Keep Calm and Carry On! How to Administer Special Events in Equity Compensation

Michael Albert, CEP, Fidelity Stock Plan Services Dan Kapinos, CEP, Aon Equity Consulting DiDi Kindilien, Acorda Therapeutics, Inc. Matt Wallace, Navient Corporation

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Agenda

Meet Our Companies

Defining Special Events

Award Modifications – Specific Employee Situations – Performance Modifications – Underwater Stock Option Exchanges

Corporate Transactions – Mergers & Acquisitions – Spinoffs

Year-Over-Year Plan Design Changes – Adopting Performance Awards – Changing Performance Awards

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Meet Acorda Therapeutics

Acorda Therapeutics, Inc., a biopharmaceutical company, identifies, develops, and commercializes therapies for neurological disorders in the United States

Over 500 employees

New Hires, Annual Grants, Promotions, and Principles & Values Awards

Current equity breakdown – Time-based stock options – Time-based restricted stock – Performance-based RSUs (based on internal goals) – Performance-based stock options (based on internal goals)

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Meet Navient Corporation

Navient (Nasdaq: NAVI) is a leading provider of asset management and business processing solutions for education, healthcare, and government clients at the federal, state, and local levels. We help our clients and millions of Americans achieve financial success through our services and support.

7,000 employees

800 employees in management receive equity as part of annual review cycle

Current equity mix determined by level: – SVPs & above – mix of stock options, restricted stock units (RSUs) & performance

stock units (PSUs) – VPs – mix of stock options and RSUs – Below VP – 100% RSUs

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Defining Special Events The significant events that cause substantial change and

confusion – Award Modifications – Corporate Transactions – Plan Design Changes

Can impact one person or many

Can cause confusion in many areas related to equity compensation – Administration – Accounting – Legal – Tax – Communication / Participant Understanding

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Special Event: Award Modification

Modifying an outstanding equity award from its original terms

Examples include: – Accelerating vesting for terminating employee – Adding anti-dilution provisions to outstanding awards – Changing retirement provisions for all employees

Modifications trigger many complications: – Remeasurement of fair value for accounting purposes to determine if

incremental expense must be recognized – Updates within your stock plan administration to adjust awards appropriately – Requires a modified award agreement and disclosure for executives – Can cause legal and tax challenges depending on changes – Employees may have limited understanding of award to begin with and

modifying it makes that worse

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Award Modifications for Employee Events

Acorda has experienced several award modifications over time. One example covers awards modified for an employee transitioning to a consultant.

As part of the transition, vested options were modified from expiring on April 3rd (3 months after termination) to expiring on October 2nd (3 months after consulting period ends). Any unvested options that would vest after termination but before the end of the consulting term were also modified to vest (would have forfeited before). Everything else that was unvested would forfeit.

This modification created many considerations for Acorda: – Changes in employee status – Different types of modifications – Changes in vesting and expiration dates – Changes in expense and additional compensation expense

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Award Modifications for Employee Events (cont’d)

Accounting – First step is to understand types of modifications involved. Acorda had options in three of the four types below (Type I, III and IV)

Type Explanation

Type I (Probable to Probable)

• Service period was likely to be met immediately before modification and still likely after modification

• Grant date expense does not go away, and any incremental expense is recognized in addition to grant date expense

Type II (Probable to Improbable)

• Service period was likely to be met immediately before modification but now unlikely after modification

• Extremely unlikely – lawsuit waiting to happen

Type III (Improbable to Probable)

• Service period was unlikely to be met immediately before modification but is now likely after modification

• Grant date expense is reversed and new post-modification fair value is recognized • One of the most common types of modifications

Type IV (Improbable to Improbable)

• Service period was unlikely to be met immediately before modification and is still unlikely after modification

• All grant date expense is reversed and nothing else is recognized • Usually a byproduct of other modifications

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Award Modifications for Employee Events (cont’d)

