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Underwater Equity
- 1. Rescuing Equity Compensation fromVolatile Markets National Association of Stock Plan Professionals 10 December 2008 Fred Whittlesey Principal, West Region Practice Leader Kiran Sahota Consultant
- 2. Today’s Discussion CapitalMarket and Economic Situation Questions of the Day Defining the Problem Increasing Equity EffectivenessTM Option Exchanges Alternatives to Exchanges 1
- 3. No Place toHide (but Treasuries) 2008 YTD Returns Through 12-05-08 10% 4.5% 0% -4.1% -1.7% -10% -12.5% -20% -15.7% -30% -27.1% -34.1% -40% -41.1% -43.1% -43.9% -45.6% -50% -51.0% -60% DJIA S&P 500 NASDAQ Comp S&P Asia 50 S&P Europe 350 MSCI Euro Morningstar Real Estate LB Commodities LB Global Corp Bond LB Global Agg Bond LB US Agg Bond LB US Treas 2
- 4. Economy & CapitalMarket Situation Recent volatility in the capital markets has led to: Staggering losses of shareholder value Significant reductions in business volume due to credit constraints Large layoffs due to company failures For equity compensation programs, we have Underwater options…and “underwater” RSUs, “underwater” performance plans Soon-to-be inflated Black-Scholes values from increased volatility…but Depressed Black-Scholes values from price declines…and The resulting impact on the use of survey data Distorted grant guidelines, if dollar-denominated Concerns about over-granting at low prices and accusations of market timing 3
- 5. Economy & CapitalMarket Situation Resulting, and parallel, economic recession US Unem ploym ent Rate (Through Nov, 2008) is creating: 7.0% 6.5% Further reductions in business volume due 6.0% to consumer and business spending 5.5% pullback 5.0% 4.5% Smaller incremental layoffs for 4.0% Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov expense management “bundled performance management” de-layering For equity compensation programs, we have Reduction in savings – “home equity”, defined contribution balances – exacerbating concerns over equity compensation value Questionable prospects for near-term stock price appreciation Uncertainty of current staffing levels complicating decisions on equity compensation 4
- 6. Questions: Equity Compensation Did a shift from options-only to other awards provide the intended insulation from market volatility this time? RSUs Cash LTIs Will shareholders allow or tolerate actions to restore LTI value? Option exchange program Off-cycle option grants to take advantage of low share prices Will this be the end of the spread of performance shares? Goal-setting difficulty Relative TSR measurement Despite governance concerns will companies “do the math” and return to option-only awards? 5
- 7. Underwater Equity: OnePart of a Broader Issue The survey(s) say(s) Salary increase budget reductions and delayed increases Missed annual incentive targets Discretionary adjustments to incentive pools Underwater equity – options, RSUs, performance plans Depleted 401(k) balances Reduced participation rates Increase in loans and withdrawals Underfunded defined benefit pension plans Nonqualified deferred compensation at greater risk Rapidly changing executive compensation environment – ripple effects 6
- 8. The Status ofEquity Compensation Equity awards of all types have gone underwater FAS123R fears are realized as a significant number of companies have 100% of options underwater “Underwater RSUs” enter the discussion as that “full value” is only half-full leading to a perception of “half-empty” Performance plans unravel as multi-year financial performance goals appear unattainable in the first year of a multi-year period Even relative TSR plans are failing Equity markets trading on panic and forced selling rather than fundamentals 7
- 9. Before We Solvethe Problem… Companies continue to evaluate the role of equity-based compensation in their total compensation strategy and now have the economic situation as an additional consideration Five years of regulatory change and focus on compliance triggered many reactive changes and companies still say they Don’t assess effectiveness of equity compensation plans Don’t calculate ROI of equity compensation Are not sure what they’re getting in return for the expenditures Corporate governance concerns surrounding executive and equity compensation continue to escalate Potential actions for underwater equity may trigger corporate governance criticisms Any action, or appearance of such action, to deliver value to employees not available to shareholders may be criticized 8
