Copyright© 2013 ERI Economic Research Institute | 8575 164th Ave NE, Suite 100, Redmond, WA 98052 (800) 627-3697 | info.eri@erieri.com | www.erieri.com

1

Equity Valuation Terminology in Executive Compensation

By Malak Kazan, CECP, GPHR, GRP, Completed Level 1 of CEP program through CEPI at Santa Clara University Senior Associate

INTRODUCTION

With various accounting standards and ongoing regulatory changes, several terms have become prevalent for explaining the value of the equity component within executive compensa-tion. The most common terms are fair market value, fair value, and intrinsic value. More recently, the terms realized pay and realizable pay have been introduced to explain the actual or highly probable compensation income that an executive derives from the equity components as part of their total compensation over a spe-cific performance measurement period.

In this white paper, we establish a framework for these equity valu-ation terms within appropriate contexts relative to publicly traded corporations’ executive compensation plans, where valuations are more readily ascertainable. We will assume “vanilla” equity plans (i.e., those with time-based vesting). Tax implications of equity compensation programs (although significant) are not within the scope of this paper.

EquityValue

Fair Market Value

Intrinsic Value

Fair ValueRealized Pay

Realizable Pay

O. Fair Market Value per share of Common Stock on any relevant date shall be determined in accordance with the following provisions:(i) If the Common Stock is at the time traded on the Nasdaq National Market, then the Fair Market Value shall be the closing selling price per share of Common Stock on the date in question, as such price is re-ported by the National Association of Securities Dealers on the Nasdaq National Market and published in The Wall Street Journal. If there is no closing selling price for the Common Stock on the date in question, then the Fair Market Value shall be the closing selling price on the last preceding date for which such quotation exists.(ii) If the Common Stock is at the time listed on any Stock Exchange, then the Fair Market Value shall be the closing selling price per share of Common Stock on the date in question on the Stock Exchange de-termined by the Plan Administrator to be the primary market for the Common Stock, as such price is officially quoted in the composite tape of transactions on such exchange and published in The Wall Street Jour-nal. If there is no closing selling price for the Common Stock on the date in question, then the Fair Market Value shall be the closing selling price on the last preceding date for which such quotation exists.

FAIR MARKET VALUE

Fair market value (FMV) refers to the quoted market price of the company stock. Most companies will grant equity awards “equal to” or “greater than” the FMV. Given the baseline definition of FMV, it is used as an input to calculate other valuations. In the case of stock awards, which have simpler calculations, the FMV is actually the only input. For newly granted awards, the specific date that the FMV is anchored to will be defined in a company’s equity plan document and can be chosen by any one of the following methods:

• Last selling price for the stock on the date immediately before or after the grant.

• Last quoted price for the stock on the date immediately before or after the grant.

• Average selling price (i.e., arithmetic mean of the high and low price during a specified period).

To the right is an example of a standard definition of FMV from the Stock Option Plan for Delaware-based corporation NetApp, Inc.

2Copyright© 2013 ERI Economic Research Institute

Equity Valuation Terms

INTRINSIC VALUE

After FMV, from a timing and foundational terminology perspective, the concept of intrinsic value should be reviewed. The financial definition of intrinsic value is the value represented by the excess of the FMV over the amount the employee is required to pay for acquiring the equity instrument as part of the employer plan. This intrinsic value standard was introduced in 1972 as Accounting Prin-ciples Board (APB) Opinion 25 – Accounting for Stock Issued to Employees. The underlying driver of APB 25 was, primarily, option awards. Regulatory bodies noticed the upside compensation that executives were earning and the fact that there were no standards to have these equity compensation transactions reflected in finan-cial statements.

With APB 25, for the first time, companies were required to calculate the intrinsic value as of the grant date to reflect the compensation expense of the award. For option awards, a reportable intrinsic

value under this standard was triggered if the option award was “in-the-money” (i.e., discounted) at grant. Otherwise, if the award was granted “at-the-money,” the intrinsic value would be zero at grant date, and no expense would be reported by the corporation. In terms of stock awards, they would have an intrinsic value equal to the FMV. If an employee had to pay a nominal cost, it would be netted out of the FMV to determine the stock award intrinsic value. Given that stock awards were not as prevalent at the time that APB 25 was put into effect, and that most companies issued at-the-money options, requiring companies to calculate the intrinsic value generally had no impact on companies’ financial statements. Let’s start with a baseline calculation for intrinsic value upon which we will build subsequent examples. Table 1 is an example with four scenarios illustrating how the intrinsic value as of grant date can be determined: option awards discounted and equal to FMV; stock awards with and without a cost to employee.

