Launching the Next Generation… …Rescuing a Generation in Crisis! …Rescuing a Generation in Crisis!
Rescuing Equity Compensation from Volatile Markets
-
Upload
fwhittlesey -
Category
Business
-
view
81 -
download
4
Transcript of Rescuing Equity Compensation from Volatile Markets
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
9
…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
11
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?
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 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
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 ReasonsWealth Creation Total Compensation Investor Expectations
Not Important
Moderately Important
Very Important
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
16
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
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 externalgovernance requirements and objectives
Aligns with internal governance model, controls, and corporate policies
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
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 StrategyEquity
Strategy
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?
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
23
Option Exchange Programs
Program constraints and issuesAccountingTaxStock exchangeShareholder approvalSecurities regulationsAdministrationCommunicationDisclosureGlobal participation
24
Option Exchange Programs
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
Option Exchange Programs
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
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?
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
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 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?
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
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
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