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Michael A. Thompson F REDERIC W. C OOK & C O. July 19, 2000

Compensation Strategies. in a. "Bifurcated" Economy. Michael A. Thompson F REDERIC W. C OOK & C O. July 19, 2000. Topics Covered. Old economy companies losing to new economy companies May be changing, but not certain Retaining high performers harder than ever

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Michael A. Thompson F REDERIC W. C OOK & C O. July 19, 2000

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  1. Compensation Strategies in a "Bifurcated" Economy Michael A. Thompson FREDERIC W. COOK& CO. July 19, 2000

  2. Topics Covered • Old economy companies losing to new economy companies • May be changing, but not certain • Retaining high performers harder than ever • Investors pushing back on dilution • Rescuing underwater options is difficult, not impossible • Innovations and trends to watch

  3. “Bifurcated” Economy Stock Market

  4. “Bifurcated” Economy Volatile Stock Market • Nasdaq was down 1/3 but recovering • Up 40% over past 12 months • Dow down slightly over past 12 mos. • Many companies have lost 50% or more of their value • Xerox Mattel • Armstrong Bank One • Sara Lee R.R. Donnelley • Sears Toys R Us • E-Toys Red Hat

  5. Mergers Acquisitions Divestitures/ Sales IPOs Spin-offs Tracking Stock “Bifurcated” Economy Corporate Transactions

  6. “Bifurcated” Economy Rise of Venture Capital • Corporate Venture Capital and Private Equity Funds • Creates significant pressure on executive compensation • Internal venture managers • Raises issues regarding “friends and family” shares on IPO

  7. “Bifurcated” Economy Corp. Venture Capital

  8. Oldcos vs. Newcos Internet Impact • Changing the game • Focus on carried interest, not Black-Scholes value • Equity interest in E-commerce units • Raises the ante for retention • Significant salary increases in some sectors, e.g., law firms • Push to client equity pools in others, e.g., consulting firms

  9. Oldcos vs. Newcos Competing Pay Models

  10. Oldcos vs. Newcos Expensive Recruiting • In the money option values: • 18 internet companies Option Gains ($000,000) CFO Top Sales CEO COO

  11. Oldcos vs. Newcos Different Pay Packages • Joseph Galli example:

  12. Oldcos vs. Newcos ($000) Internet Internet Internet GI Internet GI GI GI CFO CEO Top Sales General Counsel Generic Comparisons

  13. Oldcos vs. Newcos Pre- vs. Post-IPO Source: SCA ePay Study, April 2000 -- Over 30 pre-IPO companies and 50 post-IPO companies -- Traditional company assumed to be $400MM revenue and $275 Market Cap

  14. Oldcos vs. Newcos Company Practices Vice President Cash Compensation Median Company Ownership Bonus Salary Source: SCA ePay Study, April 2000

  15. Oldcos vs. Newcos Company Practices Source: SCA ePay Study, April 2000

  16. Oldcos vs. Newcos Annual Grants as a % of Outstanding Shares 91% Growth Run Rate Comparisons

  17. Oldcos vs. Newcos 99% Growth Potential Dilution as a % of Outstanding Shares Dilution Comparisons

  18. Oldcos vs. Newcos Candidates’ Response • More risk averse • Want additional cash • Will trade-off options for • restricted stock, • SERPs, • deferred annuities, • forgivable loans, • etc.

  19. Oldcos vs. Newcos Recent Initiatives • Tracking stock • Disney, DLJ, Quantum, Staples, ATT • Spinoffs/IPOs • ATT, GM, HP, Lucent • Subsidiary Options • Venture Capital Incentives • Merrill Lynch, ?

  20. High demand High mobility and accessible info Recruiting premiums and buyout packages “Star” system Longest bull market Options and other equity comp Stock price is major determinant of comp value Retention Reason for the Problem Labor Market Stock Market

  21. Retention Carly Fiorina Example

  22. Retention Design Provisions Beyond the traditional . . . • Option Clawbacks (Cigna, Delta, Goodyear, IBM) • Tandem option guarantees (Amazon) • Stock purchase loans (eBay, Excite@Home, Kodak) • Career Restricted Stock (Coca-Cola, GE, 3M) • Forfeitable Deferral Premiums (Alcoa, Dell, GM)

  23. Retention Design Provisions • Restricted stock • 3/5 year vesting or career • VC investment funds • Shared participation in e-commerce subsidiaries • Voluntary cash/stock deferrals, with forfeitable sweetener • Supplemental retirement plans with “bad boy” clauses

  24. Dilution Upward Trend • Higher “burn rates” and “overhang” • More scrutiny from institutional investors

  25. Dilution 2000 Voting--ISS • Opposed majority of plans (55%) • Limited impact, but still a concern • Continued flaws in model • Overvalues grants at high performers and vice-versa • Penalizes omnibus plans without limits on full-value grants • Discourages breakout from low utilization industries (defense, utilities)

  26. Dilution 2000 Voting--Others • Focused mostly on dilution, not wealth transfer • Fidelity opposed to RS without minimum 2-3 years restrictions

  27. Smaller more frequent share authorizations Shares counted on net, as issued basis, not gross, as granted basis Add back shares re-purchased with option proceeds Board approved plans for non-officers Best voting outcome because of dilution tests Add back shares to pool from stock-swap exercises, etc. Particularly with prevalent buy-back programs Possible under stock exchange rules Dilution Changes in Practices

  28. Dilution Looking Ahead • NYSE may limit broad-based exemption • Efforts needed to encourage improved investor voting rules • Especially ISS • % of salary grant guidelines no longer useful • Start with competitive % share usage, using surveys for allocation

  29. Underwater Options If shares available • Front-load future option grants • Next 2-3 years • Incentive for price recovery and retention • No additional “competitive” compensation value

  30. Underwater Options If shares not available New option grants could be made after 6 months with no variable accounting expense • Executives voluntarily cancel • Company buys back for restricted stock or cash • At fair value (Black-Scholes) • Discount from fair value

  31. Underwater Options More Drastic Hedges • Options with dividend equivalents • Replace u/w options with restricted stock • Price-recovery restricted stock • Cash-appreciation bonuses • Subsidiary options • Relative performance shares • Combination option/rs grants

  32. Innovations/Trends Option-Related • Opportunistic grant timing • More frequent grants • Shorter option terms • Offset guarantees • Reloads • Auto-acceleration at termination • Except cause or voluntary quit • Price thresholds for exercise

  33. Innovations/Trends Other • Double-trigger change-in-control stock vesting • No vesting if stock awards replaced • Personal loans • Forgivable and non-forgivable • Flexible Deferrals

  34. Innovations/Trends Likely Response • Increased share usage/dilution • Human capital value added • Greater dispersion and selectivity of rewards by individuals • Four critical factors • Focus on line-of-sight incentives • Less focus on whole • More potential for inequities

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