After the Storm – High Tech Pay in a Post-Expensing World May 25, 2005.

After the Storm –High Tech Pay in a Post-Expensing World

May 25, 2005

After the Storm – High Tech Pay in a Post-Expensing World2

Carl SchmittDirectorHuman Resources & Investor [email protected]

Brett HarsenSenior ConsultantHuman Resources & Investor [email protected]

Today’s Speakers


Today’s Session

Approximately one-hour presentation

Question and answer period to follow

Questions can be directed via e-mail to [email protected](please note this email now – we encourage questions)

INTRODUCTIONINTRODUCTION


In today’s discussion, we will cover six topics

Overview of recent accounting developments

The latest on Mellon’s research into vesting acceleration practices

Update on option valuation trends in High Tech

Developments in High Tech equity compensation programs

Expected future directions for High Tech equity compensation

Issues to consider

INTRODUCTIONINTRODUCTION

OneOne

TwoTwo

ThreeThree

FourFour

FiveFive

SixSix


Section One – Overview of Recent

AccountingDevelopments


Much has happened since our January 2005 webcast on the final FAS123R rules

April SEC delays

FAS123R IBM starts expensing (retrospectively)

ACCOUNTING DEVELOPMENTSACCOUNTING DEVELOPMENTS

??March SEC issues

SAB107

May Cisco intends to

issue new security to value employee options

Jan - May Number of companies accelerating vesting grows from

approx. 15 to over 100 High Tech companies continue to assess alternative equity

strategies, but have largely stuck to the wait-and-see mindset

Just what is in store for the future is anyone’s guess right now…

February Options bill

reintroduced in Congress


SAB 107 is meant to expand upon and clarify FAS123R…

Option Option ValuationValuation

Reinforces liberal standard of good faith effort in performing reasonable valuations

Choice in option valuation model A certain emphasis on using implied volatility if market

traded options are available (at-the-money with terms of at least six months, ideally more than one year)

Simple method for determining a “safe harbor” holding term (average of vesting and contractual term)

Change in valuation methodology is NOTNOT a change in a change in accounting principalaccounting principal

Vesting Vesting AccelerationAcceleration

Remains a viable strategy for early footnote recognition of option expenses

Requires timely disclosure



SAB 107 is meant to expand upon and clarify FAS123R…

Pro-forma Pro-forma EarningsEarnings

Prohibits including complete pro-forma income statements in SEC filings

Companies may be able to disclose a non-GAAP measure such as net income before option expense, however management must meet burden of explaining why such a measure is appropriate

Separate Line Separate Line Item Item Disclosure of Disclosure of Option Option ExpenseExpense

Prohibited in the income statement (will be included in existing lines such as SG&A)

Separate disclosure will be allowed in parenthetical notes to income statement line items, in footnotes and in the management’s discussion and analysis (MD&A)



Section Two – Vesting Acceleration


A unique window of opportunity exists to shift option costs into footnotes prior to SFAS123(r)

While a modification, no variable accounting is triggered and no fixed charge is recognized if the options are underwater (recent auditor interpretations have also indicate that in-the-money options can be accelerated without incurring substantial costs)

Requires immediate recognition of remaining grant-date fair value in the SFAS123 footnotes

Does not require shareholder approval under the new NYSE and Nasdaq corporate governance rules

Shareholders may view this as a giveaway – especially if the options accelerated are not significantly underwater and/or are held by officers or outside directors

Eliminates any remaining employee retention value associated with the award Will create spikes in option-related (footnote) expenses that may increase the difficulty of

comparing period-over-period financials

How it Works

Implications

VESTING ACCELERATIONVESTING ACCELERATION


The simplified mechanics of the strategy are as follow

Assumptions

Options Granted 1,000Stock Price at Grant $30Strike Price $30Per Share Fair Value (B-S) $20Total Award Fair Value (B-S) $20,000Vesting Schedule 4 Years, 25% annuallyCurrent Stock Price $10 (options are underwater)


