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Achieving Equity Effectiveness

Achieving Equity Effectiveness. A New Understanding. Seeking Equilibrium. Equity effectiveness is equilibrium in share utilization: Effectiveness refers to both: Grant efficiency (tax/accounting/dilution) Motivational value

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Achieving Equity Effectiveness

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  1. Achieving Equity Effectiveness A New Understanding

  2. Seeking Equilibrium Equity effectiveness is equilibrium in share utilization: • Effectiveness refers to both: • Grant efficiency (tax/accounting/dilution) • Motivational value • Optimumutilizationoccurs when the incentive effect outweighs the cost (dilution and expense) • Equilibrium point is where strongest correlation between share utilization and total shareholder return occurs

  3. Achieving Equity Effectiveness During the 1990’s, achieving balance was easy, with little or no concerns about: • Run rates • Overhang • Expense • Allocation • Motivation

  4. Achieving Equity Effectiveness In the years following the 2001-2002 recession, optimization was more difficult: • Economic pressure drove increased diversification in the use of equity plans • Changes felt across many participation levels and geographies • For a long time, the solutions were simple…

  5. But No One Expected… The 2008-2009 recession was unprecedented in: • The depth of its decline • The duration of its decline • Its global economic impact And had a profound impact on equity compensation programs

  6. Why Was This a Surprise? Are the foundations of global equity programs built on an anomaly? $1,000,000 Growth of $10 invested in the Total S&P500 Index starting in 1900 $100,000 Long-Term "Equilibrium" The “birth” of global equity $10,000 Total Return Index: 9.30%/Yr Real S&P 500 Index $1,000 Total Price Index (Dividends Reinvested) $100 $10 $1 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020 Year

  7. Potential Disconnects with Conventional Wisdom Accountants vs. entrepreneurs Option in March 2009 with strike of $4.00 <option in March 2010 with strike of $25.00 Data vs. facts Surveys are reliable source of information for compensation comparison and planning Reciprocity vs. incentive All equity grants are powerful motivators Timing is everything “Stocks for the Long Run”

  8. Current State Shareholder dissatisfaction is high Concerns about risk, dilution, and ownership have fueled broad-ranging governance initiatives Employer dissatisfaction is high Fueled by costs of administration, financial reporting, compliance, and disclosure when grant returns have declined or disappeared For employees, the motivational value is low The payoff from a grant is often viewed as a “gift” that they feel compelled to repay by working harder

  9. Equity EffectivenessTM

  10. Understanding the Disconnect: Right-Brain vs. Left-Brain In design and delivery of equity programs: Left is dominant: • Tax • Accounting • Compliance Right is dormant: • Perceptions • Behaviors • Culture

  11. Left-Brain: Determines What Equity Grant is Worth? • We use complex models to calculate stock option value • But restricted stock is the face value at grant • And performance shares are the possible delivered value • So what is the total value at the date of grant?

  12. Left-Brain: Determines What Equity Grant is Worth?

  13. Left-Brain: Drives Company Actions Anticipated Changes for Upcoming Year But actions are often reactions!

  14. Value of Stock Options vs. Restricted Stock $8,000 $7,000 $6,000 $5,000 $4,000 $3,000 $2,000 $1,000 $0 Grant 1 2 3 4 5 6 7 8 9 10 Stock Options Restricted Stock Assumes ratio of 3 stock options for every 1 restricted share Value of Stock Options vs. Restricted Stock $120,000 $100,000 $80,000 $60,000 $40,000 $20,000 $0 Grant 1 2 3 4 5 6 7 8 9 10 Stock Options Restricted Stock Assumes ratio of 3 stock options for every 1 restricted share Are these actions consistent with employee perceptions? • Two employees, same company… • But, different perceptions on value

  15. Value is tied to perceptions • Behavior Finance proposes theories based on psychology to explain anomalies in the market. • Behavioral finance assumes that the information structure and the characteristics of market participants systematically influence individuals' investment decisions as well as market outcomes. • Behavioral finance seeks to better understand economic decisions and how those decisions affect prices, returns, and the allocation of resources. To an employee, perception is reality

  16. So at the date of grant, what is the perceived value? The answer is simple, it depends…

  17. Equity characteristics… But, effectiveness for each individual is driven by their perceived value

  18. But what shapes perceived value? • Work Culture • Personal biases and experiences • Generational differences • Global cultures

  19. Work Culture • Alignment of equity compensation practices with both business strategies and work culture … • … is critical for successful change and work force commitment to the change.

