1. Benefits and Beyond, C. 11 Equity Benefits Thomas E. Murphy 1 Thomas E. Murphy 30 November 2010

2. You own the company! 2 Thomas E. Murphy 30 November 2010

3. Our employees own the company. (Avis Car Rental) Could this be the ultimate link among leaders, employees, and owners? Focused application of the Agency Theory Aligning Total Shareholder Return between traditional and employee shareholders New strategy: “attitude of ownership.” Background 3 Thomas E. Murphy 30 November 2010

4. What’s the down side? But . . . . It can be powerful Line of Sight Dilution Stock needs large public ownership to exploit market dynamics. During market slides, it could have reverse effect on employees. Thomas E. Murphy 4 30 November 2010

5. Thomas E. Murphy 5 Lyle Everingham – in W. Virginia 30 November 2010

6. 401(k) included company stock. Matches are often made in company stock Kroger grew in employee ownership from 1% to 33% in 3 years with its 401(k). Profit Sharing Retirement Plans included company stock and provided good accumulation of wealth. (P&G) ESOPs are totally company stock based. Retirement Plans and Stock 6 Thomas E. Murphy 30 November 2010

7. Discount Stock Purchase Plans (with “DRIPS.”) Brokerage fee free stock purchase plans Stock option plans Restricted stock and Restricted Stock Units Stock Appreciation Rights (SARs) All of these can lead to substantial wealth accumulation Other Plans – A U.S. Culture 7 Thomas E. Murphy 30 November 2010

8. Alignment! 8 Thomas E. Murphy 30 November 2010

9. U.S. companies prefer variable compensation plans. U.S. companies want “balance” in their rewards: short term (cash); mid-term (annual bonus); long term (stock and stock options) Equity can provide an opportunity to pay less than the market in cash compensation. Equity can be a factor in recruitment and retention. Rationale 9 Thomas E. Murphy 30 November 2010

10. Thomas E. Murphy 10 Balance – short, medium and long term reward plan 30 November 2010

11. Equity can provide an opportunity for a new level of employee communication. Equity should not be reserved for “executives only.” More companies have gravitated toward broad based stock, restricted stock, and options plans. What about the “global” use of equity? The U.K. is an exception, but inhospitable tax and policy treatment in EU. Rationale 11 Thomas E. Murphy 30 November 2010

12. What are they? 12 Thomas E. Murphy 30 November 2010

13. Grantee can buy stock at market price on date of grant (the “strike price.”) Options can be exercised when vested. Vesting can be graduated or cliff. Vested options can be exercised over their term, which is usually 10 years. Options are often granted annually. The “option spread” is taxable (ordinary income) to the grantee when exercised. What is a Stock Option 13 Thomas E. Murphy 30 November 2010

14. 30 November 2010 Thomas E. Murphy 14 The “strike price and the spread”

15. Incentive Stock Options (ISOs) are not taxed until the recipient sells the exercised stock. NQSOs are taxed on exercise. Typical exercise: see page 337. What is a stock swap: see page 338. What is a “cashless exercise?” Why would a company offer these? See page 338. Stock Options – Mostly NQSOs 15 Thomas E. Murphy 30 November 2010

16. As compared to shareholder? No money down. If stock price goes down, no actual loss to Optionee. Except lower total reward Employer’s costs Thomas E. Murphy 16 Allocation of Risks – Big Jump? 30 November 2010

17. 30 November 2010 Thomas E. Murphy 17 Options require large grants!

18. Options are compensation; therefore, they should be taxed as income. But, when and at what value? When there is a spread? When they are exercised? When they are granted? Note the cost of dilution: cents per share (at page 340 of the text). What about the discount value of options as a method to value? (The time value of money) Costing Options 18 Thomas E. Murphy 30 November 2010

19. FASB and No. 123R. Must be charged “their fair value” at grant. One method is the Black Scholes formula which considers term of grant, grant price, volatility of price, and other factors to estimate their value at grant. This represents new expense for companies, and caused some employers to re-think offering options. The charge against earnings could be significant. Cost of Options 19 Thomas E. Murphy 30 November 2010

20. What happens when the market price of the stock is below the strike price? “underwateroptions” Is the notion of an “ownership society” in trouble due to the bear market of 2008 and 2009? Thomas E. Murphy 20 Deep Thoughts . . . 30 November 2010

21. 30 November 2010 Thomas E. Murphy 21 Restricted Stock – less costly?