Without AccelerationTransition to Mandatory Expensing

Year 1 Year 2 Year 3 Year 4 TotalAPB 25 (Income Statement): $0 $0 na na $0

FAS 123 (Footnotes): $5,000 $5,000 na na $10,000FAS 123R (Income Statement): $0 $0 $5,000 $5,000 $10,000

With Vesting AccelerationAcceleration of Vesting Transition to Mandatory Expensing

Year 1 Year 2 Year 3 Year 4 TotalAPB 25 (Income Statement): $0 $0 na na $0

FAS 123 (Footnotes): $5,000 $15,000 na na $20,000FAS 123R (Income Statement): $0 $0 $0 $0 $0

Total cost of award split between footnotes and income statement

Total cost of award shifted into footnotes only


Forty percent of the 97 companies we studied were from high technology

Tech Data Flextronics Sanmina Solectron Jabil Circuit AMD Micron Technology International Rectifier Monster Worldwide InFocus

Vesting AccelerationIndustry Breakdown

GeneralIndustry

50%

High Technology

40%

LifeSciences

10%


Including some large, well-known tech companies:

n=97


The number of companies continues to grow – even immediately after the SEC’s delay of mandatory implementation in March

n= 97

Date of Acceleration

2%1% 1% 1%

10% 10%

23%24%

11%

16%

0%

5%

10%

15%

20%

25%

30%

August'04

September '04

October '04

November '04

December '04

January '05

February '05

March '05

April '05

May '05

n=97

(As of 5/09)



While most only accelerate those underwater, a growing number have accelerated in-the-money options as well

All Companies

General Industry

High Technology Life Sciences

The price on date of acceleration (all underwater options)

46% 37% 53% 75%

Specified price above the closing price on date of acceleration (specified

underwater options only)39% 46% 33% 25%

Specified price below the closing price on date of acceleration (includes some

in-the-money)14% 17% 13% 0%

n= 69 35 30 4

Price Floor For Eligible Options



Additional program design findings include…


Roughly one-quarter of outstanding options were accelerated

Only 12% excluded board options and 6% excluded officers

Only 13% placed restrictions on the sale of stock acquired through early exercises


… And from outward appearances, shareholders haven’t reacted negatively toward the stock


All Companies

General Industry


Average trade volume for two days following public announcement of

acceleration as a percent of average daily trade volume for 90 days

preceding announcement

105% 97% 114% 113%

n= 97 47 40 10

All Companies

General Industry


Average stock price close on day after announcement of acceleration as a percent of stock price close on day

before announcement

100% 100% 101% 99%

n= 97 47 40 10

Change in Stock Price Following Announcement of Acceleration

Change in Trading Volume Following Announcement of Acceleration


Section Three – Trends in

Option Valuation


Many High Tech companies are realizing that binomial is no silver bullet

The binomial model can theoretically be more accurate because it can incorporate a greater array of inputs

However, the output of the model is only as good as the quality of the inputs– Yes, the binomial model can accommodate volatility, risk-free rate

and dividend yield assumptions that vary from period to period into the future based on predicted company or market events…

– But, how many companies can reliably predict how future events will impact these variables?

In some cases, given the nature of binomial calculations, increased accuracy may even mean increased cost

Finally, it is still unclear exactly how auditors will respond to the more complex inputs required by robust binomial models as the large accounting firms are still developing their own internal guidance

OPTION VALUATIONOPTION VALUATION


Binomial complexity can easily get out of control

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

$99.60$69.60

$81.55$53.01

$66.77 $66.77$39.62 $36.77

$54.66 $54.66$28.84 $26.13

$44.76 $44.76 $44.76$20.45 $17.61 $14.76

$36.64 $36.64 $36.64$14.16 $11.46 $8.11

$30.00 $30.00 $30.00 $30.00$9.60 $7.28 $4.45 $0.00

$24.56 $24.56 $24.56$4.53 $2.45 $0.00

$20.11 $20.11 $20.11$1.34 $0.00 $0.00

$16.46 $16.46$0.00 $0.00

$13.48 $13.48$0.00 $0.00

$11.03$0.00

$9.04$0.00

Above the Line: Stock PriceBelow the Line: Option Fair Value

Vol: X%Spinoff

Vol: Y%Product Launch

Vol: Z%

RF Rate: A%

RF Rate: B%

Exercises forced by expected

layoff

(i% prob.)

