Underwater Equity

Rescuing Equity Compensation from Volatile MarketsNational Association of Stock Plan Professionals10 December 2008

Fred WhittleseyPrincipal, West Region Practice Leader

Kiran SahotaConsultant

1

Today’s Discussion

Capital Market and Economic Situation

Questions of the Day

Defining the Problem

Increasing Equity EffectivenessTM

Option Exchanges

Alternatives to Exchanges

2

No Place to Hide (but Treasuries)

-34.1%

-41.1%-43.9%

-51.0%

-43.1%-45.6%

-27.1%

-15.7%-12.5%

-4.1% -1.7%

4.5%

-60%

-50%

-40%

-30%

-20%

-10%

0%

10%

2008 YTD Returns Through 12-05-08

DJIA S&P 500 NASDAQ CompS&P Asia 50 S&P Europe 350 MSCI EuroMorningstar Real Estate LB Commodities LB Global Corp BondLB Global Agg Bond LB US Agg Bond LB US Treas

3

Economy & Capital Market Situation

Recent volatility in the capital markets has led to:

Staggering losses of shareholder value

Significant reductions in business volume due to credit constraints

Large layoffs due to company failures

For equity compensation programs, we have

Underwater options…and “underwater” RSUs, “underwater” performance plans

Soon-to-be inflated Black-Scholes values from increased volatility…but

Depressed Black-Scholes values from price declines…and

The resulting impact on the use of survey data

Distorted grant guidelines, if dollar-denominated

Concerns about over-granting at low prices and accusations of market timing

4

Economy & Capital Market Situation

Resulting, and parallel, economic recession is creating:

Further reductions in business volume due to consumer and business spending pullback

Smaller incremental layoffs for

expense management

“bundled performance management”

de-layering

For equity compensation programs, we have

Reduction in savings – “home equity”, defined contribution balances –exacerbating concerns over equity compensation value

Questionable prospects for near-term stock price appreciation

Uncertainty of current staffing levels complicating decisions on equity compensation

US Unemployment Rate (Through Nov, 2008)

4.0%

4.5%

5.0%

5.5%

6.0%

6.5%

7.0%

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov

5

Questions: Equity Compensation

Did a shift from options-only to other awards provide the intended insulation from market volatility this time?

RSUs

Cash LTIs

Will shareholders allow or tolerate actions to restore LTI value?

Option exchange program

Off-cycle option grants to take advantage of low share prices

Will this be the end of the spread of performance shares?

Goal-setting difficulty

Relative TSR measurement

Despite governance concerns will companies “do the math” and return to option-only awards?

6

Underwater Equity: One Part of a Broader IssueThe survey(s) say(s)

Salary increase budget reductions and delayed increases

Missed annual incentive targets

Discretionary adjustments to incentive pools

Underwater equity – options, RSUs, performance plans

Depleted 401(k) balances

Reduced participation rates

Increase in loans and withdrawals

Underfunded defined benefit pension plans

Nonqualified deferred compensation at greater risk

Rapidly changing executive compensation environment – ripple effects

7

The Status of Equity Compensation

Equity awards of all types have gone underwater

FAS123R fears are realized as a significant number of companies have 100% of options underwater

“Underwater RSUs” enter the discussion as that “full value” is only half-full leading to a perception of “half-empty”

Performance plans unravel as multi-year financial performance goals appear unattainable in the first year of a multi-year period

Even relative TSR plans are failing

Equity markets trading on panic and forced selling rather than fundamentals

8

Before We Solve the Problem…

Companies continue to evaluate the role of equity-based compensation in their total compensation strategy and now have the economic situation as an additional consideration

Five years of regulatory change and focus on compliance triggered many reactive changes and companies still say they

Don’t assess effectiveness of equity compensation plansDon’t calculate ROI of equity compensationAre not sure what they’re getting in return for the expenditures

Corporate governance concerns surrounding executive and equity compensation continue to escalate

Potential actions for underwater equity may trigger corporate governance criticismsAny action, or appearance of such action, to deliver value to employees not available to shareholders may be criticized

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…Let’s Define the Problem We’re SolvingPublic companies rely on outside advisory resources for executive compensation, and executive equity trends influence and drive non-executive practices

