Why Performance MattersThe reality of performance in the world of equity

Presented by

Dan Walter, Performensation Consulting

Peter Djokovich, Strategix 20/20

The foundation of measuring performance

Why Create certainty in the workplace Drive corporate, group and individual performance Achieve defensibility and legitimacy in compensation

Who Start at the top, but properly designed programs can be effective at all

levels When

Communicate as frequently as you can provide accurate information Where

Common in much of Europe and Australia Growing in US and Canada Interest in Asia

The foundation of measuring performance

What KPI - Key Performance Indicators

Can be any measurable factor Must be understood, communicated and transparent

Separate drivers of performance from results How

Single-trigger KPI Interdependent KPI Measurement Date vs. Vesting Date vs. Payout Date Multilevel Measurement

Threshold/Minimum Target/Expectation Maximum

Equity vehicle

The biggest problem with performance today is that it is often based on luck not science Imprecise and clumsy goals can work too well, or not at all

Use an axe when you need a scalpel What gets measured gets done

True only if what is measured is communicated and managed Relevance is the key to performance effectiveness

Results-only goals can lead to manipulation or abject failure Underlying drivers must be communicated when results are

communicated When goals are too single-minded all focus is aimed in only one

direction. Goals may be met at the expense of success Complex goals are hard, but so is sustained corporate

performance

Using performance to drive business success and compensation1. Define Mission, Goals and Objectives Through and Across The Organization2. Relevance

Align All Employee Business Processes Align All Human Resource Strategies Align Business Processes and Enabling Technologies

3. Employee Segmentation4. Train and Develop Skills and Expertise5. Establish Individual and Team Performance Expectations6. Measure and Report Performance Results7. Keep It Simple8. Incent For What Can Be Controlled

Pay For Quantifiable Performance Improvements

9. Recognize and Reward Individuals for Events, and Teams for Processes Avoid Unnecessary Competition Between Participants

10. Incentives & Recognition Should Not Be a Proxy For Leadership

11 types of performance-based equity

1. Performance Awarded Shares2. Performance Awarded Units3. Performance Leveraged Units4. Performance Earned Units5. Performance Accelerated Units6. Performance Priced Units7. Indexed Options8. Performance Granted Options9. Performance Accelerated Options10.Premium Priced Options11.Performance Earned Options

Common KPI for Equity

Relative TSR Total Shareholder Return as compared against a group of peer companies

Revenue Growth Operating Income Share Price Net Income EBITDA - (Earnings Before Interest, Taxes, Depreciation and Amortization) EBIT (Earnings Before Interest and Taxes) Turnover/Retention Reduced Expense (usually for large companies)

ROI (Return on Investment) (usually for small companies)

Reduced Risk Profile (recent addition to the mix) Other (reserve of outstanding inventory, customer satisfaction rating, project

delivery etc...)

Examples of some common types of Performance-based Equity Either stock or stock options that are tied to

performance metrics Type A:

Awarding of shares is triggered by the performance metrics May have vesting of shares in addition to trigger

Type B: Vesting, or lapse of restrictions, is triggered by the performance

metrics Multiple triggers may be layered to create more nuanced

awards

Type A - Ex. 1: Performance Shares without Vesting (Performance Awarded Shares) Company A wants to incent share price growth Awards 1,000 potential Performance Shares to CEO Establishes KPI of Relative TSR against S&P 500 Earning of shares is based on following levels

Minimum Payout (50% of 1,000 shares) at 50th percentile Target Payout (100% of 1,000 shares) at 75th percentile Maximum Payout (150% of 1,000) at 95th percentile Payouts between each level is based on a straight-line interpolation

At the end of the year the metric has either been achieved or not If met, award is made and fully vested

Type A - Ex. 2: Performance Awarded Units with Vesting Similar to Example 1, but with time-based vesting after award In Example 2 the trigger for the award of units to the CEO is the

out-performance of the S&P 500 for one year. At the end of the one year either it has been achieved or not