- 10. …Let’s Define theProblem We’re Solving Public companies rely on outside advisory resources for executive compensation, and executive equity trends influence and drive non- executive practices Advice still centers on benchmarking, expense, and compliance New legislative initiatives (e.g., EESA) are spreading rapidly, increasing both the compliance and governance focus Competitive benchmarking continues to be a core process in compensation analysis and design but has become highly complex due to equity program design changes and trends Benchmarking measures only inputs, not outcomes Inconsistencies and disagreement about valuation cause difficulties in benchmarking Current economic situation renders all 2008 survey data moot and current survey efforts on what companies are “considering” have no value given volatility and varying timeframes 9
- 11. …Let’s Define theProblem We’re Solving All of the historical bases of equity compensation have been eroded over the past five years Historical Drivers of Equity Compensation Usage Accounting Legislative Employee Growth Efficiency: Limited Cash U.S.-Based Support: Ownership Industry Stock Available Employees ISO, ESPP, Focus Sectors Options ESOP Equity Compensation Design Uniform No Stock Uniform US-Centric Easy Vesting Performance Options Option Term Design Liquidation Schedules Features 10
- 12. Equity Compensation: Sourceof Dissatisfaction Equity Compensation Pressures 2002 – 2008 Shareholder Capital Global Sarbanes- Sarbanes- FAS123R 409A and Proxy Market Practices Oxley Expense Compliance Advisor Volatility Convergence Compliance Policies What What Equity Compensation Pressures 2008 are we are we doing? doing? Capital Global Sarbanes- Sarbanes- Reduced Smaller Lower Pay Market Practices Oxley Participation Grants Values Volatility Convergence Compliance Why are we Why are we doing it? doing it? Equity Compensation Outcomes What are we What are we getting for Shareholder dissatisfaction Company dissatisfaction Employee dissatisfaction getting for it? it? 11
- 13. Shareholder Dissatisfaction Shareholderdissatisfaction with executive and equity compensation practices is reflected in proxy advisors’ and institutional investors’ metrics and ratings This environment is further reflected in legislation that constrains equity plan design through accounting, tax, and disclosure requirements Arbitrary value-laden standards continue to drive equity compensation design Overhang and run rate Options vs. share and share unit conversion rates Ownership guidelines “Shareholder-Friendly” option exchange guidelines The tainting of equity compensation resulting from perceptions of executive pay is driving continued changes to equity plan design 12
- 14. Employer Dissatisfaction Costs ofadministration, financial reporting, compliance, and disclosure of equity plans have increased during a period in which employee returns from grants have declined or disappeared 2004 Grants 2005 Grants 2006 Grants 13
- 15. Employer Dissatisfaction Employers clearly articulate their objectives and rationale for equity compensation programs Relative Importance of Reasons for Granting Equity to Employees Very Important Moderately Important Not Important Corporate Culture Financial Efficiency Competitive Reasons Wealth Creation Total Compensation Investor Expectations Source: iQuantic-Buck 2008 Equity Plan ROI Survey 14
- 16. Employer Dissatisfaction But employersreport being most “successful” on least important objectives Relative Success of Achieving Stated Objectives of Equity Compensation Programs Investor Expectations 16% 59% 25% Total Compensation 10% 38% 52% Wealth Creation 18% 54% 28% Competitive Reasons 4% 49% 47% Financial Efficiency 9% 64% 27% Corporate Culture 2% 51% 47% Not Successful Moderately Successful Very Successful Source: iQuantic-Buck 2008 Equity Plan ROI Survey 15
- 17. Employee Dissatisfaction Metrics Used in Measuring LTI ROI Only 31% of survey respondents reported undertaking any formal measurement of returns 100% generated by their equity compensation programs 79% 83% 80% 76% 74% Of those measuring ROI, employee satisfaction was the measure most commonly used 57% 60% 49% Yet the key purpose of equity grants – providing compensation to employees – is measured least 40% Nearly two-thirds of all stock plan participants Turnover Cost Retention of High Performers view their stock proceeds as “free money” as Employee Productivity opposed to being part of a more holistic Stock Performance financial plan and agree with the statement: Employee Satisfaction Gains to Employees “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 16