Table 1. Option Awards Stock Awards

In-the-money At-the-money

Grant Size 80,000 80,000 20,000 20,000

FMV $75 $75 $75 $75

Exercise Price $60 $75 n/a n/a

Cost to Employee n/a n/a $25 $0

Intrinsic Value $1.2M$15 X 80,000 0 $1.0M

$50 X 20,000$1.5M

$75 X 20,000

Table 2. Grant Date

*OptionAwards

StockAwards

Grant Size 80,000 20,000

FMV $75 $75 Exercise Price $75 n/a

Cost to Employee n/a $0

Cliff Vesting 100% in 3 yrs 100% in 3 yrsFair Value $2.4M or $30 X 80,000 $1.5M or $75 X 20,000Intrinsic value $0 $1.5M or $75 X 20,000

Variance $2.4M $0

*Assumes calculated Black Scholes value of $30/share

FAIR VALUE

Fair value of the equity award is an accounting definition that complies with the Securities Exchange Commission (SEC) require-ments for equity compensation disclosures in Summary Compen-sation Tables (SCT). The concept of fair value was first introduced in 1995 as Financial Accounting Standard (FAS) 123 – Accounting for Stock-Based Compensation. At the time, this standard could be voluntarily adopted by companies, allowing them to continue reporting intrinsic value under APB 25 or switch to fair value. Most companies opted to continue with intrinsic value disclosure; thus, FAS 123 had little effect on financial statements in the first ten years of use. In 2005, however, fair value became a mandatory standard and was issued as FAS 123(r), which later was renamed in 2009 as Accounting Standard Codifications (ASC) Topic 718, providing more detailed guidance.

Determining the fair value of option awards requires the use of op-tion pricing models (see Executive Compensation: Valuing Equity Compensation) and will generally result in the option value being 20% to 60% of the stock FMV. For stock awards, the fair value is equal to the stock FMV, even under this standard (i.e., same as APB 25, intrinsic value). Given the financial reporting impact of the fair value methods for each award type, companies that issue stock awards will generally make smaller grants relative to option awards, and those executive employees with low risk tolerance tend to prefer stock awards. Let’s take a look at Table 2, which shows two scenarios illustrating Grant Date Fair Value of options

granted “at-the-money” and restricted stock with no cost to the em-ployee. Note the significant variance of the options awards when comparing the intrinsic value from the baseline example for options with same the characteristics.

3Copyright© 2013 ERI Economic Research Institute

Equity Valuation Terms

REALIZED PAY & REALIZABLE PAY

Since Say-On-Pay (i.e., Dodd Frank executive compensa-tion rules issued in 2011), two new terms have come to the forefront as voluntary disclosures in proxies to support pay-for-performance transparency: realized pay and realizable pay. Because of the voluntary nature of these disclosures, currently, there are no standard definitions that can allow for cross-company comparison, unless you reverse engineer the calculation and normalize the values. Publicly traded corpo-rations are voluntarily disclosing some variation of the real pay value (e.g., realized or realizable) in their annual filings as well as their company-specific definitions.

Realized pay is generally the compensation that an execu-tive received and is reported on their W-2 as compensation income. After researching companies that reported realized pay in their latest proxy, we decided to highlight General Elec-tric (GE) disclosures on this topic because they explain how the realized pay was derived mostly from information in the tables already disclosed in the proxy. Below are excerpts from GE’s Notice of 2013 Annual Meeting and Proxy Statement, disclosing realized compensation and the specifics of how it was calculated.

iv GE 2013 Proxy Statement

Compensation decisions for Messrs. Sherin, Neal, Rice and Denniston reflect their strong contributions to the company’s overall performance and that of their respective businesses or functions. Total compensation for these named executives was also significantly affected by the change in pension value and LTPA payouts covering all three years of the 2010-2012 performance period.

sec total compensation with annualized ltPA payout. GE grants LTPAs to named executives only once every three or more years, in contrast to many companies that grant such awards annually. Nevertheless, pursuant to SEC rules, LTPA payouts are reported in full for 2012 in the “Non-Equity Incentive Plan Comp.” and “SEC Total” columns in the Summary Compensation Table. To reflect that LTPA payouts reward performance for each of the years in the performance period, we have added the “SEC Total With Annualized LTPA Payout” column to the right of the table below to show SEC total compensation with the LTPA payout reported on an annualized basis.

realized pay differs from reported total compensation. Total compensation, as reported in the Summary Compensation Table and calculated under SEC rules, includes several items that are driven by accounting and actuarial assumptions. Accordingly, it is not necessarily reflective of the compensation our named executives actually realized in 2012. To supplement that disclosure we have added the “W-2 Realized Comp.” column to the right of the table below to compare our named executives’ 2012 compensation as determined under SEC rules with W-2 income for 2012, which is the compensation our named executives actually received in 2012.

