Rescuing Equity Compensationfrom Volatile MarketsNational Association of Stock Plan Professionals10 December 2008Fred Whit...
1Today’s DiscussionCapital Market and Economic SituationQuestions of the DayDefining the ProblemIncreasing Equity Effectiv...
2No Place to Hide (but Treasuries)-34.1%-41.1%-43.9%-51.0%-43.1%-45.6%-27.1%-15.7%-12.5%-4.1% -1.7%4.5%-60%-50%-40%-30%-20...
3Economy & Capital Market SituationRecent volatility in the capital markets hasled to:Staggering losses of shareholder val...
4Economy & Capital Market SituationResulting, and parallel, economic recessionis creating:Further reductions in business v...
5Questions: Equity CompensationDid a shift from options-only to other awards provide the intendedinsulation from market vo...
6Underwater Equity: One Part of a Broader IssueThe survey(s) say(s)Salary increase budget reductions and delayed increases...
7The Status of Equity CompensationEquity awards of all types have gone underwaterFAS123R fears are realized as a significa...
8Before We Solve the Problem…Companies continue to evaluate the role of equity-based compensation intheir total compensati...
9…Let’s Define the Problem We’re SolvingPublic companies rely on outside advisory resources for executivecompensation, and...
10…Let’s Define the Problem We’re SolvingAll of the historical bases of equity compensation have been erodedover the past ...
11Equity Compensation: Source of DissatisfactionEquity Compensation Pressures 2002Equity Compensation Pressures 2002 –– 20...
12Shareholder DissatisfactionShareholder dissatisfaction with executive and equity compensationpractices is reflected in p...
13Employer DissatisfactionCosts of administration, financial reporting, compliance, and disclosureof equity plans have inc...
14Employer DissatisfactionEmployers clearly articulate their objectives and rationale for equitycompensation programsRelat...
15Employer DissatisfactionBut employers report being most “successful” on least importantobjectives9%18%10%16%51%64%49%54%...
16Employee Dissatisfaction79%76%57%74%83%49%40%60%80%100%Turnover CostRetention of High PerformersEmployee ProductivitySto...
17Equity EffectivenessTMEquity Compensation OutcomesShareholder dissatisfactionDilutionPerformanceExecutive pay impactComp...
18An integrated approachLike any business practice, the use of equity compensation foremployees should be validated from m...
19Measuring ROI: Finance Meets BehaviorProgram CostsAccountingExpenseCash FlowImpactProjectedDilutionDesign &Administratio...
20What is the objective?UnderwaterTacticUnderwaterTacticReset ValueReset ValueBack to the Problem: Underwater EquityFix Cu...
21Back to the Problem: Underwater EquityWhat really is the business problem?Retention?Engagement and motivation?Productivi...
22Back to the Problem: Underwater EquityThe alternatives should be evaluated in a framework considering :Stock PlanStock P...
23Option Exchange ProgramsProgram constraints and issuesAccountingTaxStock exchangeShareholder approvalSecurities regulati...
24Option Exchange ProgramsOption Exchanges will be more complicated than last timeAccounting and Tax Rules– Variable accou...
25Option Exchange ProgramsMany of the complexities continueAdministration– Massive electronic and paper processes– System ...
26Recent FilingsTO Filings Shareholder Approval RequestsAdvanced Analogic Advanced Micro Devices (amended)Echelon Corp For...
27Opportunities for Option Exchange ProgramsAchieving a positive ROI on an option exchange program may requireignoring mar...
28What Happens with Option Exchange ProgramsHard-dollar costs are higher than projectedProfessional fees – accounting, tax...
29Option Exchange Programs – Stop Before you SwapStrategyRe-evaluation and possible redirection of equity compensationstra...
30A Behavioral Economics View of ExchangesBehavioral economics provides us with explanations for thesuboptimal results of ...
31Option Exchange Programs – Stop Before you SwapGovernanceVolatility in capital markets creates additional risk– Pricing ...
