EQUITY COMPENSATION STRATEGIES FOR A NEW ERA

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EQUITY COMPENSATION STRATEGIESFOR A NEW ERA

• April 7, 2005

NCHRA 7th Annual Compensation Conference San
Francisco, CA
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TODAYS DISCUSSION

• Introduction
• Regulatory Update
• What Does This Mean for Your Company?
• Long-Term Incentive Strategies for the Future

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INTRODUCTION
Base Salaries
Benefits Perquisites
Total Rewards
Annual Incentives
Long-Term Incentives
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INTRODUCTION

• The world of equity compensation is getting
  exciting again!
• New rules New strategies.
• Companies are revisiting their compensation
  philosophies.
• Playing field leveling out for public and private
  companies.

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FAS 123(R)

• Background
• FASB Independent board that sets accounting
  standards for companies to use when reporting
  financials to the public.
• Waged an exhausting battle to get companies to
  recognize compensation expense for stock options.
• Silicon Valley companies even petitioned Congress
  for help.
• Prior to this, stock options were essentially
  free to companies.

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FAS 123(R)

• What is it?
• New accounting rule that requires companies to
  recognize an expense for all transactions
  involving company equity issued to employees.
• Includes (among other things)
• Restricted stock
• Stock appreciation rights
• Performance shares
• Stock options
• ESPP
• Stock options and ESPPs are causing the most
  heartburn.

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FAS 123(R)

• Effective Dates
• Public companies
• First reporting period (interim or annual) after
  June 15, 2005.
• Calendar-year companies start July 1, 2005.
• Nonpublic companies
• First annual reporting period beginning after
  December 15, 2005.
• Calendar-year companies start January 1, 2006.

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FAS 123(R)

• Basic Principles
• Fair-value measurement and recognition of all
  equity-based compensation.
• Fair value means the price at which an asset or
  liability could be exchanged in a current
  transaction between knowledgeable, unrelated
  willing parties.
• How is it determined?
• Market value (if available)
• Option pricing model (if market value not
  available)
• Once calculated, the fair value becomes an
  expense that hits the income statement.

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FAS 123(R)

• Fair Value
• Companies can choose between option pricing
  models for determining fair value, the most
  common of which are
• Black-Scholes
• Lattice model (like Binomial)
• Both models use similar inputs but there are
  notable differences
• Binomial Model is a dynamic model.
• Black-Scholes is a static, closed-form model.

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FAS 123(R)

• Fair Value
• Binomial Model
• Produces a more accurate estimate of fair value
  than Black-Scholes.
• Takes into account potential stock price paths
  and predicts option holder behavior for a variety
  of scenarios.
• Complex modeling required to determine
  assumptions.
• Valuation can cost companies anywhere from
  30,000 to 75,000.

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FAS 123(R)

• Fair Value
• Black-Scholes Model
• Currently the most commonly used valuation model.
• Uses six variables that are assumed to be
  constant for the life of the option.
• Easy to use, but not as precise as the Binomial
  Model.

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FAS 123(R)

• Employee Stock Purchase Plans
• Another casualty of FAS 123(R), ESPPs can now
  result in a charge to earnings.
• FASB ruled that any discount on the purchase of a
  stock that is not also available to the public is
  compensatory.
• Many plans have a look-back feature in which the
  employee gets a discount on the lowest stock
  price during the offering period.
• Calculated using option valuation models, the
  compensation expense resulting from look-back
  features and purchase discounts can be
  prohibitively costly.

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FAS 123(R)

• Employee Stock Purchase Plans
• What will companies do?
• Flat 15 discount on a set purchase date (no
  look-back).
• Shorter look-back window.
• Eliminate ESPP entirely.
• FASBs Safe Harbor Plan results in no
  compensation expense with the following
  conditions
• 5 discount on the date of purchase.
• No look-back allowed.
• All employees must be eligible.

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WHATS THE BIG DEAL?

• If expensing had been in effect in most recent
  fiscal year. . .

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WHAT THIS MEANS FOR YOUR COMPANY

• Companies will be making changes to manage the
  expense
• Decreasing number of options per employee.
• Limiting the number of employees eligible.
• Replacing all or some stock options with
  restricted stock.
• Some companies may discontinue stock options
  altogether.

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WHAT THIS MEANS FOR YOUR COMPANY

• Is this good news or bad news?
• Public companies
• Good news Competitive grant levels will probably
  come down.
• Bad news Cash will become king.
• Private non-profit companies
• Good news Can now compete with public companies
  for talent.
• Bad news Competitive cash pay levels could go up.

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WHAT THIS MEANS FOR YOUR COMPANY
Options
Bonus
Benefits
Base Salary
Current Total Rewards 122,200
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WHAT THIS MEANS FOR YOUR COMPANY
???
Bonus
Benefits
Base Salary
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WHAT THIS MEANS FOR YOUR COMPANY
Bonus
Benefits
Base Salary
New Total Rewards 116,000
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STRATEGIES FOR THE FUTURE
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STRATEGIES FOR THE FUTURE
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STRATEGIES FOR THE FUTURE
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STRATEGIES FOR THE FUTURE
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STRATEGIES FOR THE FUTURE
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STRATEGIES FOR THE FUTURE
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CHANGING YOUR STRATEGY

• Before making any big changes, look at the big
  picture first.
• Why did we start giving employees equity in the
  first place?
• Create an ownership culture.
• Wealth creation.
• Employee retention.
• Is the current strategy meeting those goals?

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CHANGING YOUR STRATEGY

• What are the constraints on your equity programs?
• Minimizing the impact on EPS.
• Managing to a set dilution or run-rate.
• Living with underwater options.
• Are stock options still practical?
• Could goals still be achieved if you reduce
  grants or modify option terms?
• If not, is a complete change in the type of
  equity incentive practical?

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CHANGING YOUR STRATEGY

• If you decide to make changes, a well-planned
  communications strategy is absolutely critical.
• Employees support programs when they know how
  they work and why.
• Describe the business rationale for your program
  in a few simple but hard-hitting statements.
• Must build a strong business case for your equity
  (and other) compensation programs.
• (reThink consulting, Margaret OHanlon)

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CHANGING YOUR STRATEGY

• Make sure your equity program delivers.
• Define what success looks like and check your
  progress systematically.
• Interviews, focus groups, questionnaires can
  inform you on the value perceived by employees.
• Exercise behavior / economic gain analysis can
  inform you on the actual value delivered.
• (reThink consulting, Margaret OHanlon)

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QUESTIONS?

• For questions about this presentation, please
  contact
• Brooke Green
• Presidio Pay Advisors
• [phone]
• brooke_at_presidiopay.com
• http//www.presidiopay.com