Structuring Effective Long-Term Incentive Plans

1

Structuring Effective Long-Term Incentive Plans

May 6, 2014

2

Speakers

Denver Compensation & Benefits, LLC

• John Schultz, J.D., LL.M., Managing Director

• Brennan Rittenhouse, J.D., LL.M., Manager

3

Overview of Long-Term Incentive Plans

4

Overview of LTIa. Purpose

i. The long-term benefit of an effective LTI plan can be invaluable to the long-term success of a company

ii. A well designed LTI plan aligns employee interests with those of the company owners

iii. Long-term incentives can drive employee performance, company growth, and provide a buffer against short-term drivers

iv. It can also be used to help retain high performers

5

Overview of LTIb. Prevalence

i. Approximately 75% of public companies have LTI plans

ii. LTI plans are less prevalent among private companies

1. Only about 61% of private companies utilize LTI plans, which is an increase from 35% in 2007

iii. Reasons:

1. Lack of sophistication/resources

2. Reluctance to dilute ownership

3. Minority shareholder concerns

4. Complexity

6

Overview of LTIc. Award Sizes

i. Awards are typically granted based on a percentage of base

salary

ii. Watson Wyatt Survey (under 1,000 full-time employees)

1. Company officers – 102.5%

2. Other management – 51.4%

7

Overview of LTId. Correlation to STI plan

i. Sometimes companies will coordinate their annual short-term incentives with their LTI plans

ii. Annual performance metrics and aggregate target payouts can be established

iii. The individual incentive awards are allocated between LTI and STI (e.g., 75% LTI and 25% STI)

iv. LTI awards will have a multi-year vesting and/or performance schedules (e.g., 3 years, earnings growth, EBITDA, etc.)

8

Plan Structures

9

Plan Structures

a. Public Company Practices

i. Equity (as opposed to cash) plans

1. Favorable accounting treatment

2. Simple

3. Understood

10

Plan Structuresa. Public Company Practices

ii. Equity award form

1. Stock Options

a. The right to buy a number of shares at a price fixed at grant for a specified term

b. Companies use an option-pricing model to calculate the value of awards as of the date of grant and expense that amount

11

Plan Structures

a. Public Company Practicesii. Equity award form (cont’d.)

2. Restricted Stock

a. Provide employees with shares of company stock at little or no cost, subject to a risk of forfeiture (“vesting”)

3. Restricted Stock Units

a. Similar to restricted stock, but employees do not actually

receive shares until the restrictions lapse

12


iii. Vesting Provisions

1. Time vesting

2. Performance – either used to determine grant size or vesting amount

a. Company performance

b. Business unit performance

c. Individual performance

13

Plan Structures

a. Public Company Practicesiv. Stock Options vs. Full-Value Awards

1. Historically options were preferred because of the favorable accounting treatment

2. A big shift to restricted stock with FAS 123R – 2005

a. Companies now expense options

14


iv. Stock Options vs. Full-Value Awards (cont’d.)

3. Full-value award concerns

a. Will realize value regardless of performance

b. “Pay for pulse”

i. Because most restricted stock vests on the passage of time, employees receive benefit for simply continuing employment

15

Plan Structures

a. Public Company Practicesiv. Stock Options vs. Full-Value Awards (cont’d.)

4. Stock option concerns

a. Market conditions beyond employee control can result in awards being worthless

b. Awards too far underwater lose retention effect

16

Plan Structuresb. Private Company Practices

i. Equity-based plans1. Advantages of equity-based plan

a. More closely mirror public company structure

b. People understand the plans

c. Takes care of alignment issues

d. Consolidates all factors into 1 MEASUREMENT-VALUE

17


i. Equity-based plans

2. Private company issues

a. Valuation challenges

i. Difficult/expensive to value

ii. Internal Revenue Code section 409A complexity

iii. Skepticism of valuation models

18


i. Equity-based plans

3. Lack of Liquidity

a. Makes it difficult for participants to realize value

b. Can lead to phantom income problems

c. Impacts perceived value

d. Cash flow issues

4. Minority shareholder concerns

19


ii. Cash-based plan 1. Using STI structure (including targets) and stretching terms2. Adding vesting terms3. Less favorable accounting4. Can be difficult to set metrics that work over extended periods5. Can be complex and difficult to understand/communicate