32Back to the Problem: Underwater EquityA broad array of alternatives are available for addressing underwaterequity:Do not...
33Alternatives to Option Exchange ProgramsOther equity compensation alternatives may better satisfy businessobjectives:Ear...
34Behavioral StrategiesDifferentiate internallyLarge grants of RSUs with cliff vesting for top performersMulti-year share-...
35Financial StrategiesFinancial StrategiesRe-allocate across budgetsCash to equity: Salary increase delay with the savings...
36Example: Evaluating EffectivenessAlternatives Strategy Finance Behavior GovernanceIgnore the equityprogram+ + - +Exchang...
37Closing ThoughtsAlternatives are reliant on stabilization of market volatility and arehighly riskyPast logic – “employee...
38Contact InformationFred WhittleseyPrincipal and West Region Practice LeaderBuck Consultants415.617.3820fred.whittlesey@b...
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Rescuing Equity Compensation from Volatile Markets

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THe introduction of the idea of equity effectiveness, applied to the underwater equity situation during the 2008-2009 financial crisis. Presented at multiple NASPP, GEO, and WorldatWork chapter meetings by Fred Whittlesey, Kiran Sahota, and Kathi Myers.

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Rescuing Equity Compensation from Volatile Markets

  1. 1. Rescuing Equity Compensationfrom Volatile MarketsNational Association of Stock Plan Professionals10 December 2008Fred WhittleseyPrincipal, West Region Practice LeaderKiran SahotaConsultant
  2. 2. 1Today’s DiscussionCapital Market and Economic SituationQuestions of the DayDefining the ProblemIncreasing Equity EffectivenessTMOption ExchangesAlternatives to Exchanges
  3. 3. 2No Place to Hide (but Treasuries)-34.1%-41.1%-43.9%-51.0%-43.1%-45.6%-27.1%-15.7%-12.5%-4.1% -1.7%4.5%-60%-50%-40%-30%-20%-10%0%10%2008 YTD Returns Through 12-05-08DJIA S&P 500 NASDAQ CompS&P Asia 50 S&P Europe 350 MSCI EuroMorningstar Real Estate LB Commodities LB Global Corp BondLB Global Agg Bond LB US Agg Bond LB US Treas
  4. 4. 3Economy & Capital Market SituationRecent volatility in the capital markets hasled to:Staggering losses of shareholder valueSignificant reductions in businessvolume due to credit constraintsLarge layoffs due to company failuresFor equity compensation programs, we haveUnderwater options…and “underwater” RSUs, “underwater” performance plansSoon-to-be inflated Black-Scholes values from increased volatility…butDepressed Black-Scholes values from price declines…andThe resulting impact on the use of survey dataDistorted grant guidelines, if dollar-denominatedConcerns about over-granting at low prices and accusations of market timing
  5. 5. 4Economy & Capital Market SituationResulting, and parallel, economic recessionis creating:Further reductions in business volume dueto consumer and business spendingpullbackSmaller incremental layoffs forexpense management“bundled performance management”de-layeringFor equity compensation programs, we haveReduction in savings – “home equity”, defined contribution balances –exacerbating concerns over equity compensation valueQuestionable prospects for near-term stock price appreciationUncertainty of current staffing levels complicating decisions on equitycompensationUS Unemployment Rate (Through Nov, 2008)4.0%4.5%5.0%5.5%6.0%6.5%7.0%Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov
  6. 6. 5Questions: Equity CompensationDid a shift from options-only to other awards provide the intendedinsulation from market volatility this time?RSUsCash LTIsWill shareholders allow or tolerate actions to restore LTI value?Option exchange programOff-cycle option grants to take advantage of low share pricesWill this be the end of the spread of performance shares?Goal-setting difficultyRelative TSR measurementDespite governance concerns will companies “do the math” andreturn to option-only awards?
