Making Sense of Multi-Metric Vesting Schemes for Executive Compensation

In the ever-evolving world of corporate governance, executive compensation packages are increasingly tied to specific performance metrics and goals. The leading forces behind this trend are institutional investors, major shareholders, and influential proxy advisers such as Institutional Shareholder Services and Glass Lewis.

One notable development in executive performance-based pay is the surge of performance-vesting equity grants. These grants provide executives with company stock as a component of their pay, but for the grant to vest and the executive to receive the equity, the company must successfully meet predefined performance criteria. These criteria are often a blend of earnings-based metrics, such as earnings per share, and other non-earnings targets such as stock returns, revenue growth, or return on investment. The goal of these grants is a holistic evaluation of an executive’s performance, accounting for both the financial results of the company and its non-financial strategic accomplishments. In a new paper, we investigate how the specific design of the grant’s vesting formula can significantly influence executives’ behavior.

When executives deal with multiple metrics, the challenge of meeting or exceeding targets becomes a multifaceted puzzle. Each metric carries its own payout structure, and executives must navigate these structures concurrently. If the grant’s vesting scheme is summative (meaning the final payout is the weighted sum of the payouts gained on the various metrics that compose the vesting formula) an executive may receive a partial payout by achieving targets in some metrics, even while falling short in others. These schemes may offer flexibility, allowing executives to prioritize metrics that are easier to manipulate or achieve. Under binding vesting schemes, however, no partial payout is granted unless specific binding metrics (often called “circuit-breakers”) hit or beat their threshold performance. In the case of grants that combine earnings with non-earnings binding metrics, the achievement of non-earnings strategic targets therefore acts as a pre-condition for the grant to vest on earnings metrics. Since the grant will vest only if earnings targets and non-earnings binding conditions are met, these schemes are expected to foster multi-dimensional optimization (the maximization of several dimensions at the same time), potentially reducing earnings management and misreporting. This is because executives must not only fulfill the earnings targets but also meet other (non-financial) criteria to access any payout from the grant.

In our paper, we investigate how summative and binding vesting schemes alter executive behaviors. We delve into a large sample of executive performance equity grants made to 6,947 executives in 841 S&P 1500 firms with available vesting details and executive compensation data between 2006 and 2019. The number of granting firms, performance equity grants, and executives receiving a grant increase almost steadily over sample years. Across all years, about 90 percent of the named executives at sample firms receive performance equity grants, with the grants representing about 57 percent of the total equity grants (including time-vesting option and restricted share grants) made to firm executives in the year. These trends are consistent with the increasing use of performance equity awards among S&P 500 firms, with the proportion of S&P 500 granting firms in our sample increasing from 44 percent in 2006 to 60 percent in 2019.

Since we are interested in understanding how non-earnings vesting conditions affect executive earnings management and reporting incentives, we focus on equity grants that vest based on the level or growth of one earnings metric (i.e., EPS, operating income, net income, EBITDA, EBT, EBIT) as either single-vesting metrics (the baseline in our models) or in conjunction with stock returns or other non-earnings metrics. In line with other academic studies and professional reports, the most frequent earnings metrics for our grant sample are EPS (42 percent of the grants), operating income (24 percent), net income (12 percent) and EBITDA (12 percent). Most interesting for the purposes of our analyses, we find that about 28 percent of sample grants vest on one earnings metric alone, while the remaining 72 percent vest based on earnings in conjunction with other non-earnings targets.

We consider six categories of non-earnings metrics: stock market metrics (i.e., stock price or returns); revenue metrics (i.e., revenues, revenue growth); capital efficiency metrics (i.e., ROI/ROIC, ROE, ROA); cash-flow metrics (i.e., operating cash-flow, free cash-flow); and other financial and non-financial metrics. We next categorize multi-metric vesting grants as either summative or binding and test for the different effects of non-earnings binding conditions on executive earnings management and misreporting behaviors. Out of the sub-sample of grants that combine earnings metrics with non-earnings targets, about 54 percent use non-earnings targets as summative components while 18 percent use non-earnings targets as binding conditions for the grant to vest on earnings metrics. By doing so, we make two main contributions to the limited but growing literature on performance equity grants. First, we develop a comprehensive characterization of all types of vesting metrics used in the grants and the way in which earnings are combined with non-earnings targets in multi-metric vesting grants. Second, we investigate the incentive effects from alternative functional forms of the vesting formulas that combine earnings with other targets.

We test our models over all the performance equity grants made to firm CEOs and other top executives. Since grants made to divisional executives might vest based on divisional rather than corporate earnings targets, we test the robustness of all our results after restricting the sample to grants made to corporate executives only. Together, our results indicate that vesting schemes that condition earnings-based grant vesting to non-earnings binding targets provide executives with significantly lower incentives to increase the year-to-year volatility in the realized earnings and lower incentives to misreport. This discovery carries significant implications on two fronts. First, it implies that binding vesting schemes can potentially mitigate executive tendencies towards earnings management. Second, it suggests that the complexity introduced by these schemes stimulates multi-dimensional optimization. Executives are given the incentives to excel across diverse financial and non-financial domains.

The evidence suggests that earnings-based grants give executives the incentives to manipulate financial numbers, since meeting or exceeding the earnings targets trigger at least part of grant expected payouts. This behavior can reduce the accuracy of financial reporting and a company’s overall financial stability. Binding vesting schemes, however, alter this equation. Our results indicate that vesting schemes that condition grant vesting on the contemporaneous achievement of earnings and non-earnings targets, by fostering multi-dimensional optimization efforts, can mitigate executive earnings management and aggressive reporting incentives.

This post comes to us from Francesca Franco, an associate professor of accounting at Bocconi University and Oktay Urcan, professor of accountancy and Fred & Virginia Roedgers Faculty Fellow at the University of Illinois at Urbana-Champaign. It is based on their recent paper, “Multi-metric vesting schemes in executive performance equity grants.”