Title: After the Storm High Tech Pay in a PostExpensing World
1After the Storm High Tech Pay in a
Post-Expensing World
2Todays Speakers
Carl Schmitt Director Human Resources Investor
Solutions 415-617-3914 schmitt.c_at_mellon.com
Brett Harsen Senior Consultant Human Resources
Investor Solutions 312-846-3418 harsen.b_at_mellon.
com
3INTRODUCTION
Todays Session
- Approximately one-hour presentation
- Question and answer period to follow
- Questions can be directed via e-mail to
radowick.d_at_mellon.com(please note this email now
we encourage questions)
4In todays discussion, we will cover six topics
INTRODUCTION
One
- Overview of recent accounting developments
- The latest on Mellons research into vesting
acceleration practices - Update on option valuation trends in High Tech
- Developments in High Tech equity compensation
programs - Expected future directions for High Tech equity
compensation - Issues to consider
Two
Three
Four
Five
Six
5Section One Overview of Recent
AccountingDevelopments
6Much has happened since our January 2005 webcast
on the final FAS123R rules
ACCOUNTING DEVELOPMENTS
?
- April
- SEC delays FAS123R
- IBM starts expensing (retrospectively)
- May
- Cisco intends to issue new security to value
employee options
- February
- Options bill reintroduced in Congress
- Jan - May
- Number of companies accelerating vesting grows
from approx. 15 to over 100 - High Tech companies continue to assess
alternative equity strategies, but have largely
stuck to the wait-and-see mindset
Just what is in store for the future is anyones
guess right now
7SAB 107 is meant to expand upon and clarify
FAS123R
ACCOUNTING DEVELOPMENTS
8SAB 107 is meant to expand upon and clarify
FAS123R
ACCOUNTING DEVELOPMENTS
9Section Two Vesting Acceleration
10A unique window of opportunity exists to shift
option costs into footnotes prior to SFAS123(r)
VESTING ACCELERATION
How it Works
- While a modification, no variable accounting is
triggered and no fixed charge is recognized if
the options are underwater (recent auditor
interpretations have also indicate that
in-the-money options can be accelerated without
incurring substantial costs) - Requires immediate recognition of remaining
grant-date fair value in the SFAS123 footnotes - Does not require shareholder approval under the
new NYSE and Nasdaq corporate governance rules - Shareholders may view this as a giveaway
especially if the options accelerated are not
significantly underwater and/or are held by
officers or outside directors - Eliminates any remaining employee retention value
associated with the award - Will create spikes in option-related (footnote)
expenses that may increase the difficulty of
comparing period-over-period financials
Implications
11The simplified mechanics of the strategy are as
follow
VESTING ACCELERATION
12Forty percent of the 97 companies we studied were
from high technology
VESTING ACCELERATION
Including some large, well-known tech companies
Vesting Acceleration Industry Breakdown
- Tech Data
- Flextronics
- Sanmina
- Solectron
- Jabil Circuit
- AMD
- Micron Technology
- International Rectifier
- Monster Worldwide
- InFocus
LifeSciences 10
GeneralIndustry 50
High Technology 40
n97
13The number of companies continues to grow even
immediately after the SECs delay of mandatory
implementation in March
VESTING ACCELERATION
(As of 5/09)
n97
14While most only accelerate those underwater, a
growing number have accelerated in-the-money
options as well
VESTING ACCELERATION
15Additional program design findings include
VESTING ACCELERATION
- Roughly one-quarter of outstanding options were
accelerated - Only 12 excluded board options and 6 excluded
officers - Only 13 placed restrictions on the sale of stock
acquired through early exercises
16 And from outward appearances, shareholders
havent reacted negatively toward the stock
VESTING ACCELERATION
17Section Three Trends in Option Valuation
18Many High Tech companies are realizing that
binomial is no silver bullet
OPTION VALUATION
- The binomial model can theoretically be more
accurate because it can incorporate a greater
array of inputs - However, the output of the model is only as good
as the quality of the inputs - Yes, the binomial model can accommodate
volatility, risk-free rate and dividend yield
assumptions that vary from period to period into
the future based on predicted company or market
events - But, how many companies can reliably predict how
future events will impact these variables? - In some cases, given the nature of binomial
calculations, increased accuracy may even mean
increased cost - Finally, it is still unclear exactly how auditors
will respond to the more complex inputs required
by robust binomial models as the large accounting
firms are still developing their own internal
guidance
19Binomial complexity can easily get out of control
OPTION VALUATION
Our auditors give us a hard enough time on the
six basic Black-Scholes inputs!