  7. 7. 6Underwater Equity: One Part of a Broader IssueThe survey(s) say(s)Salary increase budget reductions and delayed increasesMissed annual incentive targetsDiscretionary adjustments to incentive poolsUnderwater equity – options, RSUs, performance plansDepleted 401(k) balancesReduced participation ratesIncrease in loans and withdrawalsUnderfunded defined benefit pension plansNonqualified deferred compensation at greater riskRapidly changing executive compensation environment – rippleeffects
  8. 8. 7The Status of Equity CompensationEquity awards of all types have gone underwaterFAS123R fears are realized as a significant number of companieshave 100% of options underwater“Underwater RSUs” enter the discussion as that “full value” is onlyhalf-full leading to a perception of “half-empty”Performance plans unravel as multi-year financial performancegoals appear unattainable in the first year of a multi-year periodEven relative TSR plans are failingEquity markets trading on panic and forced selling rather thanfundamentals
  9. 9. 8Before We Solve the Problem…Companies continue to evaluate the role of equity-based compensation intheir total compensation strategy and now have the economic situation as anadditional considerationFive years of regulatory change and focus on compliance triggered manyreactive changes and companies still say theyDon’t assess effectiveness of equity compensation plansDon’t calculate ROI of equity compensationAre not sure what they’re getting in return for the expendituresCorporate governance concerns surrounding executive and equitycompensation continue to escalatePotential actions for underwater equity may trigger corporate governancecriticismsAny action, or appearance of such action, to deliver value to employeesnot available to shareholders may be criticized
  10. 10. 9…Let’s Define the Problem We’re SolvingPublic companies rely on outside advisory resources for executivecompensation, and executive equity trends influence and drive non-executive practicesAdvice still centers on benchmarking, expense, and complianceNew legislative initiatives (e.g., EESA) are spreading rapidly, increasingboth the compliance and governance focusCompetitive benchmarking continues to be a core process in compensationanalysis and design but has become highly complex due to equity programdesign changes and trendsBenchmarking measures only inputs, not outcomesInconsistencies and disagreement about valuation cause difficulties inbenchmarkingCurrent economic situation renders all 2008 survey data moot and currentsurvey efforts on what companies are “considering” have no value givenvolatility and varying timeframes
  11. 11. 10…Let’s Define the Problem We’re SolvingAll of the historical bases of equity compensation have been erodedover the past five yearsHistorical Drivers of Equity Compensation UsageAccountingEfficiency:StockOptionsLimited CashAvailableEmployeeOwnershipFocusGrowthIndustrySectorsU.S.-BasedEmployeesLegislativeSupport:ISO, ESPP,ESOPEquity Compensation DesignStockOptionsUniformVestingSchedulesUniformOption TermNoPerformanceFeaturesUS-CentricDesignEasyLiquidation
  12. 12. 11Equity Compensation: Source of DissatisfactionEquity Compensation Pressures 2002Equity Compensation Pressures 2002 –– 20082008FAS123RFAS123RExpenseExpense409A409AComplianceComplianceShareholderShareholderand Proxyand ProxyAdvisorAdvisorPoliciesPoliciesCapitalCapitalMarketMarketVolatilityVolatilityGlobalGlobalPracticesPracticesConvergenceConvergenceSarbanesSarbanes--OxleyOxleyComplianceComplianceEquity Compensation Pressures 2008Equity Compensation Pressures 2008ReducedReducedParticipationParticipationSmallerSmallerGrantsGrantsLower PayLower PayValuesValuesCapitalCapitalMarketMarketVolatilityVolatilityGlobalGlobalPracticesPracticesConvergenceConvergenceSarbanesSarbanes--OxleyOxleyComplianceComplianceEquity Compensation OutcomesEquity Compensation OutcomesShareholder dissatisfactionShareholder dissatisfaction Company dissatisfactionCompany dissatisfaction Employee dissatisfactionEmployee dissatisfactionWhatare wedoing?WhatWhatare weare wedoing?doing?Why are wedoing it?Why are weWhy are wedoing itdoing it??What are wegetting forit?What are weWhat are wegetting forgetting forit?it?