However, once triggered the actual shares vest at 33% per year. This is often used to promote retention of the executive as well as drive specific performance

Type B - Ex. 3: Performance with Multi-year, Multi-goal triggers and goal interdependency Complex structure representing a small percentage of current

programs Company wants to reduce expense and while maintaining

performance compared to peer companies Awards 1,000 units with vesting contingent upon layered metrics Threshold - Target - Maximum structure

Threshold = absolute minimum Target = stretch, but expected goal Maximum = ultimate out performance

Type B - Ex. 3: Performance With multi-year, multi-goal triggers (cont.) Certain goals are be required to be met before others can be

triggered Goal 1: TSR metrics are 50th percentile for Threshold, 75th

percentile for Target and 90th Percentile for Maximum Goal 2: Expense Reduction is 2% for Threshold, 4% for Target, 7%

growth for Max Require: Goal 1 MUST be met before Goal is triggered

These goals can be layered for multiple years and metrics on a single award

Goal measurements can vary from year to year

Performance Share Stats

Over 40% of large US public companies plan to implement performance-based equity by the end of 2009 There is some dispute to the % of companies actually utilizing these

plans

At least 150 of the FTSE 350 utilize TSR-based performance equity

Highest growth of any equity plan type over the past two years

Pros and Cons of Performance Equity

Pros Cons

Motivates employees to drive specific performance

Motivates employees to drive specific performance

Can be used as a retention tool May become a demotivator

Flexible structure May need crystal ball in structuring multi-year approach

Common Pitfalls and Issues

Too many metrics, too complex BUT - Rare that one metric will predict success of a company

Multiple year metrics in non-mature or unpredictable companies “Guaranteed” metrics in mature, predictable companies Acquisitions or divestures

Both within the company and at peer group companies Variable Accounting

Either mark-to-market, variable Fair Value accounting or Variable probability, fixed Fair Value accounting

Limited Administration, Communication and Reporting tools Poorly communicated and understood, (especially in the period

between award and measurement date)

Potential Work-Arounds or Ways to “Game the Plan” Sand bag numbers for easy targets Make award subject to Board approval Reset targets if necessary Forgive missed goals and allow for re-measurement Set metrics off industry standards instead of company-specific

goals

Performance Shares: Mature Vs. Non-Mature Companies

Mature Non-Mature

Can determine meaningful target metrics Hard to make meaningful financial targets due to lack of predictability (recruitment, innovation and product delivery can be measured)

Minimal Acquisition Activity?This depends largely on industry and current market conditions

May be Acquisitive?

Harder to manufacture false performance, but easier to create “guaranteed” results

Executives can manufacture results, but difficult to guarantee results

Key elements to managing and communicating performance Understand your KPI

How were they chosen? What are the underlying components? How does a participant impact them? How does the market impact them?

Know where you stand Communicate interim performance regularly Show trending and historical comparisons Communicate what need to be done, rather than just what has been done

Focus on percentages and measurement levels rather than payout amounts

Use performance programs as the foundation for communication, instead of an afterthought

Impact of performance on the administration of equity compensation plans Requires systems to be more nimble and flexible

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

Accounting Systems are catching up to the most common plan designs

Valuation Market-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

Impact of performance on the administration of equity compensation plans Communication

Most current websites are very limited in their ability to provide performance details

Risk of providing incorrect information if there is a limited ability to drill down or model

System Interaction Data must be updated regularly and often comes from multiple sources External TSR tracking Data from financial systems Annual Review systems Compensation Planning systems General Ledger Sales Tracking and Commission tools

Conclusion

Performance-based equity is the next wave of evolution in equity compensation

Your plan must be as unique as your company, but still be comparable to your peers

Strong communication is becomes a basic requirement rather than a valued addition

Administration and accounting systems are improving and even the most complex plans can be handled well

Questions

For more information or to discuss this topic in more detail:

Dan Walter, Performensation Consulting

917-734-4649

Dwalter@performensation.com

www.performensation.com