1. Rescuing Equity Compensation
from Volatile Markets
National Association of Stock Plan Professionals
10 December 2008
Fred Whittlesey
Principal, West Region Practice Leader
Kiran Sahota
Consultant
2. Today’s Discussion
Capital Market and Economic Situation
Questions of the Day
Defining the Problem
Increasing Equity EffectivenessTM
Option Exchanges
Alternatives to Exchanges
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3. No Place to Hide (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
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4. Economy & Capital Market 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
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5. Economy & Capital Market 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
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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?
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7. Underwater Equity: One Part 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
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8. The Status of Equity 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
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9. Before We Solve the 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
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10. …Let’s Define the Problem 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
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11. …Let’s Define the Problem 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
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12. Equity Compensation: Source of 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?
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13. Shareholder Dissatisfaction
Shareholder dissatisfaction 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
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14. Employer Dissatisfaction
Costs of administration, 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
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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
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16. Employer Dissatisfaction
But employers report 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
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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
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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
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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
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20. Measuring ROI: Finance Meets 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
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21. Back to the Problem: 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
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22. Back to the Problem: Underwater Equity
What really is the business problem?
Retention?
Engagement and motivation?
Productivity?
Competitiveness?
Philosophy?
Expense without pay delivery?
Shareholder opinion or perception?
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23. Back to the Problem: 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
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24. Option Exchange Programs
Program constraints and issues
Accounting
Tax
Stock exchange
Shareholder approval
Securities regulations
Administration
Communication
Disclosure
Global participation
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25. Option Exchange Programs
Option Exchanges 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
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26. Option Exchange Programs
Many of 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
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28. Opportunities for Option Exchange 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?
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29. What Happens with Option 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
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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
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31. A Behavioral Economics View 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”
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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
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33. Back to the Problem: 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
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34. Alternatives to Option Exchange 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
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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
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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?
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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
- - - +
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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
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39. Contact Information
Fred Whittlesey
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
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