Accounting: – Vested options fall under Type I (original grant date expense remained and any incremental was

added to the fair value) – Unvested options vesting before end of consulting period fall under Type III as they were going to

forfeit and will now vest (original grant date fair value is reversed and replaced with new post-modification fair value of modified options)

– Unvested options vesting after the end of consulting period fall under Type IV as they were not going to vest before modification and still won’t afterward (original grant date fair value is reversed and no other adjustments made)

Administration – Acorda made changes within stock plan administration system for awards that will vest and will

no longer vest in the period of modification, ensuring awards are accessible for new periods – It is also important to work with the administration system to help participants within the call

center and other areas of obtaining information (much easier this example with one employee)

Legal / Tax / Communication – Modification was documented in amendment and the changes were detailed in the year’s proxy

statement since the employee was a Named Executive Officer

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Performance Modifications

Example, assume a company has performance awards that vest once the stock price reaches $100. 2 years later, the hurdle is very unlikely to be met, so the hurdle is revised down to $70. What should you watch out for?

Consideration Explanation

Accounting • Original grant date fair value remains (Type I modification) • Incremental fair value is likely because $70 hurdle award is more valuable.

Incremental fair value is recognized in addition to the original grant date fair value.

Administration

• System needs to be updated for proper performance criteria, with correct fair value recognition and recognition period

• This change likely affects multiple participants so interaction with the participant experience of your stock plan administration system is vital

Legal / Tax • Updated award agreements or amendments must be created outlining the change • Tax considerations need to be communicated, as certain changes can trigger 162m

deductibility problems

Communication

• Employees likely already do not completely understand award so added effort around performance change is needed

• For officers, change must be disclosed publicly and company must think about how to explain the reasoning for change especially with a weakening of hurdles.

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Underwater Stock Option Exchanges

Common award modification is the exchange for underwater stock options for new at-the-money options or some other value like RSUs or cash. This was very common from 2008 to 2010. Less common now due to bull market and very punitive requirements from proxy advisors in order to recommend for shareholder approval.

Exchanges are treated just like any other modification, just on a grander scale since it affects multiple grants and employees.

Consideration Explanation

Accounting • Treated as a Type I as options were likely to vest (even if underwater) before and still likely to vest after

Administration

• System needs to be updated to track original underwater option and new option if vesting periods change as part of modification.

• System must also reset strike prices of only elected option grants • Many providers can also provide modeling to illustrate how the exchange could

impact your company, including accounting impacts and share pool impacts

Legal / Tax • Requires tender offer filings with the SEC detailing the exchange so employees can elect or ignore participation in the exchange

Communication • Employees will require much education around program in order to drive participation

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Special Event: Corporate Transaction

During corporate transactions, outstanding equity awards may be converted from stock in one company to stock in another

For accounting purposes, essentially triggers a modification assessment

Administration challenges are significant changing award types and potentially administration systems

Legal and tax complications exist with award changes and documentation requirements

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Mergers and Acquisitions

In most cases, outstanding awards are settled for some form of cash (whether immediate or future vesting) simplifying the situation.

Those simple situations aren’t why we are here though, so let’s assume Company ABC is acquiring XYZ Corp, and all equity is being converted to equity in Company ABC. More specifically… – Unvested and Vested Options in XYZ convert to vested options in ABC – Unvested RSUs in XYZ convert to unvested RSUs in ABC – Unvested PSUs in XYZ first convert to time-based RSUs based on current

performance and then to RSUs in ABC

What are the considerations for an event like this? – Potentially the most complicated event you can experience within equity

compensation

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Mergers and Acquisitions (continued) Consideration Explanation

Accounting

• Options – Treated as a modification • RSUs – Treated as a modification • PSUs – Treated as two modifications, one to RSUs and then one to ABC RSUs • Note, assumptions are assumed to be the same for both pre-modification and post-

modification fair values, since XYZ is assumed to trade like ABC at that time. As a result, incremental expense is usually only generated in two ways:

• (1) awards are modified beyond just change in company stock (like PSUs to RSUs) • (2) ratio used to convert shares differs from ratio of spot prices at time of conversion

Administration

• System conversions can be complex, especially with changes in equity types. Reach out to the post-conversion system well in advance to make sure expectations are clear.

