Everything about Performance Equity Compensation (or as much as fits into an hour presentation)

© 2010 – Performensation – all rights reserved 1

Everything You Wanted to

Know About Performance

Equity (well as much as can fit into a 1 hour

presentation)

Presented to the Bay Area Compensation Association Oct. 21,

2010

Dan Walter

President and CEO

Performensation10/21/10


DAN WALTER, CEP

Dan Walter CEP, is the President of Performensation (www.performensation.com). For more than 15 years, Dan has assisted companies with equity and performance-based compensation issues. Dan has extensive experience with both executive and broad-based programs. A unique focus is the design and management of performance share and units.

Dan provides end-to-end solutions for private and public companies based in both the United States and abroad. Dan is a popular speaker on topics involving equity compensation and success growth. His extensive work with both very small and very large companies provides his clients with a unique perspective. He creates effective, company-specific solutions paired with post-consultation support. Dan’s expertise includes diagnosis of issues, plan design, communication, administration and reporting solutions.

WWW.PERFORMENSATION.COM

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Learning ObjectivesDefinitionPopularityPurposesCommon Uses

ParticipantsMetricsEquity Instruments

Comparison to Time-based EquityAdministrative IssuesCommunicationA bit of AccountingConclusions

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"Some men give up their designs when they have almost reached the goal; while others, on

the contrary, obtain a victory by exerting, at the last moment, more vigorous efforts than

before.”-Herodotus

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Performance Equity, DefinedAward is given for meeting goals

Vesting is accelerated for meeting goals

Vesting occurs after a period of time AND goals are met

Vesting occurs ONLY when goals are met

Shares are earned, but not vested, when goals are met

Payout may be separate from earning and vesting

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11 types of Performance Equity

1. Performance Awarded Shares

2. Performance Awarded Units

3. Performance Leveraged Units

4. Performance Earned Units

5. Performance Accelerated Units

6. Performance Priced Units

7. Indexed Options

8. Performance Granted Options

9. Performance Accelerated Options

10.Premium Priced Options

11.Performance Earned Options

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The Popularity of Performance EquityMost surveys shows that 50% of US companies now have some form of performance equity program.

Outside Directors and Employees agree that there should be a link between equity compensation and relative, absolute and strategic metrics (Pearl Meyer & Partners, 2010)

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The Popularity of Performance EquityMost surveys shows that 50% of US Risk Metrics and Glass Lewis have increased emphasis on performance equity

Dodd-Frank includes provision that requires companies to explain link between performance and compensation.

Say-on-Pay becomes mandatory in 2011. Other countries show direct link between this and performance equity.

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The Purposes of Performance EquityDrive corporate performance

Align compensation to shareholder expectations

Improve “media worthiness” of equity compensation

Limit impact of volatile market movements on value of equity

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Intended consequencesIncrease shareholder value

Better align participants goals with those of investors

Reduce “lottery” aspect of equity compensation

Focus participants on those metrics which best support corporate success

Obtain shareholder buy-in for current and future share usage

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Unintended ConsequencesPay executives well when company is cutting pay or reducing headcount

Disengage participants via unreachable goals, misunderstood or poorly communicated plan details

Orient participants on specific goals at the risk of others

Losing retentive value due to early payout

Magnified payout when short-term and long-term goals are too similar

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Historic PitfallsToo many metrics, too complex

Multiple year metrics in young or unpredictable companies

“Guaranteed” metrics in mature, predictable companies

Acquisitions or divestitures (internal and peers)

Variable Accounting

Limited Administration, Communication and Reporting tools

Poorly communicated and understood, (especially in the period between award and measurement date)

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“If you can measure that of which you speak and can express it by a number, you know something of your

subject; but if you cannot measure it, your knowledge is meager and unsatisfactory."

~LORD KELVIN

Or, in today’s vernacular

"What gets measured , gets done ."~TOM PETERS

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How Companies Use Performance EquityMost common for Restricted Stock Units (Performance Units)

Most common for Executive Management

Mid and Upper management use is growing

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How Companies Use Performance EquityCommon MetricsTSR – Total Shareholder return

Absolute – your company’s numberRelative – compared against peer group(s)

Financial GoalsRevenueROICEBITDA / EBITCost

Share PriceHRIS

Performance Appraisal / Human Capital Management score

OtherRiskStaff RetentionInnovation / Product Development

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How Companies Use Performance EquityHow to shape a plan

Successful performance programs are about details and nuances

You must understand your data and direction

KPIs, metrics and measurements

Internal struggles during plan creation

Motivation factors

Administrative Simplicity

Performance drivers versus performance results

Defining the “What” Versus the “How”

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Plan Design Project Flow1. Corporate Philosophy and Intent

2. Data Analysis

3. Plan Goals

4. KPI Selection

5. Equity Instrument Selection

6. Measurement Selection

7. Plan Structure

8. Review by External and Internal Stakeholders

9. Plan Documentation

10.Approval

11.Data Integration

12.Roll-out and Implementation

* Note this entire process may take 1- 2 years

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The Equity Compensation Dilemma

The Golden Decade

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1988-1999 proved to be an anomaly. This period became basis for future equity

compensation expectations.

Since 2000, the market has been more volatile and is reflective of periods prior to 1988. Higher volatility may lead to higher values for time-base stock options, but it also leads to higher corporate

compensation expense and greater risk of delivering no value to participants


The Comparison to Time-based EquityProperly designed, performance equity can offer MORE STABILITY than time-based equity

Not completely dependent upon stock price

Can factor in influence of the market volatility on peers and self

Can provide upside leverage and downside protection

Time to achievement based on corporate success cycles rather than the orbit of the earth around the sun

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The Comparison to Time-based EquityEven if properly designed, performance equity can offer MORE RISK than time-based equity

Improper goal setting can occur when source data or future projections are incorrect.

