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
- 27. 26 Recent Filings TO 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
- 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 [email protected] Kiran Sahota Consultant Buck Consultants 415.617.3911 [email protected] For More Information: www.bucksurveys.com/underwater Visit our new underwater equity resource site