Baby Boomers’

Retirement(ii% prob.)

George’s Daughter is Accepted to

Harvard(iii% prob.)

Death or Disability (a% prob.)

Our auditors give us a hard enough time on the six basic Black-Scholes inputs!



FIRST – Scrutinize your volatility assumption(s) within the context of the new guidance (lower volatility = lower cost)

Before investing in expensive binomial technology or outsourcing, three low effort/high-impact steps should be explored


Company

12 mo. Historic

Vol

24 mo. Historic

Vol

36 mo. Historic

Vol

48 mo. Historic

Vol

Focus Company 24.8% 32.7% 68.1% 61.6% 57.9% 56.5%

PeersPeer 1 23.0% 25.5% 26.3% 28.8% 32.1% 33.5%Peer 2 17.3% 26.2% 26.9% 27.6% 27.6% 27.6%Peer 3 37.9% 44.2% 56.1% 66.7% 66.9% 65.9%Peer 4 28.2% 35.0% 32.6% 33.6% 33.3% 32.6%Peer 5 28.2% 35.0% 32.6% 33.6% 33.3% 32.6%Peer 6 29.8% 35.7% 42.4% 41.7% 42.9% 42.8%Peer 7 27.9% 40.8% 39.3% 47.0% 49.8% 49.2%Peer 8 35.8% 40.7% 41.3% 40.3% 39.4% 39.4%

Median Peer Volatility: 28.2% 35.3% 36.0% 36.9% 36.4% 36.5%

Excluding 4/1/01-6/1/01 - Announcement of SpinoffFocus Company 24.8% 32.7% 31.0% 32.2% 34.0% 37.1%

Greater flexibility now exists for building cases to excluded historic periods of extraordinary volatility…

PriceTerm (yrs)

Last Sale (or bid if sale is

na) Assumed IRAssumed

Div Implied Vol$10.00 0.8 $10.50 3.31% 0.00% 45.87%$17.50 0.8 $3.80 3.31% 0.00% 28.69%$20.00 0.8 $2.60 3.31% 0.00% 32.82%$22.50 0.8 $0.85 3.31% 0.00% 21.68%$25.00 0.8 $0.60 3.31% 0.00% 26.74%$30.00 0.8 $0.15 3.31% 0.00% 27.56%

PriceTerm (yrs)

Last Sale (or bid if sale is

na) Assumed IRAssumed

Div Implied Vol$15.00 1.7 $6.50 3.62% 0.00% 25.24%$20.00 1.7 $3.80 3.62% 0.00% 29.82%$25.00 1.7 $1.60 3.62% 0.00% 25.85%$30.00 1.7 $0.70 3.62% 0.00% 25.76%

If your company has market traded options that can be referenced, SAB 107 tells us implied volatility is a strong benchmark…

Use multiple approaches to support your case for what you expect the company’s volatility to be in the future – but be prepared for increased disclosure


SECOND – Use existing data from your option administration software or outsourcer to scrutinize historic exercise periods (shorter holding period = shorter cost)

Before investing in expensive binomial technology or outsourcing, three low effort/high-impact steps should be explored (continued)


Don’t rely on solely standard reports from your option software or outside administrator to provide accurate employee holding period data (some systems use subjective calculations, most systems will aggregate holding periods on grants with different vest schedules)

Look for different exercise patterns among employee groupings, but only use these differences if the patterns are sustainable and do not make valuation overly-complicated

Calculate the period of time employees hold options after they become exercisable so that data on grants with different vest schedules can be properly compared


Assumptions– Stock options are granted with a four-year total vest period, vesting

in tranches of 25% per year

– From historic experience, employees are shown to exercise 12 months after vest

This single grant is broken into 4 tranches based on vesting…


THIRD – Value each tranche of a ratably vested award as a different grant to recognize early exercisability