20Before investing in expensive binomial technology
or outsourcing, three low effort/high-impact
steps should be explored
OPTION VALUATION
- FIRST Scrutinize your volatility assumption(s)
within the context of the new guidance (lower
volatility lower cost)
Greater flexibility now exists for building cases
to excluded historic periods of extraordinary
volatility
If your company has market traded options that
can be referenced, SAB 107 tells us implied
volatility is a strong benchmark
Use multiple approaches to support your case for
what you expect the companys volatility to be in
the future but be prepared for increased
disclosure
21Before investing in expensive binomial technology
or outsourcing, three low effort/high-impact
steps should be explored (continued)
OPTION VALUATION
- SECOND Use existing data from your option
administration software or outsourcer to
scrutinize historic exercise periods (shorter
holding period shorter cost)
- Dont rely on solely standard reports from your
option software or outside administrator to
provide accurate employee holding period data
(some systems use subjective calculations, most
systems will aggregate holding periods on grants
with different vest schedules) - Look for different exercise patterns among
employee groupings, but only use these
differences if the patterns are sustainable and
do not make valuation overly-complicated
Calculate the period of time employees hold
options after they become exercisable so that
data on grants with different vest schedules can
be properly compared
22Before investing in expensive binomial technology
or outsourcing, three low effort/high-impact
steps should be explored (continued)
OPTION VALUATION
THIRD Value each tranche of a ratably vested
award as a different grant to recognize early
exercisability
- Assumptions
- Stock options are granted with a four-year total
vest period, vesting in tranches of 25 per year - From historic experience, employees are shown to
exercise 12 months after vest - This single grant is broken into 4 tranches based
on vesting
23Before investing in expensive binomial technology
or outsourcing, three low effort/high-impact
steps should be explored (continued)
OPTION VALUATION
THIRD Value each tranche of a ratably vested
award as a different grant to recognize early
exercisability (continued)
- this tranche-based approach virtually
eliminates the differences between Black-Scholes
and binomial (assuming all other assumptions
remain equal)
Substantially Similar
24In summary, when binomial is used to increase
option valuation complexity
OPTION VALUATION
Some things are certain
Complexity
Administrative Burden
Audit Scrutiny/Burden
Transparency
But some things are NOT
?
Accuracy
Complexity
?
Expense
Complexity
25Section Four Developments in Equity
CompensationPrograms
26Option accounting is not the only issue driving
equity compensation decisions
HIGH-TECH TRENDS
Major Drivers
Secondary Drivers
Option ExpensingFAS123R
SEC (Disclosure Requirements)
Equity Compensation
ShareholderPressure
NYSE/NASDAQ(Approval Requirements)
Taxation Deferred Compensation(AJCA)
Congress(Pending Legislation)
27High Tech companies have been (slowly) modifying
their equity compensation programs in
anticipation of option expensing
HIGH-TECH TRENDS
- The primary changes have been evolutionary
- Stock options are still the dominant form of
equity compensation - However, a notable portion of companies have
introduced alternative equity vehicles, primarily
restricted stock (units) and performance shares
Reduce overall share usage (burn rate)
Reduce participation and/or eliminate eligibility
Reduce individual grant levels
Implement/refine international differentials
28Overall share usage has been the primary focus
HIGH-TECH TRENDS
- Reducing the burn rate for equity addresses both
expensing and investor dilution concerns - High Tech companies are targeting 3.0 gross burn
rate for 2005 - Lower burn rate of 2.0 for largest tech
companies - Small and rapidly growing companies will struggle
to get below 4.0 - These target burn rates represent a significant
decline in share usage over the past few years - Burn rates have been declining 20-30 year over
year for most companies
29To reduce usage, companies have been making tough
decisions around eligibility and participation
HIGH-TECH TRENDS
- Our Summer 2004 flash survey found that companies
expected to reduce participation primarily for
lower level employees - To date, this prediction has proven to be true
30High Tech companies still believe in broad equity
grants, but are raising the bar on performance
HIGH-TECH TRENDS
- Grants to new hires are still nearly universal
- The majority of companies still grant options to
nearly all (100) new hires - Ongoing grant programs have seen the biggest
cutbacks in participation - Below the director level, universal participation
is becoming rare - Companies generally set a target portion
(15-75) of employees expected to receive a
grant in any year - Annual grants are now performance grants
- International grant levels and participation are
receiving greater scrutiny - One size fits all is an unaffordable luxury
31High Tech companies are increasing usage of stock
option alternatives
HIGH-TECH TRENDS
- Stock options are still the dominant form of
equity compensation! - And will be for the foreseeable future
- Among the alternatives, full-value grant programs
(restricted stock, performance shares) are
getting the most attention - Other option alternatives like stock-based SARs
(Stock Appreciation Rights) are becoming more
common - Some potential successors to options have lost