• Some companies have even performed a secondary independent audit to ensure data conversion is accurate.

• Expect a blackout period while data is converted. Work with your providers!

Legal / Tax

• Lots of disclosure around acquisition particularly around executive pay (potentially even CIC payments)

• Intrinsic value should be similar as part of conversion to avoid punitive tax consequences

Communication • Employees will have lots of questions and need lots of proactive guidance • Vital to work with all necessary departments to ensure a “smooth” transaction

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Spinoff

Let’s look at the Sallie Mae separation into Navient and Sallie Mae Bank – No matter where the employee went, they could hold equity in both

companies – Older grants as employees built towards separation were converted using the

“Basket Approach” meaning equity was converted to equity in both companies

– Newer grants were used to focus on their new company, so were converted using the “Concentration Approach”, where equity was only converted to equity in their new company

Similar to M&A, the intrinsic value needed to be the same immediately before and after the transaction to avoid tax penalties

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Spinoff (continued)

Consideration Explanation

Accounting

• More Incremental Expense Possibilities! • Value determination is much more complex since we cannot assume the current

company will act like the post-spin company (the post-spin company does not exist). As a result, assumptions can be different immediately before and after the conversion.

• Differences in conversion ratios can trigger incremental expense • Award modifications outside the conversion (like PSUs to RSUs) can trigger incremental

expense • Challenges also exist with financial reporting since employees can hold stock in two

different organizations (which entity recognizes expense vs. DTA, etc.)

Administration • System conversions are slightly easier as the system is usually the same before

and after; however, certain designs can be tricky, such as basket approach • Coordination with other company admin team and your provider are paramount

Legal / Tax • Lots of SEC filings (Employee Matters Agreement, Form 10, Registration

Statements) • Additional considerations around Section 16 filings and employee tax reporting

Communication

• Communication is necessary as conversions are complex, especially the basket approach

• Communication is also needed for terminated employees who may not participate in such a conversion

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Special Event: Changing Plan Designs

Changing plan designs can introduce many obstacles: – Internal teams, like accounting & administration may not have seen award

types like this before – External auditors may not have seen changes like this before – Employees probably have not seen awards like this before, creating an even

larger communication hurdle

Common plan design changes include: – Adopting performance awards for the first time – Adopting more complex performance awards like relative TSR as a modifier

or design features like post-vest holding periods

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First Time Adopting Performance Awards

Since IPO, Acorda always granted time-based awards (options and RSAs)

In 2016, the company adopted performance RSUs for the first time with vesting contingent upon certain performance goals around drug approvals.

In 2017, Acorda added another set of performance awards to the mix with the introduction of performance options with vesting contingent upon certain performance goals around drug approvals.

What considerations are necessary with the move to performance equity?

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First Time Adopting Performance Awards (continued)

Consideration Explanation

Accounting

• Accounting is very different and more complex than time-based awards • Vital to understand the difference between “Performance Conditions” and “Market

Conditions” • Performance Condition

• Anything that is internal (EPS, Revenue, EBITDA, etc.) • Fair Value is stock price on grant date and fixed (if equity settled) • Expense is equal to the fair value multiplied by the number of shares expected to

vest underlying the condition (typically starts at target but moves to align with actual performance). No expense can be recognized if the goal is not met, but expense can increase for outperformance.

• If timing changes with performance, the expense is spread over the initially anticipated timing but updated throughout.

• Market Condition • Anything that is stock price based (TSR, hurdles, market cap, etc.) • Fair value must incorporate all possible stock price outcomes through a Monte

Carlo simulation. Fair value is fixed (if equity settled). • Expense is equal to fair value multiplied by the target number of shares. No

changes are made based on performance because the fair value incorporates all possible outcomes (similar to a stock option).