22. No stock is actually issued. No dividends and no voting rights are available, except in some cases the employer can pay a cash equivalent of the dividend. They are an unfunded promise to issue a specific number of shares when the restrictions lapse. Taxed upon vesting. Withholding can occur by simply reducing the number of shares delivered. 30 November 2010 Thomas E. Murphy 22 What are RSUs? Same as RS except:

23. RS and RSUs provide added advantages There is less dilution? Granted in similar fashion. For RS, grantee can make an §83b election. Charge to earnings at grant – but known value. Query: do restricted stock grants represent lower risks to employees? (See page 342) RS and RSUs 23 Thomas E. Murphy 30 November 2010

24. What are Stock Appreciation Rights? What are their design features? What about dilution? What are the risks? How are they expensed and taxed? How are they “paid off?” See illustration at page 343 Other Equity Grants 24 Thomas E. Murphy 30 November 2010

25. Do they affect behavior? 25 Thomas E. Murphy 30 November 2010

26. Do they really motivate and change behavior? How are they abused? Mega grants and back dating. How significant is the dilution problem? Line of Sight and “Pepsi Share Power.” What are the employer’s choices if the options granted are “underwater?” Some Problems with Equity 26 Thomas E. Murphy 30 November 2010

27. Maintain the grant and hope for an increase in price. Option holders turn in their options and are given a “scrap value.” Options are turned in and new ones are issued in their place at the lower, current market price. (or exchanged for RSUs) Options are simply re-priced with a lower strike price, or are “backdated.” Thomas E. Murphy 27 The Choices for Underwater 30 November 2010

28. Do they get any of these opportunities? How do you think they react to the choices in the previous slide? So, what is another approach to equity that might really affect behavior and satisfy the interests of shareholders? Thomas E. Murphy 28 What about shareholders? 30 November 2010

29. Thomas E. Murphy 29 A different trigger – performance based vesting! 30 November 2010

30. Link vesting to the attainment of certain performance standards. What standards? Total Shareholder return? Earnings per share? Profits? Sales increases? EBITDA targets? Market share improvements? Indexed stock price increases, unit performance, department performance, individual performance? Performance Based Equity 30 Thomas E. Murphy 30 November 2010

31. There is an issue concerning the accounting treatment of performance based equity? How are they charged to the financial statements? What impact does it have on the previous stated “abuses?” How do they work? See example at page 349. Performance Based Equity 31 Thomas E. Murphy 30 November 2010

32. Does employee ownership cause them to “think like owners?” What should be the elements of a “culture of ownership?” How would you design and evaluate such a program? See: Van Meter Co. at page 351. Effectively communicating the things within their line of sight that affect the stock price. Thomas E. Murphy 32 Does it work? 30 November 2010

33. Thomas E. Murphy 33 The concomitant opportunity 30 November 2010

34. Example: 1000 Shares of SARs at $10/share; they are vested, and new price is $25 per share. How many shares do you get? (25,000-10,000 = 15,000/25 = 600 shares. Taxed as ordinary income with FICA and Medicare payroll taxes. Some cites and exercises 34 Thomas E. Murphy 30 November 2010

35. Go to www.mystockoptions.com/“quick take calculator”) 10,000 shares of NQSOs, $10 strike price, $22 current price. All are vested and exercised. What is gain? How will it be taxed and when? Exercises and cites 35 Thomas E. Murphy 30 November 2010

36. You work for a call center company that performs HR and Benefit services for a number of large employers. Your company has 10 call centers in the U.S. with about 200 employees in each. Your CEO wants you to study and recommend a possible broad-based equity benefit. What are the issues, analytical steps you would take, the potential design choices and “returns.” What would you recommend? Thomas E. Murphy 36 Does Equity Compensation Work? 30 November 2010

37. Exercises at pages 352-353 Practice. . . . More practice . . . 1. Spinoff at Call Center. Equity for employees? 2. An exercise of partially vested SARs. 3. Option exercise of partially vested shares. Why exercise with only a 50 cent increase? 4. Performance based options based on individual performance. Problems? 5. Options for European employees of U.S. company. Thomas E. Murphy 37 30 November 2010

38. Pay lower fixed compensation. Communicate with employees on a higher level. Opportunity to engage employees in the affairs of the business Thomas E. Murphy 38 The Power Potential of Equity to Create Team-Based Alignment! 30 November 2010