… this tranche-based approach virtually eliminates the differences between Black-Scholes and binomial (assuming all other assumptions remain equal)


THIRD – Value each tranche of a ratably vested award as a different grant to recognize early exercisability (continued)


1,000$30.00$30.00

Tranche

Months from Grant

Vested Percent

Expected Holding

Term (Months)

Expected Volatility

over Expected Holding Term (%)

Risk-Free Rate Over Expected holding

Term (%)

Expected Dividend Yield over Expected Holding Term (%)

Per-Share Value

Shares Per

TrancheCost Per Tranche

Per-Share Value

Shares Per

TrancheCost Per Tranche

1 12.0 25.00% 24.0 50.00% 2.00% 0.00% $8.73 250.0 $2,181.50 $8.73 250.0 $2,182.442 24.0 25.00% 36.0 45.00% 2.50% 0.00% $9.89 250.0 $2,471.50 $9.89 250.0 $2,473.293 36.0 25.00% 48.0 40.00% 3.00% 0.00% $10.58 250.0 $2,644.50 $10.59 250.0 $2,647.414 48.0 25.00% 60.0 35.00% 3.50% 0.00% $10.99 250.0 $2,747.50 $11.01 250.0 $2,751.95

Total Fair Value: $10,045.00 $10,055.09Total Face Value: $30,000.00 $30,000.00

Fair Value as a Percent of Face: 33.5% 33.5%

Black-Scholes BinomialTranche Vesting Practice

Number of SharesStrike PriceStock Price

Substantially SimilarSubstantially Similar


In summary, when binomial is used to increase option valuation complexity…


Some things are certain…

Complexity Administrative Burden

Audit Scrutiny/Burden

Transparency

But some things are NOT…

Complexity ?

=

Accuracy

=

=

=

Complexity ? Expense =


Section Four – Developments in

Equity CompensationPrograms


Option accounting is not the only issue driving equity compensation decisions

Major DriversMajor Drivers

Equity Compensation

Option ExpensingFAS123R

NYSE/NASDAQ(Approval Requirements)

SEC(Disclosure

Requirements)

Taxation &Deferred Compensation

(AJCA)

ShareholderPressure

Secondary DriversSecondary Drivers

Congress(Pending Legislation)

HIGH-TECH TRENDSHIGH-TECH TRENDS


High Tech companies have been (slowly) modifying their equity compensation programs in anticipation of option expensing

The primary changes have been evolutionary…

Stock options are still the dominant form of equity compensation– However, a notable portion of companies have introduced alternative

equity vehicles, primarily restricted stock (units) and performance shares

Reduce overall share usage (burn rate)

Reduce participation

and/or eliminate eligibility

Reduce individual grant

levels

Implement/refine international differentials



Overall share usage has been the primary focus

Reducing the burn rate for equity addresses both expensing and investor dilution concerns

High Tech companies are targeting 3.0% gross burn rate for 2005– Lower burn rate of 2.0% for largest tech companies

– Small and rapidly growing companies will struggle to get below 4.0%

These target burn rates represent a significant decline in share usage over the past few years– Burn rates have been declining 20%-30% year over year for most

companies



To reduce usage, companies have been making tough decisions around eligibility and participation

Our Summer 2004 flash survey found that companies expected to reduce participation primarily for lower level employees– To date, this prediction has proven to be true


* May not sum to 100% due to rounding

Pe

rce

nt

of

Co

mp

an

ies

100%

80%

60%

40%

20%

0%

Pe

rce

nt

of

Co

mp

an

ies

100%

80%

60%

40%

20%

0%

17%

Top 5Executives

Changes to Annual Participation in Response to Mandatory Expensing

83%

0% 0% 0%

24%

76% 69%

30%

1% 1%

OtherExecutives

Directors/Managers

ExemptIndividual

Contributors

Non-Exempts

54%46%

LowerSameHigher

57%

42%

N=107


High Tech companies still believe in broad equity grants, but are raising the bar on performance

