Performance Rights vs Options - The Reward Practice

Companies regularly engage us seeking advice on which equity instrument is best suited for their business. The fact is, there are a myriad of alternatives depending on factors such as the type of organisation (e.g., public vs private company) and stage of business (e.g., start-up vs mature). Historically, companies typically adopted one instrument for all LTI grants (e.g., Share Options). Over the past few years, our research and experience with clients shows a significant upwards trend in companies using multiple LTI instruments such as Performance Rights (also known as zero exercise priced options ZEPOs) and Share Options as part of their long-term incentive (LTI) strategies. The focus is on maintaining the flexibility to recognise changing circumstances and adapt to participant preferences where the instrument can provide very different outcomes.

What are Performance Rights?

Performance rights provide employees the right to acquire a “free” ordinary share in the future, subject to the achievement of performance hurdles (e.g., company milestones, share price performance, ongoing employment) over a vesting period (e.g., three years). Importantly, performance rights do not have an exercise price and represent an entitlement to the full value of the share i.e., the rights hold value regardless of the company’s share price.

What are Options?

Share Options provide employees a right to acquire a share in the future when they pay an exercise price (generally equal to or greater than the market value of the underlying shares at the date of grant). The value of the Options increases if the company’s share price rises above the exercise price. Options usually have a vesting period and an expiration date, after which they are no longer valid.

TRP Client Example with participant choice: Options or Performance Rights or combination of both

Under the LTI Plan, Performance Rights were offered that vest based on strategic hurdles whilst Options were offered which vest based on a premium price hurdle. Depending on the participant preference, Options were selected (typically those individuals with greater appetite for risk and able to influence Company share price) and/or Performance Rights chosen (typically those individuals who are more risk adverse).

What the data shows

Performance Rights remain the most prevalent LTI vehicle overall, but our data indicates a growing trend of companies adopting multiple LTI instruments across all sectors. Between 2021 and 2022, the use of multiple LTI vehicles increased by 9% for small ASX companies, by 4% in medium sized companies and again by 4% in large companies. See Figure 1 below.

Figure 1 – Increase in prevalence of a combination of LTI vehicles in 2022.

Data source: Market insights based on analysis from the TRP ASX database, representative of small (less than $300m), medium (between $300m and $1bn) and large (above $1bn) market capitalisation companies.

“But what about the tax implications?”

Fortunately, since 2015, tax is now less of a factor when considering Rights vs Options. Legislative changes have resolved the adverse tax outcomes of Option plans, which makes them a viable LTI alternative particularly for small to mid-cap companies with large potential share price growth.

For example, Options with a premium exercise price may be the preferred vehicle over Rights based on the potential leverage (typically a higher quantum) and concessional tax treatment (no income tax). .

Figure 2 below compares the economic outcomes (after income tax) between Options and Rights for an LTI grant with a value of $50,000.

What the chart shows:

Share price between 40c (starting share price) and 60c (50% growth): there is greater value in holding Rights due to the exercise price requirement for the Options. The economic value (after income tax) for Rights varies from $26,000 to approximately $40,000, while the economic value for Options is $0.
Share price between 60c and ~70c (80% growth): there is greater value in holding Rights due to the exercise price requirement for the Options. The economic value (after income tax) for Rights varies from $26,500 to approximately $46,000, while the economic value for Options varies from $0 to approximately $37,000.
Where the share price exceeds ~70c: there is greater value in holding Options due to the leverage (three times the number of Options vs Rights). The economic value for Options increases up to three times the grant value ($150,000) at $1.00.

Figure 2 – Economic benefit of Rights vs Options

Which LTI vehicle is right for your company?

Companies should look broader than simply defaulting to a single LTI instrument which has been used in the past. Management and Boards should consider the following when approaching this decision:

Risk profile of the participant – who is eligible to participate and what is their appetite for risk?

Share price volatility – the potential for share price growth over the medium to long term

Company value drivers – what performance measures encourage the right behaviours to driver company value and how can participants influence them

If you would like to explore LTI design in more detail, our article on Designing Employee Incentives for ROI is a useful resource.

The Reward Practice specialises in helping companies analyse their current state, current practices and strategic goals and then helps to design modern, practical remuneration structures that promote sustainable growth and provide both short and long– term benefits for the company, employees and stakeholders. If you are interested to find out how we can help, please contact us for a no obligation discussion.