Advice still centers on benchmarking, expense, and compliance

New legislative initiatives (e.g., EESA) are spreading rapidly, increasing both the compliance and governance focus

Competitive benchmarking continues to be a core process in compensation analysis and design but has become highly complex due to equity program design changes and trends

Benchmarking measures only inputs, not outcomes

Inconsistencies and disagreement about valuation cause difficulties in benchmarking

Current economic situation renders all 2008 survey data moot and current survey efforts on what companies are “considering” have no value given volatility and varying timeframes

10

…Let’s Define the Problem We’re Solving

All of the historical bases of equity compensation have been eroded over the past five years

Historical Drivers of Equity Compensation Usage

Accounting Efficiency:

Stock Options

Limited Cash Available

Employee Ownership

Focus

Growth Industry Sectors

U.S.-Based Employees

Legislative Support:

ISO, ESPP, ESOP

Equity Compensation Design

Stock Options

Uniform Vesting

Schedules

Uniform Option Term

No Performance

Features

US-Centric Design

Easy Liquidation

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Equity Compensation: Source of Dissatisfaction

Equity Compensation Pressures 2002 Equity Compensation Pressures 2002 –– 20082008

FAS123R FAS123R ExpenseExpense

409A 409A ComplianceCompliance

Shareholder Shareholder and Proxy and Proxy Advisor Advisor PoliciesPolicies

Capital Capital Market Market

VolatilityVolatility

Global Global Practices Practices

ConvergenceConvergence

SarbanesSarbanes--Oxley Oxley

ComplianceCompliance

Equity Compensation Pressures 2008Equity Compensation Pressures 2008

Reduced Reduced ParticipationParticipation

Smaller Smaller GrantsGrants

Lower Pay Lower Pay ValuesValues

Capital Capital Market Market

VolatilityVolatility

Global Global Practices Practices

ConvergenceConvergence

SarbanesSarbanes--Oxley Oxley

ComplianceCompliance

Equity Compensation OutcomesEquity Compensation Outcomes

Shareholder dissatisfactionShareholder dissatisfaction Company dissatisfactionCompany dissatisfaction Employee dissatisfactionEmployee dissatisfaction

What are we doing?

What What are we are we doing?doing?

Why are we doing it?

Why are we Why are we doing itdoing it??

What are we getting for

it?

What are we What are we getting for getting for

it?it?

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Shareholder Dissatisfaction

Shareholder dissatisfaction with executive and equity compensation practices is reflected in proxy advisors’ and institutional investors’ metrics and ratings

This environment is further reflected in legislation that constrains equity plan design through accounting, tax, and disclosure requirements

Arbitrary value-laden standards continue to drive equity compensation design

Overhang and run rateOptions vs. share and share unit conversion ratesOwnership guidelines“Shareholder-Friendly” option exchange guidelines

The tainting of equity compensation resulting from perceptions of executive pay is driving continued changes to equity plan design

13

Employer Dissatisfaction

Costs of administration, financial reporting, compliance, and disclosure of equity plans have increased during a period in which employeereturns from grants have declined or disappeared

2004 Grants

2005 Grants

2006 Grants

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Employers clearly articulate their objectives and rationale for equity compensation programs

Relative Importance of Reasons for Granting Equity to Employees

Source: iQuantic-Buck 2008 Equity Plan ROI Survey

Corporate Culture Financial Efficiency Competitive ReasonsWealth Creation Total Compensation Investor Expectations

Not Important

Moderately Important

Very Important

15


But employers report being most “successful” on least important objectives

9%

18%

10%

16%

51%

64%

49%

54%

38%

59%

47%

27%

47%

28%

52%

25%

4%

2%Corporate Culture

Financial Efficiency

Competitive Reasons

Wealth Creation

Total Compensation

Investor Expectations

Not Successful Moderately Successful Very Successful

Relative Success of Achieving Stated Objectives of Equity Compensation Programs

Source: iQuantic-Buck 2008 Equity Plan ROI Survey

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Employee Dissatisfaction

79% 76%

57%

74%

83%

49%

40%

60%

80%

100%

Turnover CostRetention of High PerformersEmployee ProductivityStock PerformanceEmployee SatisfactionGains to Employees

Metrics Used in Measuring LTI ROIOnly 31% of survey respondents reported undertaking any formal measurement of returns generated by their equity compensation programs

Of those measuring ROI, employee satisfaction was the measure most commonly used

Yet the key purpose of equity grants – providing compensation to employees – is measured least

Nearly two-thirds of all stock plan participants view their stock proceeds as “free money” as opposed to being part of a more holistic financial plan and agree with the statement:

“If I make money that’s great. If I lose it, that’s OK!”

