Transcript No Slide Title

THE FUTURE OF
EQUITY COMPENSATION
George B. Paulin
Frederic W. Cook & Co.
NASPP National Conference
October 21, 1998
“Human capital is grabbing a bigger share at
the expense of financial capital. Those who do
the work and lift the bale and tote the barge
are seeing the balance shift their way . . . This
happy trend looks set to be with us a long,
long time.”
WSJ Editorial
Optional Logic
September 21, 1998
1
SHIFTING BALANCE
Human
Capital
Financial
Capital

Equity
Compensation
2

AGENDA
 Where we are today
 How we got here
 What’s next and why
3
WHERE ARE WE?
HUGE PROPORTIONS IN U.S.
 9%-10% of all public company shares in
equity compensation plans
 Almost $1 trillion employee ownership
Source: National Center for Employee Ownership
4
WHERE ARE WE?
BROAD-BASED PARTICIPATION
Now
Then
A few executives with
stock options
Array of uses for
employees at all
levels, and outside
directors

5
WHERE ARE WE?
ARRAY OF USES
Long-Term
Incentives
- Options
- SARs
- Restricted
stock
- Performance
stock
Retirement
Savings/Investment
and Deferrals
- ESPPs
- 401(k) stock
- Voluntary
deferrals
- ERISA excess,
SERPs
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Stock in
Lieu of Cash
- Outright shares
- Options
- Restricted
stock
WHERE ARE WE?
GLOBAL ACCEPTANCE
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WHERE ARE WE?
PROFESSIONALISM
Now
Then
Brill writes Corporate
Counsel on breaks at
Dean Witter

NASPP 4,000
members strong
and growing
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HOW’D WE GET HERE?
ALIGNMENT
Company
Compensation
Objectives
Economic,
Regulatory,
and Social
Factors

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HOW’D WE GET HERE?
COMPENSATION OBJECTIVES
 Pay for performance
 Employee ownership
 Employment retention
 Retirement self-reliance
 Tax/cost effectiveness
10
HOW’D WE GET HERE?
ENVIRONMENTAL FACTORS
 Bull market
 Positive shareholder attitudes
 Supportive tax rates
 Supportive accounting rules
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WHAT’S NEXT?
MY FORECASTING RULES
 Don’t look out too far
 Don’t rely on wishful thinking
 Don’t forget history
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WHAT’S NEXT?
THE FORECAST
 5 primary predications
 Several secondary ones
-- if there is time
 Why each could happen
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WHAT’S NEXT?
FORECAST #1
Less favorable stock market will
change structure/delivery, not
diminish role.
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1. LESS FAVORABLE MARKET
SHIFT IN PSYCHOLOGY
Wealth creation
Wealth protection
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1. LESS FAVORABLE MARKET
IMPACT ON MACRO ELEMENTS
Options

Restricted stock

Performance stock

ESPPs

401(k) stock

Voluntary stock deferral

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1. LESS FAVORABLE MARKET
IMPACT ON OPTION DESIGN
Front-load grants

Premium prices

Price vesting

Performance vesting

Reloads

Indexing

Gain deferrals

Transferability

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1. LESS FAVORABLE MARKET
OTHER IMPACTS
 (Generally) lower option grant values
Volatility
Yield
Interest
Direction
BlackScholes






 Share denominated ownership guidelines vs.
current $-denominated
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1. LESS FAVORABLE MARKET
UNLIKELY NEAR-TERM TRENDS
From
To
Why Not?
Options
Full-value
grants
Fear of premature
deleveraging
Fixed-share
option grants
%-of-pay option
grants
Increased
dilution
Underwater
options
Repriced
options
Corporate
governance
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WHAT’S NEXT?
PREDICTION #2
Next trend in executive options will
be indexing.
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2. INDEXED OPTIONS
TIME HAS COME
 Conceptually sound
-- isolates company performance from
market performance
 Many influential supporters
 Less favorable market removes major
obstacle
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2. INDEXED OPTIONS
OBSTACLE REMOVED
Index out
appreciating
market element

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Index out volatile,
flat, and/or declining
market element
WHAT’S NEXT?
PREDICTION #3
Rigid ISS-type dilution voting rules
will disappear.
23
3. DILUTION VOTING RULES
LIMITED CREDIBILITY
ISS Negative
Recommendations
Number of Plans
that Fail to Pass
At least 40% of plans
proposed each year
Virtually none
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3. DILUTION VOTING RULES
MORE DIRECT DIALOGUE
 Reflects already growing practice
 Clarifies company intent
 Leads to compromise
 Abandons “1-size-fits-all”
 Accommodates trend toward flexible share
funding sources
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WHAT’S NEXT?
PREDICTION #4
ESPPs will be vehicle of choice for
“all-employee” grants.
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4. ESPPs
PERENNIALLY UNDERRATED
 Built-in 15% return
 Short-term price averaging
 Participant liquidity
 Favorable taxes and company accounting
 Payroll-based administration
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4. ESPPs
OBSTACLES CAN BE OVERCOME
Obstacle
Solution
Payroll deductions
Cashless exercise
Weak ownership
Holding periods; stock
settlements if cashless
Low sign-on
Better communication
High-paid limits
Wrap-around plans
U.S. only
Phantom plans
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4. ESPPs
FUTURE ALL-EMPLOYEE OPTIONS
 Event-driven special grants
 Start-ups and emerging companies
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WHAT’S NEXT?
PREDICTION #5
Understanding and application of
option-pricing models will improve.
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5. OPTION-PRICING MODELS
CONFUSION OVER DIFFERENT USES
 Competitive grant amounts
 Disclosure
 Trade-off between pay elements
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5. OPTION-PRICING MODELS
INAPPROPRIATE USES
 Valuing out-of-money options
 Predicting actual option gains
 Estimating what employee would pay for
option right
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5. OPTION-PRICING MODELS
ILLOGICAL RESULTS
 Option 2x as valuable day after price doubles
-- and vice versa
 3 10-year options (30 yrs. of appreciation)
equals 4 5-year options (20 yrs. of
appreciation)
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5. OPTION-PRICING MODELS
CREATIVE THINKING NEEDED
 To adjust for risk
 To adjust for historic price movement
 To adjust for common sense
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WHAT’S NEXT?
SECONDARY PREDICTIONS
Forecast
Why?
“Cafeteria” approaches (e.g.,
options for cash, voluntary
stock deferrals, etc.)
Individual choice; tax
planning
Double-trigger change-incontrol option acceleration
(i.e., only if not assumed or
assumed and employment
termination)
Current imbalance and
unintended consequences
35
WHAT’S NEXT?
MORE SECONDARY PREDICTIONS
Forecast
Why?
Continued emphasis on
ownership through design
and guidelines
Not happening otherwise
P&L expense less important
in option design
Non-cash expense;
heightened awareness of
dilution costs
Better leadership from
board compensation
committees
More information,
education, and time spent;
elevated importance
36
SUMMARY
CHANGE IS CONSTANT
 Stock-market impact on structure/delivery
 Trend toward indexed executive options
 Dialogue with investor groups
 ESPPs for all-employee equity
 Better use of option-pricing models
 Various other
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SUMMARY
FUNDAMENTAL REMAINS
Human
Capital
Financial
Capital

Equity
Compensation
38
