Structuring Effective Long-Term Incentive Plans

1. Structuring Effective Long-Term Incentive Plans May 6, 2014

2. Speakers Denver Compensation & Benefits, LLC John Schultz, J.D., LL.M., Managing Director Brennan Rittenhouse, J.D., LL.M., Manager

3. Overview of Long-Term Incentive Plans

4. Overview of LTI • Purpose • The long-term benefit of an effective LTI plan can be invaluable to the long-term success of a company • A well designed LTI plan aligns employee interests with those of the company owners • Long-term incentives can drive employee performance, company growth, and provide a buffer against short-term drivers • It can also be used to help retain high performers

5. Overview of LTI • Prevalence • Approximately 75% of public companies have LTI plans • LTI plans are less prevalent among private companies • Only about 61% of private companies utilize LTI plans, which is an increase from 35% in 2007 • Reasons: • Lack of sophistication/resources • Reluctance to dilute ownership • Minority shareholder concerns • Complexity

6. Overview of LTI • Award Sizes • Awards are typically granted based on a percentage of base salary • Watson Wyatt Survey (under 1,000 full-time employees) • Company officers – 102.5% • Other management – 51.4%

7. Overview of LTI • Correlation to STI plan • Sometimes companies will coordinate their annual short-term incentives with their LTI plans • Annual performance metrics and aggregate target payouts can be established • The individual incentive awards are allocated between LTI and STI (e.g., 75% LTI and 25% STI) • LTI awards will have a multi-year vesting and/or performance schedules (e.g., 3 years, earnings growth, EBITDA, etc.)

8. Plan Structures

9. Plan Structures • Public Company Practices • Equity (as opposed to cash) plans • Favorable accounting treatment • Simple • Understood

10. Plan Structures • Public Company Practices • Equity award form • Stock Options • The right to buy a number of shares at a price fixed at grant for a specified term • Companies use an option-pricing model to calculate the value of awards as of the date of grant and expense that amount

11. Plan Structures • Public Company Practices • Equity award form (cont’d.) • Restricted Stock • Provide employees with shares of company stock at little or no cost, subject to a risk of forfeiture (“vesting”) • Restricted Stock Units • Similar to restricted stock, but employees do not actually receive shares until the restrictions lapse

12. Plan Structures • Public Company Practices • Vesting Provisions • Time vesting • Performance – either used to determine grant size or vesting amount • Company performance • Business unit performance • Individual performance

13. Plan Structures • Public Company Practices • Stock Options vs. Full-Value Awards • Historically options were preferred because of the favorable accounting treatment • A big shift to restricted stock with FAS 123R – 2005 • Companies now expense options

14. Plan Structures • Public Company Practices • Stock Options vs. Full-Value Awards (cont’d.) • Full-value award concerns • Will realize value regardless of performance • “Pay for pulse” i. Because most restricted stock vests on the passage of time, employees receive benefit for simply continuing employment

15. Plan Structures • Public Company Practices • Stock Options vs. Full-Value Awards (cont’d.) 4. Stock option concerns • Market conditions beyond employee control can result in awards being worthless • Awards too far underwater lose retention effect

16. Plan Structures • Private Company Practices • Equity-based plans • Advantages of equity-based plan • More closely mirror public company structure • People understand the plans • Takes care of alignment issues • Consolidates all factors into 1 MEASUREMENT-VALUE

17. Plan Structures • Private Company Practices • Equity-based plans • Private company issues • Valuation challenges • Difficult/expensive to value • Internal Revenue Code section 409A complexity • Skepticism of valuation models

18. Plan Structures • Private Company Practices • Equity-based plans • Lack of Liquidity • Makes it difficult for participants to realize value • Can lead to phantom income problems • Impacts perceived value • Cash flow issues • Minority shareholder concerns

19. Plan Structures • Private Company Practices • Cash-based plan • Using STI structure (including targets) and stretching terms • Adding vesting terms • Less favorable accounting • Can be difficult to set metrics that work over extended periods • Can be complex and difficult to understand/communicate

20. Real Equity or Synthetic Proxy

21. Real Equity or Synthetic Proxy • Actual equity grant – 2 basic forms • Stock Options • Restricted Stock/RSU • Both result in the transfer of actual equity

