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

2. Denver Compensation & Benefits, LLC
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

51. Examples Hypothetical unit grant – Public company subsidiary
Plan Design
Private company creates an LTI plan that grants “units” in a pool that consists of company earnings
This LTI pool is treated like a separate entity that is divided into “units” (similar to stock)
One percent of consolidated-company profits is allocated to the pool

52. Examples Hypothetical unit grant - Public company subsidiary
Plan Design (cont’d.)
Growth of the pool is based on company profit growth-similar to valuation of private company
Employees have the option to defer payouts from the plan, and in return receive a 20 percent company match on those deferrals
Maintains incentive value even after vested

53. Examples Hypothetical unit grant - Public company subsidiary
Employee grants
Employees granted “units” based on a percentage of salary
Each grant of “units” to the employees is subject to a three year graded vesting schedule, with payout occurring in year four
This will drive employee behavior and create the desired retention effect
Grants are made annually to increase retention and smooth out unforeseeable changes in earnings

54. Examples Hypothetical unit grant - Public company subsidiary
Attempt to keep it simple so employees appreciate plan
Well developed education up front
Annual statement to communicate value

55. Examples Multiple Equity Plans Facts 1,000+ employees
Desire to build ownership culture
Maximize tax efficiency
Conserve cash in the short term

56. Examples Multiple Equity Plans Multi-plan design
Omnibus equity plan structure
Allows for stock, RSUs, options, SARs, performance units, etc.
Provides maximum flexibility

57. Examples Multiple Equity Plans Multi-plan design (cont’d.)
Nonqualified deferred compensation plan
Permits deferral of equity plan awards
Permits target employees to buy stock with pre-tax cash compensation (base & bonus)

58. Examples Multiple Equity Plans Multi-plan design (cont’d.)
Qualified plan – “KSOP”
Allows company to make stock contributions, including 401(k) match, in stock
Permits participants to direct investment in company stock

59. Examples Actual equity award – XYZ Co. Facts
Approximately $1B revenue healthcare company
Public company
Some financial statement sensitivity
Significant dilution concern
Has performed extremely well, but executive compensation has not always reflected high performance

60. Examples Actual equity award – XYZ Co. Previous Plan Design
Previously, the company used a long-term incentive award that was based on economic value
Fairly complicated plan which made it difficult for management to decipher what behavior was required to receive a payout
The calculation included variables the executives had no control over, such as the business valuation multiple
Plan had a 3-year performance period, followed by a 3-year payout period

61. Examples Actual equity award – XYZ Co. iii. Revised plan design
LTI plan granting performance based RSUs (“PBRSUs”) (1/2), time- based RSUs (1/4), and stock options (1/4)
Provides significant upside with the use of stock options, while maintaining some “handcuffs” in a down market with the use of time-based RSUs
PBRSUs directly tied to company performance (relative TSR), while limiting the dilution caused by options
To further limit dilution, PBRSUs can be settled in stock or cash

62. johnschultz@denverbenefits.com 303-779-2080
Questions?
John Schultz
Brennan Rittenhouse

63. Please note that, though we believe this presentation provides accurate information, its accuracy is not guaranteed. Also, this presentation does not provide legal, accounting or tax advice. Finally, this presentation cannot be used to avoid any tax penalty.