to a smaller or riskier company, or to make good potential benefits that will be foregone when the candidate leaves their current employment. Such forgone benefits tend to be unpaid potential short term variable remuneration (STVR) payments and unvested long term variable remuneration (LTVR) equity awards. In some cases they may simply be a one-off award to induce an individual to make a change of employer, particularly when the remuneration in the new roles will not be materially more attractive than the remuneration in the current role.
An example of a sign-on award is when an executive is offered the combined total of their current outstanding unpaid/unvested target short term and long term variable remuneration opportunities, say 60% of their proposed Fixed Pay, in the form of Service Rights which vests at the end of the first financial year, if the employee has remained employed by the company. The rationale for this approach is usually that it is an issue of fairness, to compensate for lost income opportunities.
Market Prevalence of Retention and Sign-on Awards – ASX 300
GRG undertook research on the ASX 300 (note: around 35 companies were excluded as non-disclosing entities etc.) as at November 2022, looking back 3 years, and found the following evidence of sign-on and retention awards. Nearly one quarter of the research group showed evidence of sign-on awards, and more than one third showed evidence of sign-on awards for top executives. Such grants being a minority practice which likely reflects external stakeholder concerns about such structures, however, given those concerns, the observed rates of usage may be higher than many would expect. It is interesting to note higher rates in larger businesses (note: ASX 200 and 300 groups exclude ASX 100 and 200 constituents respectively):
Note: in the foregoing “Assumed Retention” refers to cases where there was evidence of a service-only grant of equity, however, the Companies in this group did not identify this equity component as a retention arrangement explicitly. It is included here because it is identical to a retention award, and most external stakeholders would consider it a retention award. We have excluded cases where it was explicitly part of Fixed Pay.
The following key observations were made from the research:
- The grants are more prevalent in larger companies in the ASX300,
- For sign-on bonuses, they tend to be split into a combination of cash and equity (usually in Rights) with the Rights vesting over 2-3 years (either 100% or in equal tranches over the period). The rationale given is usually as a “make-good” grant on forgone entitlements from a previous employer.
- For retention grants, vesting periods ranged from 1-5 years, various instruments were used such as Service Rights and Restricted Shares.
- The sign-on bonuses were most prevalent in the Materials and Financial sectors,
- The retention grants were most prevalent in the Consumer Discretionary, Financials, Materials and Real Estate sectors,
- Both kinds of grants were often subject to a “satisfactory individual performance” gate.
Quantum of Awards
In relation to sign-on awards the quantum generally represents the fair value of the benefits that will be foregone when the candidate leaves their current employer. Determining a fair value is generally a negotiation due to uncertainty as to whether the benefits will arise and, if so, what their value may be in the future. Often the value of equity granted/held will be referred to, however, unvested equity typically has only around a 50% likelihood of vesting, and may be even lower if performance has not met expectations. Short term awards are similarly subject to often opaque and confidential vesting conditions, so it can be hard for a new employer to assess. Only deferred short term awards subject to service testing are likely to be easily valued.
In relation to retention awards, the value tends to relate to the current fixed pay of the individual, their level in the organisation and the period for which retention is required. Fixed pay (FP) tends to be the base rather than FP + STVR or FP + STVR + LTVR given that it is known amount.
Retention awards tend to be expressed as a percentage of Fixed Pay with say 20% to 50% of FP per year for the retention period for top executives, and 10% to 20% of FP for lower level employees (i.e. comparable to annual short term award values applicable to the level of the role). Thus, if the retention period for a senior executive were two years, then the retention award could be half a year’s FP, or 25% per year over two years.
Form of Awards
Both sign-on and retention awards may be paid in cash, however in the vast majority of cases it is offered as equity (usually Service Rights). An advantage of equity is when the share price is expected to rise during the retention period, the value of the award at the end of the retention period is likely to be larger and therefore more attractive to the employee than a fixed amount of cash. Another advantage of equity from the company’s point of view is that there is a link with shareholder interests via the share price, is not present when cash awards are used. It should also be noted that the taxation of share rights can be deferred by the employee for many years after the award has been earned with service (up to 15 years) which produces a tax outcome virtually identical to nil Capital Gains Tax (see GRG’s separate article on this matter for evidence). This tax deferral alternative is not available with cash.
Timing of Payment or Vesting
Standard practice is for cash retention awards to be paid when the retention period is completed. Similarly, equity based retention and sign-on awards tend to vest when the retention period is completed. When long retention periods are involved, consideration may be given to a part payment through the retention period e.g. at the end of each year for 3 years.
For smaller sign-on awards they may be paid at the time employment commences but usually with a provision that repayment is required if the person resigns within the minimum required service period.
Two shareholder approval aspects need to be considered being:
- approval of grants of equity to directors (e.g. Managing Director); Grants of equity to directors need approval under ASX Listing Rule 10.14, and
- approval of remuneration if adding the retention or sign-on award to other remuneration results in total remuneration that is not reasonable; the giving of financial benefits (includes remuneration) to a related parties (includes directors and their relatives) requires shareholders approval unless the remuneration is reasonable – s208 and s211 of the Corporations Act. Awards to other employees do not need shareholder approval.
The main stakeholders to consider are shareholders and proxy advisors. The proxy advisors present their view to shareholders and many financial institutions are bound to follow the proxy advisor recommendations or at least strongly consider them (as a matter of internal governance). Individual shareholders do not have access to proxy advisor reports but for the ASX 300 the Australian Shareholders’ Association will often send representatives to comment on resolutions.
Proxy advisors consider the explanations given in both Remuneration Reports and explanatory material accompanying resolutions put to shareholders for voting when forming recommendations. In this regard, they tend to have a negative view of equity grants that vest based on service only, unless such arrangements are clearly and demonstrably part of a Fixed Pay arrangement. Accordingly, sign-on and retention grants of equity need to be well commercially justified in Remuneration Reports (in respect of any executives or directors), and explanatory materials associated with general meetings needs to provide clear rationale, if support from proxy advisors is to be obtained. Similarly, if the total remuneration package is not reasonable, then the commercial justification for the proposed total remuneration package needs to be explained and justified.
Proxy advisors will generally assess both quantum, which relates to the reasonable and market-position-appropriate remuneration (total package) question, and structure, which relates to the form of delivery. If the total remuneration package is excessive compared to their view of market practice, then it is likely that they will recommend voting against both the remuneration report and any grant approval resolutions. Early engagement with proxy advisors may give the Board opportunity to present and test their commercial case and rationale. If the design is out-of-line with expectations, it is likely that any grant approval resolution would be voted against.
Conclusion and Maximising Shareholder Support
There are some things that Boards can do to try to maximise support for solutions to the perceived need for retention and sign-on awards:
- Consider offering additional one-off long term variable remuneration (LTVR) instead of sign-on or retention awards. Most LTVR structures have the features that external stakeholders are looking for, like long periods of exposure to markets, performance, and service testing, which will align rewards with the shareholder experience. This is generally better regarded than additional remuneration that is earned for simply “turning up”, whether or not the person is creating value or destroying it. Offering LTVR equity in addition to the annual/ongoing package amount can be compelling at the right level.
- Make the vesting period as long as possible, with service testing – short periods (1 year or less) tend to face higher criticism, while long periods (3 years or more) tend to face lesser criticism.
- Consider using Share Appreciation Rights – these operate identically to options but are typically around 75% less dilutive and reduce sales in the market to repay the exercise price. The presence of an exercise price creates a kind of performance/shareholder alignment.
- Offer clear and open communication: use the Remuneration Report and explanatory notes to notices of meeting to provide transparent and defensible reasons for the grants.