20

Real Equity or Synthetic Proxy

21


a. Actual equity grant – 2 basic forms

i. Stock Options

ii. Restricted Stock/RSU

1. Both result in the transfer of actual equity

22


b. Phantom grants – “stock”/Stock Appreciation Rights (“SAR”)

i. Acts like real equity, but only cash transferred

1. Phantom stock grants the right to receive cash based on the future value of the company's stock

2. SARs are the right to receive cash based on the appreciation in the value of the stock

23


b. Phantom grants – “stock”/SAR (cont’d.)

ii. Closest to true equity plan1. Avoids minority shareholder issues2. Company provides the liquidity3. Still has valuation issues

a. Typically addressed via formula approach

24

Performance Measures

25

Performance Measuresa. Principles for effective measures are

i. Relevant to business objectives

ii. Focus and drive executive behavior to desired results

iii. Controllable with little to no manipulation possible

iv. Integrate and recognize cross-functional nature of business processes

v. Accurate and cost-effective reporting as well as a currently audited and disclosed measure is best

vi. Sensitive to changes in business environment

vii. SIMPLE

26

Performance Measures b. Some examples of performance measure types are:

i. Top-line growth (revenue growth, operating margin, etc.)

ii. Bottom-line growth (EBIT, EBITDA, earnings per share, etc.)

iii. Ratio measurement (ROA, ROE, ROI, etc.)

iv. Operating (operating efficiency, debt management, etc.)

v. Value-added (cash-flow management, return over cost of capital, etc.)

vi. Shareholder return (EPS, TSR, etc.)

vii. Discretionary

27

Performance Measuresc. Measures can be expressed in a variety of ways

including:

i. Achievement of budgeted performance goal

ii. Improvement over prior or previous year(s)

iii. Relative to comparator group or index

iv. Achievement of strategic milestones

28

Performance Measuresd. Measures should:

i. Focus on line-of-sight

ii. Integrate success of company and that of its business units, segments or divisions

iii. Be quantifiable and measurable (easy for participants to understand)

iv. Be limited in number (three or less measures is best to focus attention to key or critical objectives for the business)

29

Performance Measures e. Weightings

i. Weightings should:

1. Reflect the importance of the measure within the incentive plan

2. Be rounded to a 10% or 5% figure

3. Not be less than 20% (if three or two measures in total) or

participants will only focus on the heavier weighted measures

ii. “Triggers” can be implemented if helpful

4. A trigger is a hurdle that must be reached before any portion of the incentive award is paid out and is usually tied to some overarching corporate measure

30

Performance Tiers

31

Performance Tiers

a. Tiers are typically defined at three levels i. Threshold reflects the minimum level at which incentive payments begin.

This level gets participants “in the game” and typically has payment levels that are below achievement levels to contribute more to the company bottom-line until profitability starts (usually this level of payout would be 50% or less of target)

ii. Target reflects “stretch” performance and is generally equal to the “planned” or “budgeted” level of performance with a moderate level of difficulty (100% achievement equals the target incentive level)

iii. Maximum reflects the maximum level of payout based on an increased level of profitability (usually this level is 200% of target)

32

Performance Tiers

b. Design Considerationsi. Setting appropriate performance goal levels is the most critical part

of the design process (and will get the most scrutiny from shareholders and outsiders if not done correctly)

ii. It is important to incorporate overall company performance into the incentive program to mitigate some overall risk issues

iii. Discretionary goals are typically very subjective and should be limited in use

1. Opt for overall corporate measures or triggers when possible

33

Award Opportunity

c. Award opportunities should be:i. Expressed as a percentage of a participant’s base salary or set dollar

amount (most programs incorporate percentages)

ii. Based on salary level and also the contributory and strategic nature of the position

iii. Tiered by level and role to streamline administration and communication of the program

iv. Expressed in terms of minimum, target and maximum (or other reference points as useful)

34

Finalizing the Program d. Program Analysis

i. Many different elements should be analyzed prior to finalizing an incentive program, but some key issues to review are:

1. Total payout of awards as a percentage of company profit to ensure it is at an acceptable level, especially at each award opportunity level

