Equity Comp - Who and How much to give

John Brown Attorney and Founder of BEI Employee Ownership Conference Minneapolis, MN : April 20-22, 2010 Dan Walter President and CEO Performensation

Introduction
Exit Planning and Equity Compensation
Basic Question: Why should I consider incentive equity compensation for my company?
Advantages of equity as an incentive.
Advantages of cash as an incentive.

Overview: Equity Based Compensation Design Considerations
Who
How much
When
Why
How to measure, basis for award, performance standard.

Exit Planning Perspective
Owner-managed companies in transition.
Baby Boomer business owners. Most want to exit .
Need management team and other key employees motivated to stay after owner leaves and to grow value.
Size of Company: 15 employees – 500 or so.
What does it take for an owner to be able to exit – via ESOP or any other path?

Seven Step Exit Planning Process
Step 1 – Identify Owner Exit Objectives
Step 2 – Quantify Business and Personal Financial Resources
Step 3 – Maximize and Protect Business Value
Step 4 – Ownership Transfer to Third Parties
Step 5 – Ownership Transfer to Insiders
Step 6 – Business Continuity
Step 7 – Personal Wealth and Estate Planning

ESOP Perspective:
Should ESOP Trustees approach equity ownership decisions in same way as owners interested in exiting their businesses?
ESOP Trustees represent ownership and much like departing owners may not be actively involved in the day to day business.
ESOPS want management and key employees to:
Stay through owner’s exit;
To have the same incentive to grow business as does ownership.
To grow business value long term & continually.

Advantages of Equity Based Incentive Compensation.
More effective than cash in motivating or retaining the key employee.
It is part of the owner’s exit strategy to transfer ownership to key employee(s).
It is cashless.
It is in anticipation of a third party sale and the owner wishes to benefit selected employees with capital gains treatment.

Advantages of cash based incentive compensation
More effective than stock in motivating and keeping key employees.
If they have to pay for equity, most employees prefer cash to ownership.
Owner’s do not want more owners.
More Flexible.
Owner’s exit path is third party sale or transfer to family.

Benefit Formulas
Performance based.
Usually calculated annually.
Performance standard benefits the owners.
Subject to “vesting”.
Usually long term goal is to grow value to a certain level or over a certain time based on owner’s exit objectives.

What do we mean by “Who should get how much”?
Who are the stakeholders?
Is Equity Fair and/or Just?
Is How much defined as:
Amount in “money”
Amount in “shares”
Amount in “ownership percentage”
The Other Side of Equity

What is meant by “Equity”
eq·ui·ty, n. pl. eq·ui·ties
1. The state, quality, or ideal of being just, impartial, and fair .
2. Something that is just, impartial, and fair.
3. Law a. Justice applied in circumstances covered by law yet influenced by principles of ethics and fairness; b. A system of jurisprudence supplementing and serving to modify the rigor of common law; c. An equitable right or claim; d. Equity of redemption.
4. The residual value of a business or property beyond any mortgage thereon and liability therein.
5. a. The market value of securities less any debt incurred; b. Common stock and preferred stock.
6. Funds provided to a business by the sale of stock.
Source: www.freedictionary.com

Is Equity Compensation truly “Fair”?
Fair, adj.
1 . free from discrimination , dishonesty, etc.; just; impartial
2. in conformity with rules or standards; legitimate a fair fight
3. (of the hair or complexion) light in colour
4. beautiful or lovely to look at
5. moderately or quite good a fair piece of work
6. unblemished; untainted
Source: freedictionary.com

Can Equity Compensation be “Just”?
Just, adj.
1. Honorable and fair in one's dealings and actions: a just ruler.
2. Consistent with what is morally right; righteous: a just cause.
3. Properly due or merited : just deserts.
4. Law Valid within the law; lawful: just claims.
5. Suitable or proper in nature ; fitting: a just touch of solemnity.
6. Based on fact or sound reason ; well-founded: a just appraisal.
Source: freedictionary.com

Common Reasons for Equity Compensation
Private Co.
Someday go public
Someday get acquired
Focus is extended period growth
Ensure strong shareholder support if there are other investors
Not planning to go public
Public Co.
Attract, Motivate and Retain high quality staff
Align staff with management and shareholders
Provide wealth-building potential
Create owners, especially among those who may not otherwise buy stock
Provide upside potential commensurate with growth in company stock price / market
Any Co.
Drive and reward success of stakeholders

Define the stakeholders
Define corporate goals
Understand impact of equity plans on each type of goal
Define acceptable risk/reward profiles for immediate needs and projected against “success”
Determine market pay requirements
Determine best case and worst case scenarios
Document plan for at least three paths
Acceptable growth
Shrinkage
Outperform
Determining Who and How Much

Performance was always the stated “reason” for offering equity.
“ We want people to share in the success and growth of the company”
NOTE: Very little mention of failure and demise of the company
Is performance simply stock price? Total Shareholder Return?
When does the progression of stock price no longer provide a reasonable link to pay?
Linking Equity to Performance

The Equity Compensation Dilemma 1988-1999 the “no lose” zone (and the period of the greatest growth in the use and value of equity compensation plans)

Virtually all market data currently available is based on the assumption created by the “no lose” market
Data from prior to that period is invalid due to the limited use of equity
Our Data is Old and Flawed

Past (assuming non-founders):
CEO Ownership at pre-IPO companies: 2.40%-4.60%
Other C-Level: 0.25%-1.95%
Hire on grants
CEO: 0.78%-2.50%
Other C-Level: 0.11% - 0.93%
All based on then current number of shares.
Does not take into account future values
Assumption that equity would grow in value, but continued new grants assumed that ownership was transitory and had to be replenished
The “How Much” of the Past

Must determine maximum % of ownership that will be “gifted” to each level (as opposed to purchased)
Must determine risk/reward profile for company
Too little or too much equity can discourage risk, which is essential for growth and innovation
These decisions must factor in the expected and possible exit strategies
Programs must incorporate reasonable indicators of performance for grant, earning, vesting and or release
These factors must be frequently reviewed as adjusted during the early years of a company
Levels of pay and relation to ownership percentages and potential value of equity must be frequently reviewed and adjusted as a company evolves
Dealing with the New Volatile Market

More emphasis being put on linking equity explicitly or implicitly to financial, operational, team an individual performance.
Not always “performance-based equity”
Often “justification-based equity”
Multiple studies link better corporate performance with higher levels of management ownership
Studies commonly show a link between broad-based ownership and improved corporate performance
Companies are starting to come off the euphoria and false conclusions caused to the “no lose” decade and starting to accept the combined impact of expensing, a volatile market, equity programs failures and increased shareholder activism
Equity Evolution

Focus first on your corporate goals, before you focus on market data
Design plans based on “just” compensation levels, rather than “fair” compensation levels
Today’s answers may not be valid a year or two from now, so don’t write too much in stone
The 10 commandments are short and so is the US Constitution.
Your Rules should define and guide, not dictate and control
Planning for Equity Compensation Success

Questions Contact Us. John H. Brown, President Business Enterprise Institute, Inc. 888-206-3009 jbrown@exitplanning.com Contact Us. Dan Walter, President and CEO Performensation 877-803-9255 x. 700 [email_address] Skype: performensation Twitter: @performensation www.performensation.com

Equity Comp - Who and How much to give

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