After the Storm High Tech Pay in a PostExpensing World

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After the Storm High Tech Pay in a
Post-Expensing World

• May 25, 2005

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Todays 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
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INTRODUCTION
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)

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In 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

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Three
Four
Five
Six
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Section One Overview of Recent
AccountingDevelopments
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Much has happened since our January 2005 webcast
on the final FAS123R rules
ACCOUNTING DEVELOPMENTS
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• April
• SEC delays FAS123R
• IBM starts expensing (retrospectively)

• March
• SEC issues SAB107

• 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
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SAB 107 is meant to expand upon and clarify
FAS123R
ACCOUNTING DEVELOPMENTS
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SAB 107 is meant to expand upon and clarify
FAS123R
ACCOUNTING DEVELOPMENTS
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Section Two Vesting Acceleration
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A 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
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The simplified mechanics of the strategy are as
follow
VESTING ACCELERATION
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Forty 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
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The number of companies continues to grow even
immediately after the SECs delay of mandatory
implementation in March
VESTING ACCELERATION
(As of 5/09)
n97
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While most only accelerate those underwater, a
growing number have accelerated in-the-money
options as well
VESTING ACCELERATION
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Additional 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

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And from outward appearances, shareholders
havent reacted negatively toward the stock
VESTING ACCELERATION
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Section Three Trends in Option Valuation
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Many 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

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Binomial complexity can easily get out of control
OPTION VALUATION
Our auditors give us a hard enough time on the
six basic Black-Scholes inputs!
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Before 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
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Before 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
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Before 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

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Before 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
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In 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
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Accuracy

Complexity
?
Expense

Complexity
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Section Four Developments in Equity
CompensationPrograms
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Option 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)
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High 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
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Overall 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

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To 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

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High 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

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High 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

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Section Five Future Directions
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Due 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)

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Now 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

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Now 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

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The 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

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The 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

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Section Six ClosingIssues to Consider
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How 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
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To 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?
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In 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
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Thank 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
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For some companies, full-value grant programs can
be a better match for their situation and needs
APPENDIX