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Achieving Equity EffectivenessA New Understanding
Seeking Equilibrium
Equity effectiveness is equilibrium in share
utilization:
• Effectiveness refers to both:
– Grant efficiency (tax/accounting/dilution)
– Motivational value
• Optimum utilization occurs when the incentive effect outweighs
the cost (dilution and expense)
• Equilibrium point is where strongest correlation between share
utilization and total shareholder return occurs
Achieving Equity Effectiveness
During the 1990’s, achieving balance was easy,
with little or no concerns about:
• Run rates
• Overhang
• Expense
• Allocation
• Motivation
Achieving Equity Effectiveness
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…
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?
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 5
00
In
de
x
Total Price Index(Dividends Reinvested)
Long-Term "Equilibrium"Total Return Index: 9.30%/Yr The “birth” of
global equity
Potential Disconnects with Conventional Wisdom
Option in March 2009 with strike of $4.00 <option in March 2010 with strike of $25.00
Surveys are reliable source of information for
compensation comparison and planning
All equity grants are powerful motivators
“Stocks for the Long Run”
Accountants vs.
entrepreneurs
Data vs.
facts
Reciprocity vs.
incentive
Timing is
everything
Current State
Shareholder
dissatisfaction
is high
Concerns about
risk, dilution, and
ownership have
fueled broad-
ranging governance
initiatives
Employer
dissatisfaction
is high
Fueled by costs of
administration,
financial reporting,
compliance, and
disclosure when
grant returns have
declined or
disappeared
For employees,
the motivational
value is low
The payoff from a
grant is often
viewed as a “gift”
that they feel
compelled to repay
by working harder
Equity EffectivenessTM
Equity Compensation Outcomes
Shareholder dissatisfaction
DilutionPerformance
Executive pay impact
Company dissatisfaction
CostsUncertain ROI
Employee impact
Employee dissatisfaction
UnderstandingValue
Behavior
Financial impact
Shareholder criteria
Objectives
Measurements
Input
Communication
Increasing Equity Compensation Effectiveness
Understanding the Disconnect: Right-Brain vs. Left-Brain
In design and delivery of equity programs:
Left is dominant:
• Tax
• Accounting
• Compliance Right is dormant:
• Perceptions
• Behaviors
• Culture
Left-Brain: Determines What Equity Grant is Worth?
• We use complex models to
calculate stock option value
• But restricted stock is the face
value at grant
• And performance shares are
the possible delivered value
• So what is the total value at
the date of grant?
Left-Brain: Determines What Equity Grant is Worth?
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
Performance ProbablityRank Distribution
Left-Brain: Drives Company Actions
0%
10%
20%
30%
40%
50%
Will do something; exploring
alternatives
More Perf. Shares than
Options
More Service RS/RSU
than Options
Relaunch ESPP
Replace Options with
cash
More Perf Shares than
RS/RSU
Anticipated Changes for Upcoming Year
But actions
are often
reactions!
Are these actions consistent with employee perceptions?
• Two
employees,
same
company…
• But, different
perceptions
on value
Assumes ratio of 3 stock options for every 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 every 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
Value is tied to perceptions
• Behavior Finance proposes theories based on psychology to
explain anomalies in the market.
• Behavioral finance assumes that the information structure and
the characteristics of market participants systematically
influence individuals' investment decisions as well as market
outcomes.
• Behavioral finance seeks to better understand economic
decisions and how those decisions affect prices, returns, and the
allocation of resources.
To an employee, perception is reality
So at the date of grant, what is the perceived value?
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…
Equity characteristics…
But, effectiveness for each individual
is driven by their perceived value
But what shapes perceived value?
• Work Culture
• Personal biases and experiences
• Generational differences
• Global cultures
Work Culture
• Alignment of equity compensation practices with both business strategies and work culture …
• … is critical for successful change and work force commitment to the change.
Work Culture
HR Programs ArchitecturePrograms Business
Results
Bonus
Options
SalaryBenefits
AIP
equity
Work
Culture
Reward Programs
Reward Programs
Reward Programs
Reward Programs
Reward Programs
SustainedSuccessDeferral
Work Culture can maximizes workforce alignment…
… and equity effectiveness
Perceptions and Behavioral Economics
The three main themes in behavioral finance 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
Behavior and Behavioral Economics
Behavioral economics provides us with explanations for the suboptimal results of option exchange programs:
Mental accounting ---- “What are these options really worth?”
Loss aversion ---- “But it’s worth something now…” Hyperbolic Discounting ---- “How long until these vest?” Endowment effect ---- “I already have these options” Decision paralysis ---- “What if I make the wrong decision?” Regret aversion ---- “What if I make the wrong decision?” Overconfidence ---- “The stock will come back” 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
Some generational differences are obvious
Implications on Perceived Equity Values
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 is reflected perceptions, social interactions
and business interactions
• Culture guides the selection of appropriate
responses in social and business situations
Hofstede’s Cultural Dimensions
Hofstede’s Cultural Dimensions
• One
company,
one Plan
• But one plan
for one
world?
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
Hofstede’s Cultural Dimensions
0
10
20
30
40
50
60
70
PDI IDV MAS UAI
European Countries
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
80
PDI IDV MAS UAI
Latin American Countries
0
10
20
30
40
50
60
70
80
90
PDI IDV MAS UAI LTO
Asian Countries
Source: Geert Hofstede™ Cultural Dimensions
Hofstede’s Cultural Dimensions
0
10
20
30
40
50
60
70
80
PDI IDV MAS UAI LTO
India
0
10
20
30
40
50
60
70
80
PDI IDV MAS UAI LTO
Singapore
0
20
40
60
80
100
120
PDI IDV MAS UAI LTO
China
0
10
20
30
40
50
60
70
80
90
100
PDI IDV MAS UAI LTO
Japan
Source: Geert Hofstede™ Cultural Dimensions
Achieving Equity Effectiveness
• If this is what an understanding of employee behavior
tells us, then how do we act today?
• By left-brain:
– Accounting
– Tax
– Compliance
• Not by right-brain:
– Perceptions
– Behaviors
– Culture
Measuring ROI: Finance Meets Behavior
Program Costs
Accounting Expense
Cash Flow Impact
Projected Dilution
Design & Administration
Document &
Disclosure
Communication & Disruption
Recruiting Success
Retention of High Value Employees
Performance Outcomes
Perceived Value
Efficient Communication
Workforce Planning
Vehicle Cost Plan Cost
Equity Equilibrium
Direct Value Indirect Value
What does this knowledge tell us about plan design going forward?
One Company, One Plan?
Looking Ahead…
0%
50%
100%
150%
200%
250%
300%
70% 80% 90% 100% 110% 120% 130%
% of Goal Achieved
% o
f T
arg
et P
aym
ent
Rec
eive
d
One company,
one plan?
Performance Share Plans
• Provide the flexibility to adapt to global differences
• Leverage can also be adjusted to respond to difference in risk profiles
• Performance metrics can be set to create global alignment and/or maximize line-of-sight
• Awards can be paid in stock, cash or a combination to maximize perceived value
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