Grants to new hires are still nearly universal– The majority of companies still grant options to nearly all (~100%)

new hires

Ongoing grant programs have seen the biggest cutbacks in participation– Below the director level, universal participation is becoming rare

– Companies generally set a target portion (15%-75%) of employees expected to receive a grant in any year

– “Annual” grants are now “performance” grants

International grant levels and participation are receiving greater scrutiny– “One size fits all” is an unaffordable luxury



High Tech companies are increasing usage of stock option alternatives

Stock options are still the dominant form of equity compensation!– And will be for the foreseeable future

Among the alternatives, full-value grant programs (restricted stock, performance shares) are getting the most attention

– Other option alternatives like stock-based SARs (Stock Appreciation Rights) are becoming more common

– Some potential successors to options have lost favor because of tax, accounting, or investor issues

A number of High Tech companies have implemented full value grant programs in the past year despite APB25 expense

– Expect the trend to increase as companies get closer to FAS123R implementation

Companies have taken widely divergent approaches with full value grants– Carve-out vs. wholesale replacement of options

– Executives only vs. all employees vs. only lower levels



Section Five – Future Directions


Due to the staggered implementation of FAS123R, equity practices will continue to evolve at a measured pace

Winter ’05/’06 Calendar YE companies

begin expensing

Fall ‘05First required Q1

releases under FAS123R (for 6/30/06 FYE)

Spring ‘06Remaining public

companies begin expensing

Option acceleration increases in lead-up to fiscal year ends

Wider use of full-value shares and stock-based SARs in lieu of options

Continued reduction in equity burn rates and grant levels

Revival of exchange programs for underwater options (repricing)

Summer ‘05June 30 FYE

companies begin expensing

Accounting

Equity C

ompensation

FUTURE DIRECTIONSFUTURE DIRECTIONS


Now: Acceleration of underwater optionsFuture: Exchange of underwater options

We expect the pace of vesting accelerations to increase as companies approach their fiscal year ends– After adoption of FAS123R, acceleration is considered “non

substantive” and has no accounting benefit

– We expect to see increasing acceleration of vesting on in-the-money options

• Under APB25/FIN44, recognition of expense for in-the-money value is contingent upon an event that would have otherwise caused forfeiture

• As year end approaches, potential APB 25 cost of acceleration is minimized



Now: Acceleration of underwater optionsFuture: Exchange of underwater options

After adoption of FAS123R, we expect option exchanges (repricing) to experience a resurgence– No longer any need for the “6 month and a day” (6+1) maneuver

– Exchanges can occur immediately after close of tender offer

Under FAS123R, the exchange only increases accounting cost if incremental value is delivered– Most exchanges will be done on a value-neutral basis, so there will

be no incremental expense

For most companies, shareholder approval is required for option exchanges– Need for shareholder approval may constrain frequency and

variation in practices



The “level playing field” will give full value shares closer parity with option programs

Once companies have to recognize an expense for all equity grants, the full-value grants will be a viable alternative– We expect an increasing portion of companies to incorporate full

value grants into their equity programs

– Options will likely remain the most common form of equity

In High Tech companies, the accounting cost of options is starting to become an issue for budgeting and planning purposes– Planning for future grants and impact on earnings guidance

– Internal budgeting for equity costs by department/function

The net result will be increasing downward pressure on equity grant levels– “What gets measured, gets managed”



The “level playing field” will give full value shares closer parity with option programs

A key issue for the options vs. full value shares is trade-off ratio– As companies reduce their option valuations, the implied trade-ratio

becomes higher in order to remain expense neutral

At higher trade-off ratios, it takes only minimal stock price increases for options to achieve higher gains– The following table illustrates the gain required and years to achieve

under various stock price growth scenarios

Options for Restricted Stock Trade Off RatioOptions for Restricted Stock Trade Off Ratio

1.5 for 1 1.5 for 1 2 for 12 for 1 3 for 13 for 1 4 for 14 for 1 5 for 15 for 1

Implied Option Value(% of Stock Price)

66.7% 50% 33.3% 25% 20%

Stock Price Gain Required for Option Gain to Equal RS

200% 100% 50% 33% 25%

Years Required to Achieve Equal Gain:

– At 5% Growth Rate



40.0

13.3

8.0

20.0

6.7

4.0

10.0

3.3

2.0

6.7

2.2

1.3

5.0

1.7

1.0



Section Six – Closing:

Issues to Consider


How much do all your programs cost?Who benefits from each program?