22. Real Equity or Synthetic Proxy • Phantom grants – “stock”/Stock Appreciation Rights (“SAR”) • Acts like real equity, but only cash transferred • Phantom stock grants the right to receive cash based on the future value of the company's stock • SARs are the right to receive cash based on the appreciation in the value of the stock

23. Real Equity or Synthetic Proxy • Phantom grants – “stock”/SAR (cont’d.) • Closest to true equity plan • Avoids minority shareholder issues • Company provides the liquidity • Still has valuation issues • Typically addressed via formula approach

24. Performance Measures

25. Performance Measures • Principles for effective measures are • Relevant to business objectives • Focus and drive executive behavior to desired results • Controllable with little to no manipulation possible • Integrate and recognize cross-functional nature of business processes • Accurate and cost-effective reporting as well as a currently audited and disclosed measure is best • Sensitive to changes in business environment • SIMPLE

26. Performance Measures b. Some examples of performance measure types are: • Top-line growth (revenue growth, operating margin, etc.) • Bottom-line growth (EBIT, EBITDA, earnings per share, etc.) • Ratio measurement (ROA, ROE, ROI, etc.) • Operating (operating efficiency, debt management, etc.) • Value-added (cash-flow management, return over cost of capital, etc.) • Shareholder return (EPS, TSR, etc.) • Discretionary

27. Performance Measures c. Measures can be expressed in a variety of ways including: • Achievement of budgeted performance goal • Improvement over prior or previous year(s) • Relative to comparator group or index • Achievement of strategic milestones

28. Performance Measures d. Measures should: • Focus on line-of-sight • Integrate success of company and that of its business units, segments or divisions • Be quantifiable and measurable (easy for participants to understand) • Be limited in number (three or less measures is best to focus attention to key or critical objectives for the business)

29. Performance Measures e. Weightings • Weightings should: • Reflect the importance of the measure within the incentive plan • Be rounded to a 10% or 5% figure • Not be less than 20% (if three or two measures in total) or participants will only focus on the heavier weighted measures ii. “Triggers” can be implemented if helpful • A trigger is a hurdle that must be reached before any portion of the incentive award is paid out and is usually tied to some overarching corporate measure

30. Performance Tiers

31. Performance Tiers a. Tiers are typically defined at three levels • Threshold reflects the minimum level at which incentive payments begin. This level gets participants “in the game” and typically has payment levels that are below achievement levels to contribute more to the company bottom-line until profitability starts (usually this level of payout would be 50% or less of target) • Target reflects “stretch” performance and is generally equal to the “planned” or “budgeted” level of performance with a moderate level of difficulty (100% achievement equals the target incentive level) • Maximum reflects the maximum level of payout based on an increased level of profitability (usually this level is 200% of target)

32. Performance Tiers b. Design Considerations • Setting appropriate performance goal levels is the most critical part of the design process (and will get the most scrutiny from shareholders and outsiders if not done correctly) • It is important to incorporate overall company performance into the incentive program to mitigate some overall risk issues • Discretionary goals are typically very subjective and should be limited in use • Opt for overall corporate measures or triggers when possible

33. Award Opportunity c. Award opportunities should be: • Expressed as a percentage of a participant’s base salary or set dollar amount (most programs incorporate percentages) • Based on salary level and also the contributory and strategic nature of the position • Tiered by level and role to streamline administration and communication of the program • Expressed in terms of minimum, target and maximum (or other reference points as useful)

34. Finalizing the Program d. Program Analysis • Many different elements should be analyzed prior to finalizing an incentive program, but some key issues to review are: • Total payout of awards as a percentage of company profit to ensure it is at an acceptable level, especially at each award opportunity level • Review elements of risk and how they could impact each of the measures and the respective payouts at each award opportunity level (list the types of risk categories reviewed and what the potential impact might be) • Review the incentive program and how it fits into the total compensation program and company pay philosophy

35. Implementation and Communication • Key considerations • Create a design and implementation team prior to designing the program that would include compensation, HR, finance (accounting and tax), legal and IT to ensure you can design a measurable and easily administered program • Simplify as much as possible, the program has to be easy for the participant to understand or it will not motivate properly

