Equity effectiveness: creating alignment and value with your equity compensation plans

Compensation practice

Jim Sillery and Sandra Sussman

October 25, 2012

Equity effectiveness: creating alignment and

value with your equity compensation plans


Seeking equilibrium

Equity effectiveness is the point of equilibrium in share utilization:

• Effectiveness refers to both:

– Grant efficiency (tax/accounting/dilution)

– Motivational value

• Optimum utilization occurs when the return (motivational effect)

outweighs the cost (dilution, expense and administration)

• Equilibrium point is where strongest correlation between share

utilization and total shareholder return occurs

2


Achieving equity effectiveness

3

During the 1990s, achieving equilibrium was easy, with little or

no concerns about:

• Run rates

• Overhang

• Expense

• Allocation

• Motivation



4

In the years following the 2001-2002 recession, optimization was

more difficult:

• Economic pressure drove increased diversification in the use of

equity plans

• Changes felt across many participation levels and geographies

• For a long time, the solutions were simple…


But no one expected…

5

The 2008-2009 recession was unprecedented in:

• The depth of its decline

• The duration of its decline

• Its global economic impact

…And had a profound impact on equity compensation programs


Why was this a surprise?

6

Are the foundations of global equity programs built on an

anomaly?

Growth of $10 invested in the Total

S&P500 Index starting in 1900

$1

$10

$100

$1,000

$10,000

$100,000

$1,000,000

1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020

Year

Re

al S

&P

50

0 In

de

x

Total Price Index

(Dividends Reinvested)

Long-Term "Equilibrium"

Total Return Index: 9.30%/Yr The “birth” of

global equity


Potential disconnects of today’s reality with

conventional wisdom

7

Option in March 2009 with strike of $4.00 <

option in March 2012 with strike of $20.00

Surveys are reliable source of information for

compensation comparison and planning

Equity grants are powerful motivators,

especially when based on performance

“Stocks for the Long Run”

Accountants vs.

entrepreneurs

Data vs.

facts

Reciprocity vs.

incentive

Timing is

everything


Current state

8


Understanding the disconnect:

right-brain vs. left-brain

9

In design and delivery of equity programs:

Left is dominant:

• Tax

• Accounting

• Compliance Right is dormant:

• Perceptions

• Behaviors

• Culture


Left-brain: determines what an equity grant is worth

10

• We use complex models to calculate

stock option value

• But restricted stock is the face value at

grant

• Performance shares are the

possible delivered value

• What about long-term cash?

So, what is the total value delivered at grant?


So at the date of grant, what is the perceived value?

11

Assumes ratio of 3 stock options for exery 1 restricted share

Value of Stock Options vs. Restricted Stock

$0

$1,000

$2,000

$3,000

$4,000

$5,000

$6,000

$7,000

$8,000

Grant 1 2 3 4 5 6 7 8 9 10

Stock Options Restricted Stock

Assumes ratio of 3 stock options for exery 1 restricted share

Value of Stock Options vs. Restricted Stock

$0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

Grant 1 2 3 4 5 6 7 8 9 10

Stock Options Restricted Stock

The answer is

simple… it

depends…


But what does perceived value depend on?

• Work culture

• Personal biases and experiences

• Generational differences

• Global cultures

12


Work culture

Alignment of equity compensation

practices with both business

strategies and work culture…

13

… is critical for successful

change and work force

commitment to the change.


Perceptions and behavioral economics

The three main themes in behavioral economics are:

• People often make decisions based on “rules of thumb”, not rational

analysis

• The way a problem is presented will affect the decision a person

makes on how to act

• There are behavioral explanations for observed market outcomes

that are contrary to rational expectations and market efficiency

14


15

Behavior and behavioral economics

Behavioral economics provides us with insight into employee

perceptions:

• Mental accounting -- “What is this grant worth now?”

• Loss aversion -- “What if it goes underwater?”

• Hyperbolic Discounting -- “But, when do they become mine?”

• Decision paralysis -- “What if I don’t know how to decide?”

• Regret aversion -- “What if I make the wrong decision?”

• Overconfidence -- “This should be easy!!!!”

• Following the herd -- “But it’s a best practice”


Behavior and generational differences

• Generational differences manifest themselves in several ways,

including how individuals view their compensation

• There is variation in the nature of intrinsic rewards each

generation considers

• The generations also relate to their organizations differently

16


Implications on perceived equity values

17

Baby Boomer:

• Optimistic + Involved + High Risk/High Rewards = Preference for

highly leveraged grants like stock options

Generation X:

• Cautious + Conservative + Distrustful = Preference for low

leverage grants like service-based restricted stock

Generation Y:

• Realistic + Confident + Career Focused = Preference for moderate

leverage grants like performance shares


Behavior and global culture

• Culture is the underlying value

framework that guides an

individual’s behavior

• Culture reflects perceptions,

social interactions and

business interactions

• Culture guides the selection of

appropriate responses in

social and business situations

Hofstede

Cultural Dimensions

Small Power Distance Big Power Distance

Individualism Collectivism

Masculinity Femininity

Strong Uncertainty Avoidance Comfort with Uncertainty

Long-Term Orientation Short-Term Orientation

18


One company, one plan?