2012 summary compensation and realized compensation

Name and Principal Position Salary Bonus

Stock Awards

Option Awards

Non-Equity Incentive

Plan Comp.

Change in Pension

Value and Nonqualified

Deferred Comp.

EarningsAll Other

Comp. SEC Total

SEC Total Without

Change in Pension

Value

SEC Total With

Annualized LTPA Payout

W-2 Realized

Comp.

Jeffrey R. ImmeltChairman of the Board and CEO

$3,300,000 $4,500,000 $0 $ 0 $12,080,250 $5,351,595 $ 574,507 $25,806,352 $20,592,769 $17,752,852 $7,907,751

Keith S. Sherin Vice Chairman and CFO

$1,850,000 $3,500,000 $0 $ 0 $ 8,595,563 $5,953,692 $ 258,110 $20,157,365 $14,302,883 $14,426,990 $6,574,575

Michael A. Neal Vice Chairman

$2,100,000 $3,800,000 $0 $ 0 $ 9,137,625 $7,821,436 $ 343,922 $23,202,983 $15,497,598 $17,111,233 $6,927,241

John G. Rice Vice Chairman

$2,200,000 $3,800,000 $0 $ 0 $ 9,447,375 $7,524,925 $2,075,677 $25,047,977 $17,678,431 $18,749,727 $8,484,728

Brackett B. Denniston IIISVP, General Counsel and Secretary

$1,575,000 $2,650,000 $0 $3,040,000 $ 6,659,625 $1,909,377 $ 461,890 $16,295,892 $14,401,341 $11,856,142 $6,736,113

For more information on total compensation as calculated under SEC rules, see the narrative and notes accompanying the 2012 Summary Compensation Table on page 32. For more information regarding amounts reported in the “W-2 Realized Comp.” column, see “2012 Realized Compensation” on page 31. For a reconciliation of realized compensation and total compensation as shown above, see “Reconciliation of Realized Compensation Table to Summary Compensation Table” on page 53. The amounts reported as realized compensation differ substantially from the amounts reported as total compensation in the 2012 Summary Compensation Table and are not a substitute for those amounts.

GE 2013 Proxy Statement 53

OtHEr infOrmAtiOnExplanation of non-GAAp financial measuresInformation on how GE calculates ENI for GE Capital, Industrial CFOA, Industrial ROTC, operating EPS and Industrial segment organic revenue growth, as presented on pages iii and 21 through 26, is disclosed on GE’s proxy website (see “Helpful Resources” on page 55) and on pages 78 to 83 of GE’s Annual Report on Form 10-K for the year ended December 31, 2012, as filed with the SEC.

reconciliation of realized compensation table to Summary compensation tableThe amounts reported in the 2012 Realized Compensation Table on page 31 reflect income for the years shown as reported on the named executives’ W-2 Forms. These amounts differ substantially from the amounts reported as total compensation in the 2012 Summary Compensation Table on page 32 required under SEC rules and are not a substitute for the amounts reported in that table. For 2012, realized compensation represents: (1) total compensation, as determined under applicable SEC rules, minus (2) the aggregate grant date fair value of equity awards (as reflected in the Option Award column), minus (3) the year-over-year change in pension value and nonqualified deferred compensation earnings (as reflected in the Change in Pension Value and Nonqualified Deferred Comp. Earnings column), minus (4) contributions to the S&SP and medical premiums that are deducted from income on a pretax basis, minus (5) the difference between the cost attributable to personal use of aircraft as calculated under SEC rules versus tax rules, minus (6) the company’s S&SP match (as reflected in the 2012 All Other Compensation Table on page 33), plus (7) the value realized from the vesting of RSUs before payment of any applicable withholding taxes and brokerage commissions (as reflected in the 2012 Option Exercises and Stock Vested Table on page 37), including the value realized from the payment of any dividend equivalents, plus (8) travel costs attributable to the named executives’ guests where there is no aggregate incremental cost to the company under SEC rules but there is imputed income for tax purposes. In addition, realized compensation reflects any bonus and LTPA actually paid in the year shown, whereas total compensation under SEC rules reflects any bonus and LTPA earned for the year shown. For realized compensation purposes, most other benefits (as disclosed in the 2012 Other Benefits Table on page 33) are accounted for on a tax year of November through October, whereas these benefits are accounted for on a calendar-year basis under SEC rules. For more information on total compensation as calculated under SEC rules, see the narrative and notes accompanying the 2012 Summary Compensation Table on page 32.