- 18. Equity EffectivenessTM Equity Compensation Outcomes Shareholder dissatisfaction Company dissatisfaction Employee dissatisfaction Dilution Costs Understanding Performance Uncertain ROI Value Executive pay impact Employee impact Behavior Financial impact Objectives Input Shareholder criteria Measurements Communication Increasing Equity Compensation Effectiveness 17
- 19. An integrated approach Like any business practice, the use of equity compensation for employees should be validated from multiple perspectives Supports the business strategy of the organization and has a clearly identifiable role in its human capital strategy Is financially efficient and cost-effective relative to the returns realized Encourages and rewards the behaviors required for the execution of the company’s strategy Is designed and delivered in a manner consistent with external governance requirements and objectives Aligns with internal governance model, controls, and corporate policies 18
- 20. Measuring ROI: FinanceMeets Behavior Program Costs Vehicle Cost Plan Cost Document Accounting Cash Flow Projected Design & Communication & Expense Impact Dilution Administration & Disruption Disclosure Return On Investment Retention of Recruiting Performance Perceived Efficient Workforce High Value Success Outcomes Value Communication Planning Employees Direct Value Indirect Value 19
- 21. Back to theProblem: Underwater Equity What is the objective? Underwater Equity Tactic Strategy Reset Value Rethink Strategy Fix Current Awards Move to New Forms of Pay Mirror Past Pay Allocation Differentiate Based on Value Employee Choice Target Pay to Valuable Staff Reduce Expense Achieve Positive ROI 20
- 22. Back to theProblem: Underwater Equity What really is the business problem? Retention? Engagement and motivation? Productivity? Competitiveness? Philosophy? Expense without pay delivery? Shareholder opinion or perception? 21
- 23. Back to theProblem: Underwater Equity The alternatives should be evaluated in a framework considering : Fixing Rescuing Equity Underwater Compensation Awards Stock Plan Total Compensation Strategy FAS123R Expense Total Financial Impact Retention and Engagement Overall Behavioral Implications S/H and ISS Approval Corporate Governance 22
- 24. Option Exchange Programs Program constraints and issues Accounting Tax Stock exchange Shareholder approval Securities regulations Administration Communication Disclosure Global participation 23
- 25. Option Exchange Programs OptionExchanges will be more complicated than last time Accounting and Tax Rules – Variable accounting gone but incremental expense Taxation – Simple in the US, complex in many countries – ISO considerations Shareholder Approval Requirements – Wait for annual meeting or hold special meeting? Institutional Investors and Proxy Advisory Firms – ISS criteria Securities Regulations – Tender offer requirements – SEC filings – Constraints from previous CD&A statements 24
- 26. Option Exchange Programs Manyof the complexities continue Administration – Massive electronic and paper processes – System and software constraints Communication – Internal: Employees, Managers, Board of Directors, Compensation Committee, Officers – External: Investor relations and media Coordination with other grant processes – Annual/focal – New hire and promotion 25
- 27. Recent Filings TO Filings Shareholder Approval Requests Advanced Analogic Advanced Micro Devices (amended) Echelon Corp FormFactor (withdrawn) Emulex Corporation Airspan Exar Corp Healthways, Inc Isle of Capri Casinos Magma Design Automation, Inc Maxim Integrated Products Inc Metabasis MGM Mirage Who’s Quantum Fuel Systems Technolgies Worldwide Next? Radvision LTD Retractable Technologies Spark Networks Inc United Therapeutics Corp UTStarcom Zhone Technologies 26
- 28. Opportunities for OptionExchange Programs Achieving a positive ROI on an option exchange program may require ignoring 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? 27
