Stock Based Compensation

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Stock Based Compensation

• Presented by
• Brendan Olivier
• Cell 082 573 0335
• Email compensation_at_mweb.co.za

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Topics to be covered

• Public scrutiny
• Types of vehicles
• Accounting for Stock Based Compensation
• Intrinsic Value vs Fair Value
• Compensation Expense Taxation
• Budget 2004

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Public scrutiny
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Long-term Incentive Vehicles

• Phantom Share Scheme
• Performance Unit Plan
• Bonus Banking
• EVA / CFROI / EP

• Phantom Share Options
• Cash SARs

Unquoted Market

• Restricted Shares
• Restricted Share Units
• Share Purchase Scheme
• Deferred Allotment
• Convertible Debentures

• Share Option Scheme
• Stock Settled SAR
• Deferred Delivery Plan

Quoted Market
Absolute Value
Incremental Value
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Share Option Terminology
Time Based Vesting The only criteria required for
a person to exercise is to remain in service
At the money
Discounted
Ratable Vesting 33 33
33
Performance Based Vesting Additional criteria are
certain hurdles (eg EPS growth) and may have
later retesting
Yr 1
Yr 2
Yr 3
Yr 4
Yr 5
Yr 6
Yr 7
Option Period (Expiry) Time period until which
the option can be exercised. It is said to lapse
after this date
Cliff Vest 100
Exercise Take up the right previously granted to
acquire the share at any time between vesting and
expiry _at_ strike price (excluding any closed
periods)
Option Strike or Exercise Price Price individual
needs to pay at date of exercise to acquire the
share (set at date of offer)
Vesting Period Period on or after which the
option may be exercised
European Option can be exercised only at the
date of expiry American Option can be exercised
at any time until expiry
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Shares vs Options

• Example Assumptions
• Both schemes cliff vest (i.e. 100) after 3 years
• Options are exercised at vesting date (i.e. no
  exercise delay)
• Share for Option replacement ratio of 13
• Ignore any performance vesting criteria

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Restricted Stock RSUs
Restricted Stock Issue of shares to employees
that may only be sold after certain time and/or
performance vesting criteria have been
met Restricted Stock Units Unfunded promise to
deliver shares at future date. Unlike Restricted
Stock, tax is in effect only once delivery is
received and NOT once restrictions lapse (can
defer receipt into retirement for tax planning)
Restricted Stock US Tax without 83b election
Ordinary Income _at_ Price on vesting
Capital Gains on increment
Vest
Sell
Yr 1
Yr 2
Yr 3
Yr 4
Yr 5
Restricted Stock US Tax with 83b election
Capital Gains on increment
Ordinary Income _at_ Price on issue

• Why is Restricted Stock the new rage
• Restricted Stock requires fewer shares for
  equivalent fair value (replacement ratio)
• Thus places less burden on outstanding equity
  (overhang)
• Provides value (and retention) in downturn
  periods
• Does not create as massive a payout (and thus
  public scrutiny) as options

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Accounting for Stock Based Comp
Original Accounting Debate Should share
options granted to Employees be expensed ?
IASB
FASB
APB 25 (USA)
SFAS 123 (USA)
IFRS 2 (Intl)
Companies reqd to use APB 25 Intrinsic Value
expensing
Companies can voluntarily adopt Fair Value
expensing
Effective date from 1 Jan 2005 Fair Value
expensing Applicable to all equity-settled
share-based payments granted after 7 Nov 2002,
that are not yet vested

• Accounting standards are broader in coverage,
  including -
• Share or Stock Option Plans
• Phantom Share Schemes (Cash SAR)
• Restricted Share Schemes

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Intrinsic Value

• SFAS123 Definition
• The amount by which the market price of the
  underlying stock exceeds the exercise price of an
  option

Intrinsic Value (or spread) R40
Option issued at the money Strike Price
R60 Intrinsic Value R0
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Fair Value

• IFRS 2 Definition
• The amount for which an asset could be
  exchanged, a liability settled, or an equity
  instrument granted could be exchanged, between
  knowledgeable, willing parties in an arms length
  transaction

• Quoted market prices in active markets are the
  best evidence of fair value and should be used as
  the basis for measurement
• If quoted prices are unavailable, the estimate of
  fair value is then based on the best information
  available using an acceptable valuation technique
• BlackScholes model
• Binomial model

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Valuation Models
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Professional judgment is required
Differences in fair valuation, using
Black-Scholes, of a 3 year cliff vested option,
with a 7 year expiry
Yr 1
Yr 2
Yr 3
Yr 4
Yr 5
Yr 6
Yr 7
Allocation _at_ R 100
Option Expiry
100 Vest
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Black-Scholes vs Binomial
IFRS SFAS Leaning
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Compensation Expense Taxation

• Accounting Expense
• IFRS 2 differentiates between
• Equity settled, cash settled or combination
• Market and non-market performance conditions
• SFAS 123 differentiates between
• Performance vs time vested
• Judgment call on likelihood of performance
  criteria being met
• Recoupment of fair value already expensed if
  participants leave
• Company Taxation
• In USA, IRS Section 83 allows company a deduction
  as it is taxable in hands of employees
• Recently UK tax laws amended to allow company tax
  deduction
• No precedent in RSA as yet, but current tax law
  would NOT allow deduction unless company could
  show economic burden

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FASB Share Option vs Cash SAR Expense
Share Price
R 11
R 12.1
R 13.31
R 14.64
R 16.11
R 17.12
R 10
Fair Value
R 3.12
R 3.24
R 3.31
R 4.64
R 6.11
R 7.12
R 3.00
Comp Expense R1.00
Comp Expense R1.00
Comp Expense R1.00
Share Options (Fixed)
Yr 1
Yr 2
Yr 3
Yr 4
Yr 5
Yr 6
1/3
2/3
3/3
Comp Expense R1.04
Comp Expense R1.12
Comp Expense R1.15
Comp Expense R1.33
Comp Expense R1.47
Cash SAR Fair Value (Variable)
Yr 1
Yr 2
Yr 3
Yr 4
Yr 5
Yr 6
Comp Expense R1.00
Comp Expense R1.10
Comp Expense R1.21
Comp Expense R1.33
Comp Expense R1.47
Cash SAR Intrinsic Value
Yr 1
Yr 2
Yr 3
Yr 4
Yr 5
Yr 6
Exercise Date
Vesting Date
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Budget 2004

• In his 2004/2005 Budget speech, Finance Minister
  Trevor Manuel referred to

The introduction of a broad-based empowerment
equity participation scheme

• Intended to encourage ALL workers to participate
  in company share schemes
• Low income employees will NOT be taxed on the
  benefit (capped at certain level)
• Shares must be held for an extended period, else
  subject to Normal Income Tax
• For High income earners, tax deferrals likely to
  be disallowed
• Government may also deem the profit from Option
  sales to be income in future, as opposed to
  capital gains

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Options Outstanding

• Typ companies would like no more than 5 to 15
  of issued share capital outstanding in share
  scheme
• Use example of R 30b market cap company (300m
  shares _at_ R100)

10 for Typical Participants
25 for Broad Based Participation
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Conclusions

• This is a highly complex issue
• Statements may change
• Examples given are indicative and are not
  professional opinions
• RSA likely to follow IFRS 2, and likely to adopt
  for Financial Years ending 1 Jan 2005 onwards
• Require professional accounting advice
• Require professional taxation advice
• Require professional valuation advice
• Require professional remuneration advice

BE PREPARED !!!