2. Review elements of risk and how they could impact each of the measures and the respective payouts at each award opportunity level (list the types of risk categories reviewed and what the potential impact might be)

3. Review the incentive program and how it fits into the total compensation program and company pay philosophy

35

Implementation and Communication

a. Key considerationsi. Create a design and implementation team prior to

designing the program that would include compensation, HR, finance (accounting and tax), legal and IT to ensure you can design a measurable and easily administered program

ii. Simplify as much as possible, the program has to be easy for the participant to understand or it will not motivate properly

36

Implementation and Communicationa. Key considerations (cont’d.)

iii. Pick measures on which you can regularly report results to participants to continue the excitement throughout the year

iv. “Brand” your communications so participants will easily recognize them and make them as brief as possible or they will not read them thoroughly

v. Show how this incentive plan ties into total compensation and specifically links to business objectives and provide ideas on how participants can impact results

37

Implementation and Communication

b. Rememberi. If you communicate often and clearly, your program will be

successful regardless of whether it is the best “theoretical” design or a poorer design

ii. If participants understand the program (not necessarily like it) they can more actively affect their compensation and the positive results of the company

38

Traps & Tricks

39

Traps & Tricks

a. Know your shareholders!

i. If you’ll be seeking shareholder approval

1. Understand the implications of shareholder groups

2. Stay up to date on their guidelines

3. Consult with them in advance if you are not sure

40

Traps & Tricks

b. Beware of the “qualified” option!i. Disqualifying dispositions of both Incentive Stock

Options and Employee Stock Purchase Plans means they are taxable based on the spread at EXERCISE, not sale

ii. And the spread at exercise is subject to Alternative Minimum Tax

1. Exercise high and sell low can yield a very bad result

41

Traps & Tricksc. Wages or Wages?

i. The definition of wages for income tax is different than wages for FICA

ii. If there is a deferral feature in the plan (e.g., RSU) the value will be subject to FICA when vested but income tax when paid

iii. Make sure you have a FICA tax payment provision built into the plan

42

Traps & Tricks

d. What’s my grant date?i. The grant date is the measurement date for both

accounting and tax, but what is it?

ii. Picking wrong can result in erroneous accounting charges, SEC and Exchange violations and penalties, and/or retroactive taxation plus penalties

iii. Make sure that the rules, the documents, and the PROCESS are in sync

43

Traps & Trickse. Accelerated Vesting – is it worth it?

i. Accelerations are common but can be tricky

ii. They can result in unexpected:1. Accounting charges

2. Lost deductions under Internal Revenue Code (“IRC”) section 162(m)

3. IRC section 409A violations and penalties

4. IRC section 280G excise taxes and lost deductions

5. Impacts on the potential transaction

iii. Understand the application of each trigger under various scenarios

44

Traps & Tricksf. IRC section 409A – since when is equity deferred compensation?

i. It is not just the grant date that can get you (FMV at grant requirement)

ii. Any modification is a potential disqualifier

iii. Do not grant stock options on anything other than plain vanilla common stock

iv. Be careful of anti-dilution provisions

v. Especially careful with deferred Restricted Stock Units1. Distribution triggers

2. Change in control definition

3. 6 month delay for public company Named Executive Officers

45

Traps & Tricks

g. Why all the fuss over IRC section 162(m)?

i. With the trend from using stock options to RSAs/RSUs, qualifying for the performance-based exception has changed

ii. Now cannot just rely on the stock plan exception, but need to comply with ALL the requirements

iii. And the IRS changed some of the rules, so improper accelerators can taint the whole plan

46

Long-Term Incentive Design Examples

47

Examplesa. Actual equity award – ABC Co.

i. Facts1. $10 million manufacturing company2. 35 employees3. Private equity backed4. Some financial statement sensitivity 5. Short term focus; 3-5 year exit strategy

48


ii. Plan Design

1. Individual incentive awards are allocated 25% to STI and 75% to

LTI

2. For the LTI portion, the Participants are granted restricted stock units and/or stock options, which vest over a three-year period

3. The target size and make-up of the award is based on the individual’s position, responsibilities, compensation level,

performance, historical contribution, and market practices

49


ii. Plan Design (cont’d.)