  20. Work Culture Work Culture can maximizes workforce alignment… … and equity effectiveness

  21. Perceptions and Behavioral Economics The three main themes in behavioral finance are: • People often make decisions based on “rules of thumb”, not rational analysis • The way a problem is presented will affect the decision a person makes on how to act • There are behavioral explanations for observed market outcomes that are contrary to rational expectations and market efficiency

  22. Behaviorand Behavioral Economics Behavioral economics provides us with explanations for the suboptimal results of option exchange programs: • Mental accounting ----“What are these options really worth?” • Loss aversion ---- “But it’s worth something now…” • Hyperbolic Discounting ---- “How long until these vest?” • Endowment effect ---- “I already have these options” • Decision paralysis ---- “What if I make the wrong decision?” • Regret aversion ---- “What if I make the wrong decision?” • Overconfidence ---- “The stock will come back” • Following the herd ---- “But it’s a best practice”

  23. Behavior and Generational Differences • Generational differences manifest themselves in several ways, including how individuals view their compensation. • There is variation in the nature of intrinsic rewards each generation considers • The generations also relate to their organizations differently

  24. Some generational differences are obvious

  25. Implications on Perceived Equity Values Baby Boomer: Optimistic + Involved + High Risk/High Rewards = Preference for highly leveraged grants like stock options Generation X: Cautious + Conservative + Distrustful = Preference for low leverage grants like service-based restricted stock Generation Y: Realistic + Confident + Career Focused = Preference for moderate leverage grants like performance shares

  26. Behavior and Global Culture • Culture is the underlying value framework that guides an individual’s behavior • Culture is reflected perceptions, social interactions and business interactions • Culture guides the selection of appropriate responses in social and business situations

  27. Hofstede’s Cultural Dimensions

  28. Hofstede’s Cultural Dimensions • One company, one Plan • But one plan for one world?

  29. Hofstede’s Cultural Dimensions Source: Geert Hofstede™ Cultural Dimensions

  30. Hofstede’s Cultural Dimensions Source: Geert Hofstede™ Cultural Dimensions

  31. Achieving Equity Effectiveness • If this is what an understanding of employee behavior tells us, then how do we act today? • By left-brain: • Accounting • Tax • Compliance • Not by right-brain: • Perceptions • Behaviors • Culture

  32. Program Costs Vehicle Cost Plan Cost Document Accounting Cash Flow Projected Design & Communication & Expense Impact Dilution Administration & Disruption Disclosure Equity Equilibrium Retention of Recruiting Performance Perceived Efficient Workforce High Value Success Outcomes Value Communication Planning Employees Direct Value Indirect Value Measuring ROI: Finance Meets Behavior

  33. What does this knowledge tell us about plan design going forward? One Company, One Plan?

  34. Looking Ahead… Performance Share Plans • Provide the flexibility to adapt to global differences • Leverage can also be adjusted to respond to difference in risk profiles • Performance metrics can be set to create global alignment and/or maximize line-of-sight • Awards can be paid in stock, cash or a combination to maximize perceived value One company, one plan?

  35. Parting Thoughts • Technical aspects of equity are important, but not enough • To understand perceived value, a better understanding of the global workforce is needed • Value is perceived, not calculated • Classical rational decision-making is not the model for actual employee decision-making • Triangulate to get answers rather than focusing on the single best base of information • Design simplicity should be an imperative • More intuition, less conventional wisdom

  36. Questions Jim Sillery Principal +1 (1) 312 846 3145 James.sillery@buckconsultants.com

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