• If timing changes with performance, a derived service period is calculated and expense is recognized over such period (and can be accelerated if the goal is met sooner).

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First Time Adopting Performance Awards (continued)

Consideration Explanation

Administration

• Most administration systems can handle performance awards now, from all perspectives, including administration, financial reporting and participant experience

• Vital to be in contact with admin partner to ensure proper setup and education of your team around functionality

• Also an opportunity to leverage your admin partner to support employee education of new programs

Legal / Tax

• Form 4 filings for executives change based on criteria involved • Performance-based awards can be 162m deductible if designed appropriately • Disclosure is very important as shareholders and proxy advisors will want to

understand the change and why its important for the company

Communication

• Performance awards are extremely complex relative to time-based awards and present massive comprehension problems for companies (perceived value is very low)

• Communication from the onset is vital and many partners and vendors can help you through customized education content and performance tracking

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Adopting Complex Design Nuances

The last 20 slides just covered common situations that occur within equity compensation to be on the lookout for.

However, this is not the end, as many other design nuances are emerging that trigger even more complexity. – Market Conditions such as relative TSR can be introduced into performance

awards, potentially even as a modifier – Post-vest holding periods can be added requiring a certain amount of time to

pass between vesting and the sale of the underlying shares

Each nuance is becoming more prominent introducing complexity and your own considerations to make sure changes are adopted smoothly

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Relative TSR as a Modifier

Growing in prevalence but not widespread yet

Emerged as a middle ground between shareholders who favor TSR and executives who favor internal metrics

Consideration Explanation

Accounting

• Accounting models are merged together • Fair value incorporates the impact of the Market Condition and any additional

shares earned or shares removed based on Market Condition performance • This fair value is substituted into the Performance Condition model which is then

spread over the number of shares expected to vest under the Performance Condition only. No adjustments to shares for changes based on Market Condition

Administration • Many systems, if they don’t have a specific solution, have workarounds to make

financial reporting work but communication is vital • Connection with participants is necessary as award complexity is raised

Legal / Tax • Still qualifies as performance award so similar requirements and considerations; however, disclosure may prove more difficult with added complexity

Communication • Award complexity is higher so communication with participants is vital to help

explain and educate on the award’s design • Use your industry partners to leverage educational aids

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Post-Vest Holding Periods

Also growing in prevalence but not widespread yet

Emerged as a good governance feature with accounting benefits

Consideration Explanation

Accounting

• Accounting has always allowed for a fair value reduction for a post-vest holding period; however, an evolution in theory is producing much more advantageous discounts, including 10% to 15% in savings for 1 to 2-year holding periods

• Big 4 have agreed on these discounts for defined holding periods but still an emerging trend that may not have filtered down to local offices

Administration • Many systems can handle this type of restriction • Some providers can even provide education and prevalence data on holding

patterns

Legal / Tax • Clear disclosure is required as outlined by the SEC • Tax considerations with lack of liquidity at the time of vesting but problem is mostly

solved with the use of units

Communication • Typically not granted to broad population and aimed only at executives but

education is still required and advantages of the holding period (like more shares granted). Can be broad-based though through ESPPs

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Takeaways Education is vital

– Attend industry events like the CEP Symposium to get education and content – Industry events also create the opportunity to meet people with similar

experiences or even expertise, including the speakers (like us)

Reach out to your partners – Often have expertise you are looking for or can direct to you new experts – Also have resources leveraged with other clients that may make life easier

Get all relevant departments involved – Equity is unique in that it touches many departments in a corporation – Certain events can be important to get everyone involved from day 1

Focus on participants – They potentially already don’t understand what they have so these changes

can create added barriers that need to be addressed

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Questions

Contact us…

DiDi Kindilien dkindilien@acorda.com

914.326.5145

Matt Wallace matthew.b.wallace@navient.com

984.200.2491

Michael Albert mike.albert@fmr.com

617.960.7981

Dan Kapinos dkapinos@radford.com

215.255.1874