IFRS 2, good/bad leavers, settlement alternatives, and IPO/exit

[antihawk34]

Hi all,

Background

A question surrounding a share-based payment (SBP) arrangement, if I may. The background and terms/conditions are as follows:

A company puts its own shares into a trust for its own employees (so no group element to the arrangement -- note that the entity has not chosen to consolidate the employee benefit trust but treat it as an extension of itself). The employees receive the shares in three years, contingent only on continued employment, a service condition. So, if the employee leaves in this three year period, they forfeit the future shares.

Once the shares have been issued after three years, if the employee leaves, the company has the choice (not obligation) to redeem their shares within eighteen months of their leaving. If they are a "good leaver", the company can buy back the share at then-fair value. If they are a bad leaver, the company can buy back the share at a £0.01 nominal value. Importantly, in the scheme terms, it is clear that the company decides who is a good or bad leaver upon leaving, so the employees do not have an understanding at the grant date whether they might be deemed a good or bad leaver.

Furthermore, the specific share class issued after three years to employees is entitled to preferential return on an exit event e.g. IPO or change in control.

From this alone, this seems to me a SBP arrangement, at inception, with three mutually exclusive possible outcomes:

1) Employee leaves during initial three year period and receives no shares
2) Employee receives shares having satisfied initial three years, stays to an exit event and is handsomely rewarded through the sale proceeds
3) Employee receives shares having satisfied initial three years, and only then leaves. The company then has a choice to redeem the shares for cash (different prices for good and bad leavers, as above).

Really, outcome 3 can be split into different sub-outcomes -- whether the company chooses equity or cash settlement, and whether the employee is a good or bad leaver.

In scenario 2, the settlement would be in equity; in scenario 3, the company would need to be IFRS 2 guidance when the entity has the choice of settlement and consider whether it has a present obligation to pay cash, and only then would it be able to determine whether it classifies the arrangement as equity- or cash-settled.

My queries are as follows:

1) When does settlement occur? My intuition is that settlement occurs either upon (i) exit when the employee receives proceeds from the sale or (ii) upon leaving. Settlement does not occur when the shares are issued to the employees after the initial three-year period because of the leaver clause, implying that they do not have an unconditional right to retain the shares -- as the company can buy them at their discretion. This appears to be an implicit service condition until a hypothetical exit event. So the settlement must be realised either through exit or leaving the business. Would you agree?

2) Assuming settlement does not occur after the first three years and the shares are issued to employees, there is still a vesting period and vesting conditions to consider. Either the SBP is settled through an exit event or the employee leaving, but which of these is chosen could have implications for equity- vs cash settlement. If settlement occurs through the exit event, the SBP is equity-settled because the company is not the party paying the cash. If settlement occurs on leaving, the entity has the choice of settlement -- either cash (buying back the shares) or equity (allowing the employee to retain the shares).

These mutually exclusive outcomes appear, to me, to imply the "switching approach" outlined in the KPMG IFRS 2 handbook. You calculate multiple, independent grant-date fair values for each possible outcome. You assess at grant which outcome is most probable, and recognise that FV as the SBP expense. If, during the period, a different outcome becomes more likely, you "switch" to that different FV, and true up the expense accordingly.

Initially, let's say the entity considered it most probable that there wouldn't be any leavers, and employees would stay through to the exit event (a non-market performance condition). Would you account for the SBP as if it were just a non-market performance condition with a variable vesting period? i.e. assess the most likely time horizon to the exit event and then spread the FV over that period initially.

However, if an exit event, several years into the scheme, became unlikely, you would need to switch to another outcome that is now more likely? That is, that settlement is unlikely to occur through an equity-settled exit event, and now, that the shares will only be settled when an employee leaves -- essentially, there is an indefinite service condition here. In this instance, settlement alternative guidance in which the entity has the choice will need to be considered as to whether the SBP is equity- or cash-settled. If the entity determines it has a present obligation to pay cash, then the classification of the arrangement would need to change to cash-settled. This would be accounted for as either a (i) modification or (ii) replacement award as the good/bad leaver terms were not explicitly outlined at grant.

Would you say this is reasonable?

Apologies for the lengthy post. This arrangement is a complicated one for me, and I would appreciate any input. Thanks!

[Leo]

How the shares will be valued?

[antihawk34]

How will they be valued? It depends on the mutually exclusive outcome. The entity initially deems the exit event to be most likely, and no leavers for the management-team members shares were granted to, so shares will be valued in this outcome with a Monte Carlo, with an expected term equal to the most likely time horizon to the exit event. The Monte Carlo is required because of the contingent payoff structure -- there are hurdles for proceeds in the Company's constitutional documents/Articles of Association that state that their shares will will receive variable proceeds depending on the sale price of the company. So we need to model in e.g. 100k simulation paths of the projected share price under the Monte Carlo and build in the waterfall to each path to determine the proceeds this specific class of shareholders would receive under each equity valuation. The average of these proceeds would be the grant-date fair value.

[Marek Muc]

This scenario might be too complex to address in a forum post, I'm afraid...

[Marek Muc]

PS. You should be able to find some answers in KPMG's IFRS 2 handbook: https://assets.kpmg.com/content/dam/kpm ... yments.pdf