- 29. What Happens withOption Exchange Programs Hard-dollar costs are higher than projected Professional fees – accounting, tax, legal, consulting Filings and shareholder communications Employee communications A layer of hidden costs resulting from lost productivity during and after Communications from the company Discussion among employees regarding the choice Discussion afterwards about the outcome of the choice Companies are often disappointed with the results of an exchange program Participation rates below expectations A continuing underwater option problem Two groups of employees 28
- 30. Option Exchange Programs– Stop Before you Swap Strategy Re-evaluation and possible redirection of equity compensation strategy Finance Volatility impact on option valuation, exchange ratios, expense Expense-neutral constraint may create other costs Choice of replacement: cost of cash vs. equity Choice of replacement: availability of cash vs. equity Behavior Voluntary: poor choices No opportunity for management action and differentiation 29
- 31. A Behavioral EconomicsView of Exchanges Behavioral economics provides us with explanations for the suboptimal 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” 30
- 32. Option Exchange Programs– Stop Before you Swap Governance Volatility 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 not ensure good governance – Major governance metrics don’t agree on what “good governance” is CD&A disclosures about equity compensation strategy and plan design may be a constraint 31
- 33. Back to theProblem: Underwater Equity A broad array of alternatives are available for addressing underwater equity: Do nothing – it’s a small piece of total compensation Do nothing – it’s a long-term incentive Allow an exchange of the existing award(s) Modify the existing award(s) Grant an additional award Increase another form of pay Communicate to and educate employees Do a combination of these 32
- 34. Alternatives to OptionExchange Programs Other equity compensation alternatives may better satisfy business objectives: Early grant Move the ’09 grant into late ’08…can you call the bottom? Mega-grant Double-down with large targeted grants Stub grant Fix a short-term problem with a short-term program Integrated programs Roll the ’09 focal into the exchange program and leverage it Extend the option term Assume other programs retain and engage and buy some time 33
- 35. Behavioral Strategies Differentiate internally Large grants of RSUs with cliff vesting for top performers Multi-year share-based retention bonuses with accelerated vesting based on company performance Additional grants – with cliff vesting – for a team that surpasses expectations Differentiate externally Stand out from the “peer group” Implement and market a solution not easily replicated 34
- 36. Financial Strategies Re-allocate across budgets Cash to equity: Salary increase delay with the savings funding targeted retention share grants Cash to deferred cash: A zero bonus pool with a portion rolled forward to supplement the 2009 pool to “double down” Cash to performance equity: A zero bonus pool with target awards for 2008 converted to performance shares for 2009 Measure the ROI Calculate the all-in cost of each alternative Understand which financial metric is being optimized Turnover cost? Productivity? FAS123R expense? 35
- 37. Example: Evaluating Effectiveness Alternatives Strategy Finance Behavior Governance Ignore the equity program + + - + Exchange: option for option + + - - Exchange: option for RSU - + - - Exchange: option for + - ly - - On cash Early Grant + t tion ra + + - Mega-Grant + Illus - + - Stub Grant - + - + Integrated Exchange + + + - Extend option term - - - + 36
- 38. Closing Thoughts Alternatives are reliant on stabilization of market volatility and are highly risky Past logic – “employees will leave and reprice themselves” – may not apply this time A focus on single-vehicle solutions may miss an opportunity for restructuring the total compensation portfolio Short-term recession expense reduction and underwater equity actions can blind a company to a longer-term ROI focus and re- evaluation of equity compensation strategy 37
- 39. Contact Information FredWhittlesey Principal and West Region Practice Leader Buck Consultants 415.617.3820 fred.whittlesey@buckconsultants.com Kiran Sahota Consultant Buck Consultants 415.617.3911 navkiran.sahota@buckconsultants.com Visit our new underwater equity resource site For More Information: www.bucksurveys.com/underwater 38