Written by Kristian Piippo
Performance Share Units (PSUs) are a type of equity compensation offered by private and public companies to their employees as a form of incentive pay. They are similar to stock options and restricted shares in that they give employees the opportunity to share the company's success. However, there are some key differences that make PSUs a distinct form of compensation.
One of the main differences between stock options and PSUs is that PSUs are tied to specific performance goals, rather than just the passage of time. This means that the recipients of PSUs must meet certain targets for the units to vest and be converted into shares of company stock. Additionally, PSUs have no strike price for employees to pay, meaning that there is no capital outlay for the employees.
The performance goals are generally divided into two categories.
Internal company target (also called non-market target)
These goals can be internal company measures like financial targets or more discretionary targets. Common financial targets are metrics such as a certain level of profitability, revenue growth, EBIT/EBITDA, Return on Invested Capital (ROIC) and more. Companies often combine financial targets with other internal company measures that are critical to the company’s long-term success and overall strategy, like various sustainability measures.
Target based on the company’s share price performance (also called market-based goals)
These goals are based on the company’s share price performance and can take various forms. Common market-based goals are for the share price to reach a certain level, for the share price to yield a certain return during the performance period, or for the company’s share price to outperform a peer group or an index.
The company will grant the employees the PSUs, where the performance period will or has already started, dependent on the program structure. At the performance period’s end, the final calculation of performance will be made, and employees will know how many shares they have received based on the performance against the targets set out in the agreement.
It is common for performance periods to range from one to three years (and more) dependent on the company’s vision and compensation strategy. After the performance period’s end and subsequent calculation of the outcome, shares will be transferred to the participants for ownership. Some companies also choose to operate with an additional vesting period after the performance period to increase the focus on long term value creation and retention.
Below is a visual example of what a timeline looks like for a company that grants PSUs to their employees, with a subsequent performance period starting immediately, and with additional vesting before the shares are delivered to the participants.
Why do companies use PSUs?
One of the main advantages for using PSUs is that the company can set extremely specific and relevant targets which align with stakeholders’ vision for the company’s future, where the recipient of the PSUs (the employees) will have goals that are very aligned with what investors, the Board and management wants to achieve.
If shareholder return is the focus, the PSUs can be structured based on that. If there is a greater emphasis on value creation through business development, for example in a volatile or down-trending stock market and/or macro environment, PSUs can be structured to focus on internal company goals. This is done to compensate employees for their continued value creation despite a challenging macro environment that negatively affects the stock price.
Additionally, PSUs are seen as a fair form of compensation because employees will only get compensated if goals are reached. This means that if the program is structured in a good way, employees only get a payout from the PSUs if they have contributed to the company reaching it’s targets.
To further underline how PSUs can be structured as a balanced form of compensation, consider this example:
The stock market is in a downturn and overall predictions for the stock in the coming years is rather weak with a recession looming over the global economy. The company knows that they must continue to compensate their employees in a competitive way to motivate and retain them, even if the share price appreciation is not as strong as in the past. Increase in cash compensation is off the table as the company is preserving its cash base. Options can prove to be difficult, as they are solely dependent on a share price increase.
However, the company can choose to use PSUs, even with various performance targets. For example, they can use one internal metric that will be a good proxy for the company’s long term value creation, such as return on invested capital (ROIC) and even combine this with a market-based target. In this case, the market-based target should not be based on the company’s share reaching a certain target, given the poor outlook for the stock market in general, but maybe rather be based on how the company performs versus its peer group. This way the company has a focus on its internal value drivers while also focusing on a certain share price performance.
In conclusion, performance share units are a flexible and customizable form of equity compensation that can be used by companies to align employee incentives with specific business goals and performance metrics. They can be a good choice for companies with a longer-term focus and a great way to align the compensation structure with the interests of other stakeholders.
Get in touch to learn more about PSUs and how to manage your PSU program to maximize its potential!