Source: “Bridging the Knowledge Gap,” Fidelity Stock Plan Services Stock Plan Participant Survey, 2008

17

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

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An integrated approach

Like any business practice, the use of equity compensation for employees should be validated from multiple perspectives

Supports the business strategy of the organization and has a clearly identifiable role in its human capital strategy

Is financially efficient and cost-effective relative to the returns realized

Encourages and rewards the behaviors required for the execution of the company’s strategy

Is designed and delivered in a manner consistent with externalgovernance requirements and objectives

Aligns with internal governance model, controls, and corporate policies

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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

Return On Investment

Direct Value Indirect Value

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What is the objective?

Underwater Tactic

Underwater Tactic

Reset ValueReset Value

Back to the Problem: Underwater Equity

Fix Current AwardsFix Current Awards

Mirror Past Pay AllocationMirror Past Pay Allocation

Employee ChoiceEmployee Choice

Reduce ExpenseReduce Expense

Rethink StrategyRethink Strategy

Move to New Forms of PayMove to New Forms of Pay

Differentiate Based on ValueDifferentiate Based on Value

Target Pay to Valuable StaffTarget Pay to Valuable Staff

Achieve Positive ROIAchieve Positive ROI

Equity StrategyEquity

Strategy

21


What really is the business problem?Retention?

Engagement and motivation?

Productivity?

Competitiveness?

Philosophy?

Expense without pay delivery?

Shareholder opinion or perception?

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The alternatives should be evaluated in a framework considering :

Stock PlanStock Plan Total Compensation StrategyTotal Compensation Strategy

FAS123R ExpenseFAS123R Expense Total Financial ImpactTotal Financial Impact

Retention and EngagementRetention and Engagement Overall Behavioral ImplicationsOverall Behavioral Implications

S/H and ISS ApprovalS/H and ISS Approval Corporate GovernanceCorporate Governance

Fixing Underwater

Awards

Fixing Underwater

Awards

Rescuing Equity Compensation

Rescuing Equity Compensation

23

Option Exchange Programs

Program constraints and issuesAccountingTaxStock exchangeShareholder approvalSecurities regulationsAdministrationCommunicationDisclosureGlobal participation

24


Option Exchanges will be more complicated than last timeAccounting and Tax Rules

– Variable accounting gone but incremental expenseTaxation

– Simple in the US, complex in many countries– ISO considerations

Shareholder Approval Requirements– Wait for annual meeting or hold special meeting?

Institutional Investors and Proxy Advisory Firms– ISS criteria

Securities Regulations– Tender offer requirements– SEC filings– Constraints from previous CD&A statements

25


Many of the complexities continueAdministration

– Massive electronic and paper processes– System and software constraints

Communication– Internal: Employees, Managers, Board of Directors,

Compensation Committee, Officers– External: Investor relations and media

Coordination with other grant processes– Annual/focal– New hire and promotion

26

Recent FilingsTO Filings Shareholder Approval Requests

Advanced Analogic Advanced Micro Devices (amended)

Echelon Corp FormFactor (withdrawn)

Emulex Corporation Airspan

Exar Corp

Healthways, Inc

Isle of Capri Casinos

Magma Design Automation, Inc

Maxim Integrated Products Inc

Metabasis

MGM Mirage Who’s

Quantum Fuel Systems Technolgies Worldwide Next?

Radvision LTD

Retractable Technologies

Spark Networks Inc

United Therapeutics Corp

UTStarcom

Zhone Technologies

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Opportunities for Option Exchange Programs

Achieving a positive ROI on an option exchange program may require ignoring market data and altering “typical” provisions such as:

Eligibility – bracketed tranches?Vesting and blackouts – more restrictive?New option term - shorter?Strike price – premium?Form – options, shares, or cash?Treatment of existing awards – vested vs. unvested options?Replacement ratios – incremental value?The “program” – or part of a strategy?