19

0

10

20

30

40

50

60

70

80

90

100

PDI IDV MAS UAI LTO

United States

0

10

20

30

40

50

60

70

PDI IDV MAS UAI LTO

World Average

0

10

20

30

40

50

60

70

80

PDI IDV M AS UAI

Latin American Countries

0

10

20

30

40

50

60

70

80

90

PDI IDV MAS UAI LTO

Asian Countries

0

10

20

30

40

50

60

70

PDI IDV MAS UAI

European Countries

Source: Geert Hofstede™ Cultural Dimensions



20

• If this is what an understanding of employee behavior tells us, then

how should we act today?

• By left-brain:

– Accounting

– Tax

– Compliance

• And right-brain:

– Perceptions

– Behaviors

– Culture


Looking ahead at equity effectiveness

21


But, how do we make this work?

First, ask five simple questions:

• What does our participant group look like?

• Is our plan aligned with our work culture?

• How should/does the plan work?

• What behaviors and outcomes do we want to drive?

• Are we meeting the needs of all constituencies?

22


But, how do we make this work?

0%

50%

100%

150%

200%

250%

300%

70% 80% 90% 100% 110% 120% 130%

% of Goal Achieved

% o

f T

arg

et

Pa

ym

en

t R

ec

eiv

ed

Workforce

Analysis

Work Culture

Diagnostic

Pay for

Performance

Design

Outcome Analysis

ROI

Analysis TSR

Retention

Wealth

Creating

Alignment…

Creating Line of

Sight…

Creating Value…

23


Workforce analysis

24

An analysis of workforce demographics can provide insights into

who your employees are, how their perceptions are formed and

how you can manage those perceptions


Work culture diagnostic

• A company’s work culture defines

− How it is organized

− How roles are defined

− Who succeeds

− How performance is managed

− How people are rewarded

• Using a series of diagnostic tools to assess the current, and desired,

work culture to ensure that equity grants are creating alignment with

those attributes that have the greatest impact on performance

25


Pay for performance analysis

• There is a range of metrics associated with value creation.

• Some like Free Cash Flow are “drivers” of future value while others

like TSR measure the value created

26


Pay for performance analysis

• A pay for performance analysis looks for the cause and effect

relationship between the plan design and desired/final performance

outcomes

• This analysis ensure that there is a direct correlation between key

financial, economic and behavioral factors and desired/realized

outcomes

27


Design outcome analysis

• Performance-based

incentives can and often

do have unintended

consequences

• The design outcome

analysis allows a

company to look at the

“inner working” of a plan

before it is implemented

0.0%

0.1%

0.1%

0.2%

0.2%

0.3%

0.3%

0.4%

0.4%

0.5%

-200% -100% 0% 100% 200% 300% 400%

TSR Distribution

Simulation

Theoretical

28


Design outcome analysis

• By running multiple scenarios of potential outcomes, this analysis

can quickly pinpoint if and where plan design may deviate from plan

intent so that it can be recalibrated

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 80.00% 90.00% 100.00%

Rank

Rank Distribution Vol 50%

29


ROI analysis

• The ROI Analysis looks at the end-of-plan return to all stakeholders:

- Shareholders

- Company

- Participants

• This provides a key look at the effectiveness of the equity plan —

was there equilibrium between the return to shareholder and the

company (left brain) and the return to the participants (right-brain)

• It also provides valuable feedback to enhancing future plan

effectiveness

30


ROI analysis

• The success factors considered in this analysis can and will vary

across organizations and their constituencies

- Companies may define success in terms of a combination of cost,

retention, recruitment, commitment, market position and/or other factors

- Shareholders may define success in in terms of increased share price

relative to dilution, dividends and/or other factors

- Participants may define success based on delivered value compared to date of grant value, stock ownership, long-term capital accumulation,

financial security and/or other factors

• These success factors should be identified at the onset, checked on

an ongoing basis to confirm their continued relevance and then

measured at the end of the period

31


Parting thoughts

• Technical aspects of equity are important, but not enough

• To understand perceived value, a better understanding of the global

workforce is needed

• Value is perceived, not calculated

• Classical rational decision-making is not the model for actual

employee decision-making

• Triangulate to get answers rather than focusing on the single best

base of information

• Design simplicity should be an imperative

• More intuition, less conventional wisdom

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Questions

33

Jim Sillery Principal

612.215.6940 [email protected]

Sandra Sussman Director

415.617.3935 [email protected]

mailto:[email protected]

mailto:[email protected]

Business

Equity effectiveness: creating alignment and value with your equity compensation plans