  13. 13. 12Shareholder DissatisfactionShareholder dissatisfaction with executive and equity compensationpractices is reflected in proxy advisors’ and institutional investors’ metricsand ratingsThis environment is further reflected in legislation that constrains equityplan design through accounting, tax, and disclosure requirementsArbitrary value-laden standards continue to drive equity compensationdesignOverhang and run rateOptions vs. share and share unit conversion ratesOwnership guidelines“Shareholder-Friendly” option exchange guidelinesThe tainting of equity compensation resulting from perceptions of executivepay is driving continued changes to equity plan design
  14. 14. 13Employer DissatisfactionCosts of administration, financial reporting, compliance, and disclosureof equity plans have increased during a period in which employeereturns from grants have declined or disappeared2004 Grants2005 Grants2006 Grants
  15. 15. 14Employer DissatisfactionEmployers clearly articulate their objectives and rationale for equitycompensation programsRelative Importance of Reasons for Granting Equity to EmployeesSource: iQuantic-Buck 2008 Equity Plan ROI SurveyCorporate Culture Financial Efficiency Competitive ReasonsWealth Creation Total Compensation Investor ExpectationsNot ImportantModerately ImportantVery Important
  16. 16. 15Employer DissatisfactionBut employers report being most “successful” on least importantobjectives9%18%10%16%51%64%49%54%38%59%47%27%47%28%52%25%4%2%Corporate CultureFinancial EfficiencyCompetitive ReasonsWealth CreationTotal CompensationInvestor ExpectationsNot Successful Moderately Successful Very SuccessfulRelative Success of Achieving Stated Objectives of Equity Compensation ProgramsSource: iQuantic-Buck 2008 Equity Plan ROI Survey
  17. 17. 16Employee Dissatisfaction79%76%57%74%83%49%40%60%80%100%Turnover CostRetention of High PerformersEmployee ProductivityStock PerformanceEmployee SatisfactionGains to EmployeesMetrics Used in Measuring LTI ROIOnly 31% of survey respondents reportedundertaking any formal measurement of returnsgenerated by their equity compensationprogramsOf those measuring ROI, employee satisfactionwas the measure most commonly usedYet the key purpose of equity grants – providingcompensation to employees – is measured leastNearly two-thirds of all stock plan participantsview their stock proceeds as “free money” asopposed to being part of a more holisticfinancial plan and agree with the statement:“If I make money that’s great. If I lose it,that’s OK!”Source: “Bridging the Knowledge Gap,” Fidelity Stock Plan Services Stock Plan Participant Survey, 2008
  18. 18. 17Equity EffectivenessTMEquity Compensation OutcomesShareholder dissatisfactionDilutionPerformanceExecutive pay impactCompany dissatisfactionCostsUncertain ROIEmployee impactEmployee dissatisfactionUnderstandingValueBehaviorFinancial impactShareholder criteriaObjectivesMeasurementsInputCommunicationIncreasing Equity Compensation Effectiveness
  19. 19. 18An integrated approachLike any business practice, the use of equity compensation foremployees should be validated from multiple perspectivesSupports the business strategy of the organization and has aclearly identifiable role in its human capital strategyIs financially efficient and cost-effective relative to the returnsrealizedEncourages and rewards the behaviors required for theexecution of the company’s strategyIs designed and delivered in a manner consistent with externalgovernance requirements and objectivesAligns with internal governance model, controls, and corporatepolicies
  20. 20. 19Measuring ROI: Finance Meets BehaviorProgram CostsAccountingExpenseCash FlowImpactProjectedDilutionDesign &AdministrationDocument&DisclosureCommunication& DisruptionRecruitingSuccessRetention ofHigh ValueEmployeesPerformanceOutcomesPerceivedValueEfficientCommunicationWorkforcePlanningVehicle Cost Plan CostReturn On InvestmentDirect Value Indirect Value
  21. 21. 20What is the objective?UnderwaterTacticUnderwaterTacticReset ValueReset ValueBack to the Problem: Underwater EquityFix Current AwardsFix Current AwardsMirror Past Pay AllocationMirror Past Pay AllocationEmployee ChoiceEmployee ChoiceReduce ExpenseReduce ExpenseRethink StrategyRethink StrategyMove to New Forms of PayMove to New Forms of PayDifferentiate Based on ValueDifferentiate Based on ValueTarget Pay to Valuable StaffTarget Pay to Valuable StaffAchieve Positive ROIAchieve Positive ROIEquityStrategyEquityStrategy
  22. 22. 21Back to the Problem: Underwater EquityWhat really is the business problem?Retention?Engagement and motivation?Productivity?Competitiveness?Philosophy?Expense without pay delivery?Shareholder opinion or perception?
