Delayed Settlement: A Better Pick for Post-Vest Holding Requirements?

Post-vest holding requirements (PVHRs) have become increasingly common in executive equity programs. They often have been used for special, retention or mega-grant awards, and they may become more common as updated proxy advisor guidelines treat some awards with PVHRs as performance-based grants. PVHRs extend shareholder alignment and are viewed favorably by proxy advisors. They also can qualify for a valuation discount.

So, what does a PVHR look like in practice? In one sense, it’s like a grilled cheese sandwich, where the recipe is in the name. It’s a requirement to hold the earned shares for an additional period of time after they vest. The details, however, can vary considerably. Some implementation approaches deliver better shareholder alignment, executive upside and tax efficiency than others.

Consider Delayed Settlement for Your Structure

In a traditional PVHR, shares are issued upon vesting of restricted stock units (RSUs) or performance stock units (PSUs) that are subject to restrictions on sale or transfer for a period of one to two years. Once the restricted period ends, the shares become unencumbered, other than limitations that apply to the individual holder (such as insider trading rules and ownership guidelines).

A more tax-efficient approach can be to delay the issuance of the shares. In the U.S., delaying settlement brings Internal Revenue Code Section 409A into consideration. Companies must structure these instruments to be 409A-compliant, though this is generally straightforward to do.

On the vest date, the RSUs or PSUs are no longer at substantial risk of forfeiture, but the underlying shares aren’t delivered to the recipient. Instead, they’re delivered without restrictions at the end of the holding period. Only then are income taxes triggered. As seen in the table below, that difference in timing has cascading effects on the award’s incentives and payout.

How the Structure Can Improve Executive Economics

At first blush, the two approaches seem equivalent, with the only difference being when income tax is triggered. The economic outcome can be quite different, though. Delayed settlement lets the executive keep more shares invested until the taxable event.

If the stock price rises, the longer holding period creates additional upside for the executive (and for the U.S. Internal Revenue Service [IRS]), since the pie gets larger before it’s sliced up for taxes. The longer holding period also means more downside exposure if the stock price falls. But this can be a governance positive because the larger post-vest ownership interest tightens the shareholder alignment that PVHRs are intended to create.

Consider the following simplified example, which uses assumptions typical of high-earning executives in higher-tax states to illustrate the mechanics. (Note: This example is simplified in order to illustrate the mechanics. For example, employment taxes are due in the year of vest, even in a delayed settlement framework. Further, every executive’s tax situation is unique, and the impact of any arrangement of this nature should be considered in context.)

In this example, delayed settlement produces higher net pay as the stock price rises because more shares remain invested before income tax is paid. The more the stock appreciates during the holding period, the greater the potential net-pay advantage.

Of course, this is taxation, not magic. In a world where the price declines, delayed settlement would leave the executive with lower take-home pay. That outcome reflects the shareholder alignment goals of a PVHR and often is perfectly palatable to all parties when designing high-leverage, high-incentive executive awards.

Delayed settlement has two additional benefits: First, proxy advisors view it favorably in the same way they view a traditional PVHR, and second, it qualifies for a larger fair value discount for lack of marketability (DLOM). Since DLOMs are computed on the net shares after taxes withheld at vest, delayed settlement results in less withholding at vest (since only employment taxes are due, not income taxes). The resulting DLOM is, therefore, larger, meaning a lower fair value for the award.

The Other Upsides

PVHRs are an important part of the executive compensation toolkit. The incremental burden is limited since executives already are accustomed to restrictions on trading activity. Meanwhile, the upsides may include shareholder alignment, favorable proxy advisor treatment and a valuation discount.

Delayed settlement can preserve or even improve all of these core benefits. It can increase the post-vest ownership exposure that supports shareholder alignment and can produce a larger valuation discount. When the stock appreciates, it also can boost the executive’s net payout. For companies considering a PVHR, delayed settlement deserves strong consideration as the default structure.

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