4. Funded by the LTI award pool of approximately 15% of fully diluted common stock

5. After the pool has been exhausted, the company may reassess whether additional funding of the LTI plan is in the best interests of the company, shareholders and participants

6. Payout terms are linked to owners; i.e., participants get paid when the shareholders get paid

50

Examples

b. Hypothetical unit grant – Public company subsidiaryi. Facts

1. US subsidiary of very large, publicly traded, foreign parent

2. Service company with related company activities

3. Need to evaluate performance on a combined-entity basis

4. Some financial statement sensitivity

5. Cross-border issues and individual tax sensitivity

51

Examples

b. Hypothetical unit grant – Public company subsidiary

ii. Plan Design

1. Private company creates an LTI plan that grants “units” in a pool that consists of company earnings

2. This LTI pool is treated like a separate entity that is divided into “units” (similar to stock)

3. One percent of consolidated-company profits is allocated to the pool

52

Examples

b. Hypothetical unit grant - Public company subsidiary

ii. Plan Design (cont’d.)

4. Growth of the pool is based on company profit growth-similar to valuation of private company

5. Employees have the option to defer payouts from the plan, and in return receive a 20 percent company match on those deferrals

a. Maintains incentive value even after vested

53

Examples

b. Hypothetical unit grant - Public company subsidiary iii. Employee grants

1. Employees granted “units” based on a percentage of salary

2. Each grant of “units” to the employees is subject to a three year graded vesting schedule, with payout occurring in year four

3. This will drive employee behavior and create the desired retention effect

4. Grants are made annually to increase retention and smooth out unforeseeable changes in earnings

54

Examplesb. Hypothetical unit grant - Public company

subsidiary iv. Attempt to keep it simple so employees

appreciate plan1. Well developed education up front2. Annual statement to communicate value

55

Examples

c. Multiple Equity Plansi. Facts

1. 1,000+ employees2. Desire to build ownership culture3. Maximize tax efficiency4. Conserve cash in the short term

56

Examples

c. Multiple Equity Plansii. Multi-plan design

1. Omnibus equity plan structurea. Allows for stock, RSUs, options, SARs,

performance units, etc.i. Provides maximum flexibility

57

Examples

c. Multiple Equity Plans

ii. Multi-plan design (cont’d.)

2. Nonqualified deferred compensation plan

a. Permits deferral of equity plan awards

b. Permits target employees to buy stock with pre-tax cash compensation (base & bonus)

58

Examples

c. Multiple Equity Plans ii. Multi-plan design (cont’d.)

3. Qualified plan – “KSOP”a. Allows company to make stock contributions,

including 401(k) match, in stockb. Permits participants to direct investment in

company stock

59

Examplesd. Actual equity award – XYZ Co.

i. Facts1. Approximately $1B revenue healthcare company2. Public company3. Some financial statement sensitivity4. Significant dilution concern 5. Has performed extremely well, but executive

compensation has not always reflected high performance

60


ii. Previous Plan Design

1. Previously, the company used a long-term incentive award that was based

on economic value

2. Fairly complicated plan which made it difficult for management to decipher what behavior was required to receive a payout

3. The calculation included variables the executives had no control over, such as the business valuation multiple

4. Plan had a 3-year performance period, followed by a 3-year payout period

61


iii. Revised plan design

1. LTI plan granting performance based RSUs (“PBRSUs”) (1/2), time-based RSUs (1/4), and stock options (1/4)

2. Provides significant upside with the use of stock options, while maintaining some “handcuffs” in a down market with the use of time-based RSUs

3. PBRSUs directly tied to company performance (relative TSR), while limiting the dilution caused by options

4. To further limit dilution, PBRSUs can be settled in stock or cash

62

Questions?

John [email protected]

303-779-2080

Brennan [email protected]

303-779-2082

mailto:[email protected]

mailto:[email protected]

63

Please note that, though we believe this presentation provides accurate information,

its accuracy is not guaranteed. Also, this presentation does not provide legal,

accounting or tax advice. Finally, this presentation cannot be used to avoid any tax

penalty.

Documents

Structuring Effective Long-Term Incentive Plans