  23. 23. 22Back to the Problem: Underwater EquityThe alternatives should be evaluated in a framework considering :Stock PlanStock Plan Total Compensation StrategyTotal Compensation StrategyFAS123R ExpenseFAS123R Expense Total Financial ImpactTotal Financial ImpactRetention and EngagementRetention and Engagement Overall Behavioral ImplicationsOverall Behavioral ImplicationsS/H and ISS ApprovalS/H and ISS Approval Corporate GovernanceCorporate GovernanceFixingUnderwaterAwardsFixingUnderwaterAwardsRescuing EquityCompensationRescuing EquityCompensation
  24. 24. 23Option Exchange ProgramsProgram constraints and issuesAccountingTaxStock exchangeShareholder approvalSecurities regulationsAdministrationCommunicationDisclosureGlobal participation
  25. 25. 24Option Exchange ProgramsOption Exchanges will be more complicated than last timeAccounting and Tax Rules– Variable accounting gone but incremental expenseTaxation– Simple in the US, complex in many countries– ISO considerationsShareholder Approval Requirements– Wait for annual meeting or hold special meeting?Institutional Investors and Proxy Advisory Firms– ISS criteriaSecurities Regulations– Tender offer requirements– SEC filings– Constraints from previous CD&A statements
  26. 26. 25Option Exchange ProgramsMany of the complexities continueAdministration– Massive electronic and paper processes– System and software constraintsCommunication– Internal: Employees, Managers, Board of Directors,Compensation Committee, Officers– External: Investor relations and mediaCoordination with other grant processes– Annual/focal– New hire and promotion
  27. 27. 26Recent FilingsTO Filings Shareholder Approval RequestsAdvanced Analogic Advanced Micro Devices (amended)Echelon Corp FormFactor (withdrawn)Emulex Corporation AirspanExar CorpHealthways, IncIsle of Capri CasinosMagma Design Automation, IncMaxim Integrated Products IncMetabasisMGM Mirage Who’sQuantum Fuel Systems Technolgies Worldwide Next?Radvision LTDRetractable TechnologiesSpark Networks IncUnited Therapeutics CorpUTStarcomZhone Technologies
  28. 28. 27Opportunities for Option Exchange ProgramsAchieving a positive ROI on an option exchange program may requireignoring market data and altering “typical” provisions such as:Eligibility – bracketed tranches?Vesting and blackouts – more restrictive?New option term - shorter?Strike price – premium?Form – options, shares, or cash?Treatment of existing awards – vested vs. unvested options?Replacement ratios – incremental value?The “program” – or part of a strategy?