Payout based on excellent past performance, but delivered during poor current performance.

Grants at historically low prices it can in tremendous value delivery

Goals always seems ambitious until, and unless, they are achieved.

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It’s Execution, NOT AdministrationProcesses

How to fit new features and manual processes into Sarbanes-Oxley approved processes

ResponsibilityWho is responsible for each piece? Checks an balances. From beginning to end

AccountabilityWho can be held accountable if it goes wrong?

Plan EvolutionTomorrows plan design in today’s systemsHow to augment the familiar with the unusual

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Impact on AdministrationRequires systems to be more nimble and flexible

Lack of fixed dates, fixed prices and fixed numbers of shares significantly increases system complexity

AccountingSystems are catching up to the most common plan designs

ValuationMarket-based goals require more complex valuation that can be automatically offered by software

Additional cost and timing of using valuation professionals as frequently as every quarter

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Administrative IssuesAutomate Goal Tracking and Communication

Integrate data elements from internal and external sources

Metrics Vs Goals

System must support What, When Why, How, Who and the type of instrument the goal applies to

Provide access to managers and participants

Link to financia reporting an stock administration systems

Provide a path to drive, rather than reward, performance

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Administrative IssuesStock Administration System

System should be able to store awards with minimum, target and maximum awards amounts

System should allow for description of goals for each tranche of shares

System should properly amortize expense for shares expected to vest

System should allow for update of probabilities or vesting, metrics achieved/missed

System should allow for shares associated with missed goals to be pushed to a later date.

“forgiveness” or “second chance”

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How to Make Administration EasierDefine a seamless path of communication1. Number of shares approved

for grant by the board2. Confirmation from Legal or

HR of the goals and metric3. Approval of the number of

shares vesting 4. Any decisions regarding

stock should immediately be forwarded to Stock Admin

(many thanks to Paz Dizon)

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Communicating the Not So ObviousAlways use prices and growth rates that reflect expectations, not hopes

Provide examples of both up and down market conditions

Understand why and how each instrument and its goals have been designed

Performance equity only works if you watch performance closely and regularly recognize participants for interim achievement

Regular communications of small pieces of information are likely to be more effective than one huge communication covering “everything”

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Communicating the Not So ObviousBest practices for communicating performance-based equity?

“Communication is the key to a successful program” – Allison McBride, International Paper

Educate participants on how the goals drive corporate success and why they apply to the individual

Communicate often, consistently and with enough detail for individuals to understand how they are linked to the movement of the underlying metrics

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Communicating the Not So ObviousDo employees like receiving performance-based equity?

Results are mixedWhen alignment and line-of sight are correctly positioned and the individuals can see their role plans seem to be positively received

When performance is low, the result can be similar to impact of underwater stock options

For lower level staff minimums may need to be structured to ensure some value even when performance is not great

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Multi-National OverviewOutside the US, performance is a main foundation of share-based compensation

98% of FTSE 300 have performance share schemes

More than 80% of Australian companies have performance-based share remuneration

Say on Pay is the biggest driver of these plans

The following countries have some version of Say on Pay rules in place

UK, Australia, Sweden, Norway, Netherlands, Italy, Portugal, Spain, Austria, Germany, Ireland, Croatia, Hungary, Poland, Denmark, Finland, Estonia, Luxembourg, Switzerland, Belgium and more on the way

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Multi-National OverviewMake sure that you obtain professional advice before rolling out a performance award program

May need special documentation/acknowledgements from employees beyond what using for time-based awards

Don’t assume that tax favored treatment will/will not be available for performance awards (e.g., France)

Be prepared to make changes to program design for non- U.S. employees

(many thanks to Jennifer George, Partner Orrick)

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Some Basics on Accounting / ASC 718 (FAS 123R)

Two basic “types” of performance metrics

Performance conditions: Requires achievement of metric that is not directly related to company stock price

Example: ROIC, Revenue

Is not included in Fair Value calculation

Market conditions: Requires achievement of metric based or indexed on company stock price

Example: TSR or Stock price

This does get included in the Fair Value calculation

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Fair Value: Per share amount that must be expensed as compensation (non-cash expense)

Private companies may use “Calculated Value” that is based on a measure of past volatility, rather than implied volatility

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Compensation for all performance equity is amortized across the Requisite Service Period

For market conditions this is factored into the Fair Value calculation and generally does not change after the grant

For Service and Performance conditions this is estimated at the time of award, based on the probability of achieving the metric. This is adjusted, post-award, if probability of achieve changes

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Accounting – The Basics are Not EnoughValuation cannot be performed on Market Conditions using Black-Scholes.

Monte-Carlo modeling requires tool, expertise and experience only possessed by a true valuation professional.

Amortization on Performance Conditions is a story with multiple possible endings.

While the total possible expense is generally fixed, the amount accrued each quarter depends on understanding both the award structure and the influences on the underlying metrics.

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ConclusionsWe are on the fast track to more performance equity

Say on Pay, Investor Concerns, Market Volatility, Media scrutiny and more will pus this quickly

Performance equity has both the potential for more stability and more risk.

Keys include design, communication and execution

Accounting is not for the inexperienced

Valuation, amortization and modifications are unlikely to ever be fully automated, but systems are getting better

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Questions?Dan Walter, CEP, President

Performensation514 Precita Ave, Suite 100San Francisco, CA 94110877-803-9255 (toll free)

415-625-3406 (office)

917-734-4649 (mobile)

[email protected]

www.performensation.com

Twitter: www.twitter.com/performensation

LinkedIn: www.linkedin.com/in/danwalter

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Everything about Performance Equity Compensation (or as much as fits into an hour presentation)