36. Implementation and Communication • Key considerations (cont’d.) iii. Pick measures on which you can regularly report results to participants to continue the excitement throughout the year iv. “Brand” your communications so participants will easily recognize them and make them as brief as possible or they will not read them thoroughly v. Show how this incentive plan ties into total compensation and specifically links to business objectives and provide ideas on how participants can impact results

37. Implementation and Communication b. Remember • If you communicate often and clearly, your program will be successful regardless of whether it is the best “theoretical” design or a poorer design • If participants understand the program (not necessarily like it) they can more actively affect their compensation and the positive results of the company

38. Traps & Tricks

39. Traps & Tricks • Know your shareholders! • If you’ll be seeking shareholder approval • Understand the implications of shareholder groups • Stay up to date on their guidelines • Consult with them in advance if you are not sure

40. Traps & Tricks b. Beware of the “qualified” option! • Disqualifying dispositions of both Incentive Stock Options and Employee Stock Purchase Plans means they are taxable based on the spread at EXERCISE, not sale • And the spread at exercise is subject to Alternative Minimum Tax • Exercise high and sell low can yield a very bad result

41. Traps & Tricks c. Wages or Wages? • The definition of wages for income tax is different than wages for FICA • If there is a deferral feature in the plan (e.g., RSU) the value will be subject to FICA when vested but income tax when paid • Make sure you have a FICA tax payment provision built into the plan

42. Traps & Tricks d. What’s my grant date? • The grant date is the measurement date for both accounting and tax, but what is it? • Picking wrong can result in erroneous accounting charges, SEC and Exchange violations and penalties, and/or retroactive taxation plus penalties • Make sure that the rules, the documents, and the PROCESS are in sync

43. Traps & Tricks e. Accelerated Vesting – is it worth it? • Accelerations are common but can be tricky • They can result in unexpected: • Accounting charges • Lost deductions under Internal Revenue Code (“IRC”) section 162(m) • IRC section 409A violations and penalties • IRC section 280G excise taxes and lost deductions • Impacts on the potential transaction iii. Understand the application of each trigger under various scenarios

44. Traps & Tricks f. IRC section 409A – since when is equity deferred compensation? • It is not just the grant date that can get you (FMV at grant requirement) • Any modification is a potential disqualifier • Do not grant stock options on anything other than plain vanilla common stock • Be careful of anti-dilution provisions • Especially careful with deferred Restricted Stock Units • Distribution triggers • Change in control definition • 6 month delay for public company Named Executive Officers

45. Traps & Tricks g. Why all the fuss over IRC section 162(m)? • With the trend from using stock options to RSAs/RSUs, qualifying for the performance-based exception has changed • Now cannot just rely on the stock plan exception, but need to comply with ALL the requirements • And the IRS changed some of the rules, so improper accelerators can taint the whole plan

46. Long-Term Incentive Design Examples

47. Examples • Actual equity award – ABC Co. • Facts • $10 million manufacturing company • 35 employees • Private equity backed • Some financial statement sensitivity • Short term focus; 3-5 year exit strategy

48. Examples • Actual equity award – ABC Co. • Plan Design • Individual incentive awards are allocated 25% to STI and 75% to LTI • For the LTI portion, the Participants are granted restricted stock units and/or stock options, which vest over a three-year period • The target size and make-up of the award is based on the individual’s position, responsibilities, compensation level, performance, historical contribution, and market practices

49. Examples • Actual equity award – ABC Co. ii. Plan Design (cont’d.) • Funded by the LTI award pool of approximately 15% of fully diluted common stock • After the pool has been exhausted, the company may reassess whether additional funding of the LTI plan is in the best interests of the company, shareholders and participants • Payout terms are linked to owners; i.e., participants get paid when the shareholders get paid

50. Examples • Hypothetical unit grant – Public company subsidiary • Facts • US subsidiary of very large, publicly traded, foreign parent • Service company with related company activities • Need to evaluate performance on a combined-entity basis • Some financial statement sensitivity • Cross-border issues and individual tax sensitivity