  29. 29. 28What Happens with Option Exchange ProgramsHard-dollar costs are higher than projectedProfessional fees – accounting, tax, legal, consultingFilings and shareholder communicationsEmployee communicationsA layer of hidden costs resulting from lost productivity during and afterCommunications from the companyDiscussion among employees regarding the choiceDiscussion afterwards about the outcome of the choiceCompanies are often disappointed with the results of an exchangeprogramParticipation rates below expectationsA continuing underwater option problemTwo groups of employees
  30. 30. 29Option Exchange Programs – Stop Before you SwapStrategyRe-evaluation and possible redirection of equity compensationstrategyFinanceVolatility impact on option valuation, exchange ratios, expenseExpense-neutral constraint may create other costsChoice of replacement: cost of cash vs. equityChoice of replacement: availability of cash vs. equityBehaviorVoluntary: poor choicesNo opportunity for management action and differentiation
  31. 31. 30A Behavioral Economics View of ExchangesBehavioral economics provides us with explanations for thesuboptimal results of option exchange programs:Mental accounting ---- “This is house money”Loss aversion ---- “The stock will come back”Sunk cost fallacy ---- “I’m already vested in these options”Endowment effect ---- “I already have these options”Framing effect ---- “You want me to give these back?”Decision paralysis ---- “What if I make the wrong decision?”Regret aversion ---- “What if I make the wrong decision?”Overconfidence ---- “The stock will come back”Following the herd ---- “They didn’t exchange either”
  32. 32. 31Option Exchange Programs – Stop Before you SwapGovernanceVolatility in capital markets creates additional risk– Pricing of exchange driven by offer period timing– Exchange too early: more underwater options– Exchange with perfect timing: “spring-loading”Following SEC rules and proxy advisory firms’ guidelines does notensure good governance– Major governance metrics don’t agree on what “goodgovernance” isCD&A disclosures about equity compensation strategy and plandesign may be a constraint
  33. 33. 32Back to the Problem: Underwater EquityA broad array of alternatives are available for addressing underwaterequity:Do nothing – it’s a small piece of total compensationDo nothing – it’s a long-term incentiveAllow an exchange of the existing award(s)Modify the existing award(s)Grant an additional awardIncrease another form of payCommunicate to and educate employeesDo a combination of these
  34. 34. 33Alternatives to Option Exchange ProgramsOther equity compensation alternatives may better satisfy businessobjectives:Early grantMove the ’09 grant into late ’08…can you call the bottom?Mega-grantDouble-down with large targeted grantsStub grantFix a short-term problem with a short-term programIntegrated programsRoll the ’09 focal into the exchange program and leverage itExtend the option termAssume other programs retain and engage and buy sometime
  35. 35. 34Behavioral StrategiesDifferentiate internallyLarge grants of RSUs with cliff vesting for top performersMulti-year share-based retention bonuses with acceleratedvesting based on company performanceAdditional grants – with cliff vesting – for a team that surpassesexpectationsDifferentiate externallyStand out from the “peer group”Implement and market a solution not easily replicated
  36. 36. 35Financial StrategiesFinancial StrategiesRe-allocate across budgetsCash to equity: Salary increase delay with the savings funding targetedretention share grantsCash to deferred cash: A zero bonus pool with a portion rolled forwardto supplement the 2009 pool to “double down”Cash to performance equity: A zero bonus pool with target awards for2008 converted to performance shares for 2009Measure the ROICalculate the all-in cost of each alternativeUnderstand which financial metric is being optimizedTurnover cost?Productivity?FAS123R expense?
  37. 37. 36Example: Evaluating EffectivenessAlternatives Strategy Finance Behavior GovernanceIgnore the equityprogram+ + - +Exchange: option foroption+ + - -Exchange: option forRSU- + - -Exchange: option forcash+ - - -Early Grant+ + + -Mega-Grant+ - + -Stub Grant- + - +Integrated Exchange+ + + -Extend option term- - - +Illustration Only
  38. 38. 37Closing ThoughtsAlternatives are reliant on stabilization of market volatility and arehighly riskyPast logic – “employees will leave and reprice themselves” – maynot apply this timeA focus on single-vehicle solutions may miss an opportunity forrestructuring the total compensation portfolioShort-term recession expense reduction and underwater equityactions can blind a company to a longer-term ROI focus and re-evaluation of equity compensation strategy
  39. 39. 38Contact InformationFred WhittleseyPrincipal and West Region Practice LeaderBuck Consultants415.617.3820fred.whittlesey@buckconsultants.comKiran SahotaConsultantBuck Consultants415.617.3911navkiran.sahota@buckconsultants.comFor More Information:www.bucksurveys.com/underwaterVisit our newunderwater equityresource site

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