This approach is most easily used in the valuation of stock options. For instance, most companies will use the Single-Point Black-Scholes model to value their option grants; however, a move towards the Multiple-Point Black-Scholes model maintains the same disclosure (you are still using the Black-Scholes model) but with potentially sizable discounts in fair value — sometimes as much as 7%. This approach does not require any change in the option’s design, which means there is no impact to award holders’ perceived value.
Award holders have the potential to earn large windfall payments at the end of the performance period because of the leveraging of relative TSR awards. For example, if a company grants an award with a 200% maximum payout and the company’s stock price triples over a three-year performance period, the award holder will receive 600% of the target value of the award. In some respects, this is to be expected. After all, the intention of the plan was to incentivize and reward increases in stock price. However, some companies wish to limit the overall value that can be recognized by award holders for governance and optics reasons. Limiting the value recognized by award holders is as simple as defining that maximum value. Maximum caps also serve as a governance control to limit windfall payouts due to extreme stock price performance. However, it can also provide moderate reductions in fair value without significantly impacting the perceived value of awards on the part of employees as the cap may be deemed unlikely to come into play. While only around 10% of plans in the U.S. contain maximum caps, this is a growing number in the past three years.