ESPP$4 MM

Bonuses$60 MM

Options$70 MM

Benefits (no pension)$60 MM

Salaries$300 MM

Company has more than $1.5 B in revenues

Company has more than $200 MM in profits

Bonuses are 30% of profits

Options are 35% of profits

ESPP is 2% of profits

Everything must be taken in context

LONGER-TERM STRATEGIESLONGER-TERM STRATEGIES


SHAREHOLDERSHAREHOLDERCONCERNSCONCERNS

Manage dilutionManage dilution

SHAREHOLDERSHAREHOLDERCONCERNSCONCERNS

Manage dilutionManage dilution

To support the total rewards philosophy, the design of LTI programs requires balancing several factors

ORGANIZATION STRATEGY

ORGANIZATION STRATEGY

What is our business strategy?

What goals do we need to achieve over the next Year? Two Years? Three years?

What is our business strategy?

What goals do we need to achieve over the next Year? Two Years? Three years?

COMPETITIVE NORMS

COMPETITIVE NORMS

What are competitive opportunities at similar companies? Do we have to match the opportunities?

How deep do these opportunities extend and what forms do they take?

What are competitive opportunities at similar companies? Do we have to match the opportunities?

How deep do these opportunities extend and what forms do they take?

Does our pay philosophy support:

• Pay for performance• Risk/reward tradeoffs

What is the culture we want to reinforce and how far do we have to go to achieve it?

Does our pay philosophy support:

• Pay for performance• Risk/reward tradeoffs

What is the culture we want to reinforce and how far do we have to go to achieve it?

ORGANIZATION SITUATION

ORGANIZATION SITUATION

PLANDESIGNPLAN

DESIGN


Do you want to be a "first mover“ (“market leader”), "market follower", or in the middle?


In conclusion…

High Tech is changing its equity practices at an evolutionary rate There are specific accounting related actions that can (and

should) be taken before implementing FAS123R Over time, grant levels will likely continue to decrease and

become more focused on top performers In considering changes to equity programs, look at equity and its

cost in the context of total rewards and the business strategy

… The times, they are changing



Thank You

Questions?(email now to: [email protected])

Carl [email protected]

Brett Harsen312-846-3418

[email protected]


For some companies, full-value grant programs can be a better match for their situation and needs

Stock OptionsStock Options(Appreciation Awards)(Appreciation Awards)

Restricted StockRestricted Stock(Full Value Awards)(Full Value Awards)

Description • A right to purchase stock at a specified price during a specified period

• Full shares of stock that typically vest over time based on continued employment

Advantages • Creates a direct link between employee and shareholder interests

• Provides more leverage than full-value stock arrangements

• Simple to administer and easy to understand

• Promotes shareholder interest by facilitating stock ownership

• Powerful retention vehicle• Requires fewer shares than option awards to

deliver competitive value• Provides downside protection to employee

Disadvantages • Subject to market fluctuations• May not be aligned with business/ rewards

objectives• Requires more shares than full-value stock

arrangements to deliver competitive value

• Less performance oriented than other vehicles because of downside protection

• Employees cannot control timing of tax event (award is generally taxed at vest)

Variants • Other forms of appreciation awards include:

– Stock appreciation rights (SARs)• Stock-based SARs• Cash-based SARs

– Indexed options– Premium-priced options– Phantom stock units

• Other forms of full-value awards include:– Performance shares– Restricted stock units (RSUs)– Performance units– Deferred stock units

APPENDIXAPPENDIX

After the Storm – High Tech Pay in a Post-Expensing World May 25, 2005.

Documents

Transcript of After the Storm – High Tech Pay in a Post-Expensing World May 25, 2005.