28

What Happens with Option Exchange Programs

Hard-dollar costs are higher than projectedProfessional fees – accounting, tax, legal, consultingFilings and shareholder communicationsEmployee communications

A layer of hidden costs resulting from lost productivity during and afterCommunications from the companyDiscussion among employees regarding the choiceDiscussion afterwards about the outcome of the choice

Companies are often disappointed with the results of an exchangeprogram

Participation rates below expectationsA continuing underwater option problemTwo groups of employees

29

Option Exchange Programs – Stop Before you Swap

StrategyRe-evaluation and possible redirection of equity compensation strategy

Finance Volatility impact on option valuation, exchange ratios, expenseExpense-neutral constraint may create other costsChoice of replacement: cost of cash vs. equity Choice of replacement: availability of cash vs. equity

Behavior Voluntary: poor choicesNo opportunity for management action and differentiation

30

A Behavioral Economics View of Exchanges

Behavioral economics provides us with explanations for the suboptimal results of option exchange programs:

Mental accounting ---- “This is house money”Loss aversion ---- “The stock will come back”Sunk cost fallacy ---- “I’m already vested in these options”Endowment effect ---- “I already have these options”Framing effect ---- “You want me to give these back?”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 ---- “They didn’t exchange either”

31

Option Exchange Programs – Stop Before you Swap

Governance

Volatility in capital markets creates additional risk

– Pricing of exchange driven by offer period timing

– Exchange too early: more underwater options

– Exchange with perfect timing: “spring-loading”

Following SEC rules and proxy advisory firms’ guidelines does not ensure good governance

– Major governance metrics don’t agree on what “good governance” is

CD&A disclosures about equity compensation strategy and plan design may be a constraint

32


A broad array of alternatives are available for addressing underwater equity:

Do nothing – it’s a small piece of total compensationDo nothing – it’s a long-term incentiveAllow an exchange of the existing award(s)Modify the existing award(s)Grant an additional awardIncrease another form of payCommunicate to and educate employeesDo a combination of these

33

Alternatives to Option Exchange Programs

Other equity compensation alternatives may better satisfy business objectives:

Early grantMove the ’09 grant into late ’08…can you call the bottom?

Mega-grantDouble-down with large targeted grants

Stub grantFix a short-term problem with a short-term program

Integrated programsRoll the ’09 focal into the exchange program and leverage it

Extend the option termAssume other programs retain and engage and buy some time

34

Behavioral Strategies

Differentiate internally

Large grants of RSUs with cliff vesting for top performers

Multi-year share-based retention bonuses with accelerated vesting based on company performance

Additional grants – with cliff vesting – for a team that surpasses expectations

Differentiate externally

Stand out from the “peer group”

Implement and market a solution not easily replicated

35

Financial StrategiesFinancial Strategies

Re-allocate across budgets

Cash to equity: Salary increase delay with the savings funding targeted retention share grants

Cash to deferred cash: A zero bonus pool with a portion rolled forward to supplement the 2009 pool to “double down”

Cash to performance equity: A zero bonus pool with target awards for 2008 converted to performance shares for 2009

Measure the ROI

Calculate the all-in cost of each alternative

Understand which financial metric is being optimized

Turnover cost?

Productivity?

FAS123R expense?

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Example: Evaluating Effectiveness

Alternatives Strategy Finance Behavior Governance

Ignore the equity program + + - +Exchange: option for option + + - -Exchange: option for RSU - + - -Exchange: option for cash + - - -Early Grant + + + -Mega-Grant + - + -Stub Grant - + - +Integrated Exchange + + + -Extend option term - - - +

Illustration Only

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Closing Thoughts

Alternatives are reliant on stabilization of market volatility and are highly risky

Past logic – “employees will leave and reprice themselves” – may not apply this time

A focus on single-vehicle solutions may miss an opportunity for restructuring the total compensation portfolio

Short-term recession expense reduction and underwater equity actions can blind a company to a longer-term ROI focus and re-evaluation of equity compensation strategy

38

Contact Information

Fred WhittleseyPrincipal and West Region Practice Leader Buck [email protected]

Kiran SahotaConsultant Buck [email protected]

For More Information:

www.bucksurveys.com/underwater

Visit our new underwater equity

resource site

mailto:[email protected]

mailto:[email protected]

http://www.bucksurveys.com/underwater

Documents

Underwater Equity