THe introduction of the idea of equity effectiveness, applied to the underwater equity situation during the 2008-2009 financial crisis. Presented at multiple NASPP, GEO, and WorldatWork chapter meetings by Fred Whittlesey, Kiran Sahota, and Kathi Myers.
Rescuing Equity Compensation from Volatile Markets
1. Rescuing Equity Compensation
from Volatile Markets
National Association of Stock Plan Professionals
10 December 2008
Fred Whittlesey
Principal, West Region Practice Leader
Kiran Sahota
Consultant
2. 1
Today’s Discussion
Capital Market and Economic Situation
Questions of the Day
Defining the Problem
Increasing Equity EffectivenessTM
Option Exchanges
Alternatives to Exchanges
3. 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 Comp
S&P Asia 50 S&P Europe 350 MSCI Euro
Morningstar Real Estate LB Commodities LB Global Corp Bond
LB Global Agg Bond LB US Agg Bond LB US Treas
4. 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
5. 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
6. 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?
7. 6
Underwater Equity: One Part of a Broader Issue
The 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
8. 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
9. 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 plans
Don’t calculate ROI of equity compensation
Are 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
criticisms
Any action, or appearance of such action, to deliver value to employees
not available to shareholders may be criticized
10. 9
…Let’s Define the Problem We’re Solving
Public 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
11. 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
12. 11
Equity Compensation: Source of Dissatisfaction
Equity Compensation Pressures 2002Equity Compensation Pressures 2002 –– 20082008
FAS123RFAS123R
ExpenseExpense
409A409A
ComplianceCompliance
ShareholderShareholder
and Proxyand Proxy
AdvisorAdvisor
PoliciesPolicies
CapitalCapital
MarketMarket
VolatilityVolatility
GlobalGlobal
PracticesPractices
ConvergenceConvergence
SarbanesSarbanes--
OxleyOxley
ComplianceCompliance
Equity Compensation Pressures 2008Equity Compensation Pressures 2008
ReducedReduced
ParticipationParticipation
SmallerSmaller
GrantsGrants
Lower PayLower Pay
ValuesValues
CapitalCapital
MarketMarket
VolatilityVolatility
GlobalGlobal
PracticesPractices
ConvergenceConvergence
SarbanesSarbanes--
OxleyOxley
ComplianceCompliance
Equity Compensation OutcomesEquity Compensation Outcomes
Shareholder dissatisfactionShareholder dissatisfaction Company dissatisfactionCompany dissatisfaction Employee dissatisfactionEmployee dissatisfaction
What
are we
doing?
WhatWhat
are weare we
doing?doing?
Why are we
doing it?
Why are weWhy are we
doing itdoing it??
What are we
getting for
it?
What are weWhat are we
getting forgetting for
it?it?
13. 12
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 rate
Options vs. share and share unit conversion rates
Ownership 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
14. 13
Employer Dissatisfaction
Costs of administration, financial reporting, compliance, and disclosure
of equity plans have increased during a period in which employee
returns from grants have declined or disappeared
2004 Grants
2005 Grants
2006 Grants
15. 14
Employer Dissatisfaction
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 Reasons
Wealth Creation Total Compensation Investor Expectations
Not Important
Moderately Important
Very Important
16. 15
Employer Dissatisfaction
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
17. 16
Employee Dissatisfaction
79%
76%
57%
74%
83%
49%
40%
60%
80%
100%
Turnover Cost
Retention of High Performers
Employee Productivity
Stock Performance
Employee Satisfaction
Gains to Employees
Metrics Used in Measuring LTI ROI
Only 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
18. 17
Equity EffectivenessTM
Equity Compensation Outcomes
Shareholder dissatisfaction
Dilution
Performance
Executive pay impact
Company dissatisfaction
Costs
Uncertain ROI
Employee impact
Employee dissatisfaction
Understanding
Value
Behavior
Financial impact
Shareholder criteria
Objectives
Measurements
Input
Communication
Increasing Equity Compensation Effectiveness
19. 18
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 external
governance requirements and objectives
Aligns with internal governance model, controls, and corporate
policies
20. 19
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
21. 20
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
Strategy
Equity
Strategy
22. 21
Back to the Problem: Underwater Equity
What really is the business problem?
Retention?
Engagement and motivation?
Productivity?
Competitiveness?
Philosophy?
Expense without pay delivery?
Shareholder opinion or perception?
23. 22
Back to the Problem: Underwater Equity
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
24. 23
Option Exchange Programs
Program constraints and issues
Accounting
Tax
Stock exchange
Shareholder approval
Securities regulations
Administration
Communication
Disclosure
Global participation
25. 24
Option Exchange Programs
Option Exchanges will be more complicated than last time
Accounting and Tax Rules
– Variable accounting gone but incremental expense
Taxation
– 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
26. 25
Option Exchange Programs
Many of the complexities continue
Administration
– 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
28. 27
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?
29. 28
What Happens with Option Exchange Programs
Hard-dollar costs are higher than projected
Professional fees – accounting, tax, legal, consulting
Filings and shareholder communications
Employee communications
A layer of hidden costs resulting from lost productivity during and after
Communications from the company
Discussion among employees regarding the choice
Discussion afterwards about the outcome of the choice
Companies are often disappointed with the results of an exchange
program
Participation rates below expectations
A continuing underwater option problem
Two groups of employees
30. 29
Option Exchange Programs – Stop Before you Swap
Strategy
Re-evaluation and possible redirection of equity compensation
strategy
Finance
Volatility impact on option valuation, exchange ratios, expense
Expense-neutral constraint may create other costs
Choice of replacement: cost of cash vs. equity
Choice of replacement: availability of cash vs. equity
Behavior
Voluntary: poor choices
No opportunity for management action and differentiation
31. 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”
32. 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
33. 32
Back to the Problem: Underwater Equity
A broad array of alternatives are available for addressing underwater
equity:
Do nothing – it’s a small piece of total compensation
Do nothing – it’s a long-term incentive
Allow an exchange of the existing award(s)
Modify the existing award(s)
Grant an additional award
Increase another form of pay
Communicate to and educate employees
Do a combination of these
34. 33
Alternatives to Option Exchange Programs
Other equity compensation alternatives may better satisfy business
objectives:
Early grant
Move the ’09 grant into late ’08…can you call the bottom?
Mega-grant
Double-down with large targeted grants
Stub grant
Fix a short-term problem with a short-term program
Integrated programs
Roll the ’09 focal into the exchange program and leverage it
Extend the option term
Assume other programs retain and engage and buy some
time
35. 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
36. 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?
37. 36
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
38. 37
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
39. 38
Contact Information
Fred Whittlesey
Principal and West Region Practice Leader
Buck Consultants
415.617.3820
fred.whittlesey@buckconsultants.com
Kiran Sahota
Consultant
Buck Consultants
415.617.3911
navkiran.sahota@buckconsultants.com
For More Information:
www.bucksurveys.com/underwater
Visit our new
underwater equity
resource site