favor because of tax, accounting, or investor
issues - A number of High Tech companies have implemented
full value grant programs in the past year
despite APB25 expense - Expect the trend to increase as companies get
closer to FAS123R implementation - Companies have taken widely divergent approaches
with full value grants - Carve-out vs. wholesale replacement of options
- Executives only vs. all employees vs. only lower
levels
32Section Five Future Directions
33Due to the staggered implementation of FAS123R,
equity practices will continue to evolve at a
measured pace
FUTURE DIRECTIONS
- Winter 05/06
- Calendar YE companies begin expensing
- Fall 05
- First required Q1 releases under FAS123R (for
6/30/06 FYE)
- Spring 06
- Remaining public companies begin expensing
- Summer 05
- June 30 FYE companies begin expensing
Accounting
Equity Compensation
- Option acceleration increases in lead-up to
fiscal year ends - Wider use of full-value shares and stock-based
SARs in lieu of options - Continued reduction in equity burn rates and
grant levels - Revival of exchange programs for underwater
options (repricing)
34Now Acceleration of underwater optionsFuture
Exchange of underwater options
FUTURE DIRECTIONS
- We expect the pace of vesting accelerations to
increase as companies approach their fiscal year
ends - After adoption of FAS123R, acceleration is
considered non substantive and has no
accounting benefit - We expect to see increasing acceleration of
vesting on in-the-money options - Under APB25/FIN44, recognition of expense for
in-the-money value is contingent upon an event
that would have otherwise caused forfeiture - As year end approaches, potential APB 25 cost of
acceleration is minimized
35Now Acceleration of underwater optionsFuture
Exchange of underwater options
FUTURE DIRECTIONS
- After adoption of FAS123R, we expect option
exchanges (repricing) to experience a resurgence - No longer any need for the 6 month and a day
(61) maneuver - Exchanges can occur immediately after close of
tender offer - Under FAS123R, the exchange only increases
accounting cost if incremental value is delivered - Most exchanges will be done on a value-neutral
basis, so there will be no incremental expense - For most companies, shareholder approval is
required for option exchanges - Need for shareholder approval may constrain
frequency and variation in practices
36The level playing field will give full value
shares closer parity with option programs
FUTURE DIRECTIONS
- Once companies have to recognize an expense for
all equity grants, the full-value grants will be
a viable alternative - We expect an increasing portion of companies to
incorporate full value grants into their equity
programs - Options will likely remain the most common form
of equity - In High Tech companies, the accounting cost of
options is starting to become an issue for
budgeting and planning purposes - Planning for future grants and impact on earnings
guidance - Internal budgeting for equity costs by
department/function - The net result will be increasing downward
pressure on equity grant levels - What gets measured, gets managed
37The level playing field will give full value
shares closer parity with option programs
FUTURE DIRECTIONS
- A key issue for the options vs. full value shares
is trade-off ratio - As companies reduce their option valuations, the
implied trade-ratio becomes higher in order to
remain expense neutral - At higher trade-off ratios, it takes only minimal
stock price increases for options to achieve
higher gains - The following table illustrates the gain required
and years to achieve under various stock price
growth scenarios
38Section Six ClosingIssues to Consider
39How much do all your programs cost?Who benefits
from each program?
LONGER-TERM STRATEGIES
Benefits (no pension) 60 MM
- Company has more than 1.5 B in revenues
- Company has more than 200 MM in profits
- Bonuses are 30 of profits
- Options are 35 of profits
- ESPP is 2 of profits
ESPP 4 MM
Salaries 300 MM
Options 70 MM
Bonuses 60 MM
Everything must be taken in context
40To support the total rewards philosophy, the
design of LTI programs requires balancing several
factors
LONGER-TERM STRATEGIES
- SHAREHOLDERCONCERNS
- Manage dilution
COMPETITIVE NORMS
ORGANIZATION STRATEGY
- What are competitive opportunities at similar
companies? Do we have to match the opportunities? - How deep do these opportunities extend and what
forms do they take?
- What is our business strategy?
- What goals do we need to achieve over the next
Year? Two Years? Three years?
PLAN DESIGN
ORGANIZATION SITUATION
- Does our pay philosophy support
- Pay for performance
- Risk/reward tradeoffs
- What is the culture we want to reinforce and how
far do we have to go to achieve it?
Do you want to be a "first mover (market
leader), "market follower", or in the middle?
41In conclusion
LONGER-TERM STRATEGIES
- High Tech is changing its equity practices at an
evolutionary rate - There are specific accounting related actions
that can (and should) be taken before
implementing FAS123R - Over time, grant levels will likely continue to
decrease and become more focused on top
performers - In considering changes to equity programs, look
at equity and its cost in the context of total
rewards and the business strategy
The times, they are changing
42Thank You Questions? (email now to
radowick.d_at_mellon.com)
Carl Schmitt 415-617-3914 schmitt.c_at_mellon.com
Brett Harsen 312-846-3418 harsen.b_at_mellon.com
43For some companies, full-value grant programs can
be a better match for their situation and needs
APPENDIX