Section 16(a) Beneficial Ownership reporting complianceSection 16(a) of the Exchange Act requires GE’s directors and executive officers, and persons who beneficially own more than 10% of our common stock, to file initial reports of ownership and reports of changes in ownership of our common stock and our other equity securities with the SEC. As a practical matter, GE assists its directors and officers by monitoring transactions and completing and filing Section 16 reports on their behalf. Based solely on a review of the copies of such forms in our possession and on written representations from reporting persons, we believe that during fiscal 2012 all of our executive officers and directors filed the required reports on a timely basis under Section 16(a), except that one Form 4 to report a stock option grant to Jamie Miller was inadvertently filed late due to an administrative error.

2014 SHArEOWnEr prOpOSAlSShareowner proposals for inclusion in next year’s proxy StatementTo be considered for inclusion in next year’s proxy statement, shareowner proposals submitted in accordance with SEC Rule 14a-8 must be received at our principal executive offices no later than the close of business on November 13, 2013. Proposals should be addressed to Brackett B. Denniston III, Secretary, General Electric Company, 3135 Easton Turnpike, Fairfield, CT 06828.

Other Shareowner proposals for presentation at next year’s Annual meetingOur by-laws require that any shareowner proposal that is not submitted for inclusion in next year’s proxy statement under SEC Rule 14a-8, but is instead sought to be presented directly at the 2014 Annual Meeting, must be received at our principal executive offices not earlier than the 150th day and not later than the close of business on the 120th day prior to the first anniversary of the date the company commenced mailing of its proxy materials in connection with the 2013 Annual Meeting. As a result, proposals, including director nominations, submitted pursuant to these provisions of our by-laws must be received no earlier than October 14, 2013 and no later than the close of business on November 13, 2013. Proposals should be addressed to Brackett B. Denniston III, Secretary, General Electric Company, 3135 Easton Turnpike, Fairfield, Connecticut 06828, and include the information set forth in those by-laws, which are posted on our website. SEC rules permit management to vote proxies in its discretion in certain cases if the shareowner does not comply with this deadline or, if this deadline does not apply, a deadline of the close of business on January 27, 2014, and in certain other cases notwithstanding the shareowner’s compliance with these deadlines.

AdditiOnAl infOrmAtiOn

4Copyright© 2013 ERI Economic Research Institute

Equity Valuation Terms

Realizable pay is similar to realized pay except that it has an in-cremental value that includes unexerciseable in-the-money option awards and unvested stock awards. There are two schools of thought in terms of how this incremental value is calculated: 1) con-tinue reporting the grant date fair value pro-rated for the unexer-cised or unvested portion of the award, or 2) determine the intrinsic value at the end of a performance measurement period. Applying the second approach can align with other compensation compo-nents reported in the SCT when the same fiscal year end is used versus the grant date. Building on the earlier examples, Table 3 de-picts realizable pay with both FMV appreciation and depreciation.

In the context of pay for performance, we see in this example that, when FMV appreciates, the executive can realize more compensa-tion income from the equity instruments than the accounting value reported on grant date. Similarly, when FMV depreciates, the ex-ecutive will realize less compensation income. As a business prac-titioner, trueing up performance results against the target expecta-tions is an intuitive standard, and the introduction of real pay value allows for this in the context of executive compensation. We can expect more information and best practices on this topic to evolve in the near future.

Table 3. Year 2Equity Appreciation

Year 2Equity Depreciation

Option Awards

Stock Awards

Option Awards

Stock Awards

Grant Size 80,000 20,000 80,000 20,000

FMV $110 $110 $50 $50

Exercise Price $75 n/a $75 n/a

Cost to Employee n/a $0 n/a $0 3-year Cliff Vest 0% 0% 0% 0%

Realizable Equity Pay $2.8M or $35 X 80,000 $2.2M $110 X 20,000 $0 $1.0M or $50 X 20,000

*Grant Date Fair Value $2.4M or $$30 X 80,000 $1.5M or $75 X 20,000 $2.4M or $$30 X 80,000 $1.5M or $75 X 20,000

Variance $400K $700K -$2.4M -$500K

*Assumes a calculated Black Scholes value of $30/share

References:General Electric. (2013, April 24). Notice of 2013 Annual Meeting and Proxy Statement. Retrieved from http://www.tscviewer.com/Ge/iversion/NoticeOf2013AnnualMeetingAndProxyStatement_i1

NetApp, Inc. (2011, July 14). Stock Option Plan. Retrieved from http://contracts.onecle.com/netapp/stock-option-plan-1999-2011-07-24.shtml

A significant portion of executive compensation packages are comprised of equity awards. Depending on the context of the dis-cussion, the audience, and scenario specifics, the value of option awards and stock awards will vary. Understanding the fundamen-tals of these calculations is invaluable to the business practitioner directly or indirectly involved in executive compensation. For more information regarding executive compensation analytic tools and solutions, please visit www.erieri.com.