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WaW 2012 Annual Value and Valuation.pptx

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Presentation Slides & Transcript

Presentation Slides & Transcript

Value and Valuation: Making Sense of Long-Term Incentive DataTerry Adamson, CEPFred Whittlesey, CEP, CCP, CECP

Presentation OutlineThis is Important if…Statement of the ProblemHistory of LTI ValuationAccounting Fair ValueSurvey ValuesProxy Statement ValuesProxy Advisory Firm ValuesRe-Emerging MethodologiesEmerging Effects on ValueYour Next Steps

This is Important if…You reference survey data and/or proxy data in your compensation analyses, andYour compensation market data includes LTI data, andYour company grants LTI to the positions you are analyzing, orYour company does not grant LTI to the positions you are analyzing, orA proxy adviser or institutional shareholder has questioned your executive or equity compensation program (in the say-on-pay process), orYour CEO is the subject of unfavorable headlines for being “overpaid”

Statement of the ProblemLong-term incentive compensation represents a small to significant portion of total compensation depending onPositionIndustryLocationForm of organizationCompany pay philosophyUnlike cash compensation, LTI values are subject to a wide variety of conflicting methodologies

Statement of the ProblemAccountants and the SEC have a unified approach to LTI valuationThese are increasingly being challenged as “pay value”Corporate compensation practitioners use LTI market data represented in a wide range of valueData is often combined/averaged like base salary and total cash compensation dataVarious forms of LTI are, in turn, combined into dollar-denominated valuesCorporate governance advocates assess LTI value as an element of their analysesEach has its their valuation method

Statement of the Problem

Survey Valuation Methodologies

A Brief History of Valuation1980sGrant ValueGrant Value MultipleAllowed LTI-to-LTI comparisons (if all options)Allowed crude pay mix comparisonsNo “total compensation” calculation possibleNote: At that time, SEC disclosure rules did not require a total compensation figure

Grant Value

A Brief History of Valuation (continued)1990sGain ValueAllows for comparison and addition to cash compensationDriven by 3 controversial assumptionsGrowth rateDiscount rateTime periodProxy statement table5% and 10% growth rate

Gain Value

A Brief History of Valuation (continued)1990sFAS123: Optional accounting fair value (footnote required) endorsing (without naming) Black-Scholes and driven by:VolatilityExpected Life (not full term)Risk-free Interest RateDividend YieldAny discount/premium from fair market value for strike price

Black-Scholes Value$13.03

A Brief History of Valuation (continued)Proxy Statement – Summary Compensation TablePre-1993: Total cash compensation, number of stock options1993: $ value of RS and PS but # of options2004: $ values of all forms of LTI (except cash)2007: Grant date fair value and “total comp” plus cash LTI in NEIPFair value accrued in that year for all years’ grants2010: Back to grant date fair value

A Brief History of Valuation (continued)The Past DecadeISS Burn Rate table1995: FAS123Option pricing model endorsed by FASB1997: Share Value Transfer method released2004: FAS123RBinomial model endorsed as preferred method2005: SAB107 adds some shortcutsExpected Life = (T + V)/2

Topic 718 RequirementsValuation – Traditional Models* Simplification such that there is an equal probability of downward and upward movements. This is generally not the case as the probability of upward and downward movements are governed by the volatility, the dividend yield, and the discount rate.@Black-ScholesTraditional Binomial ModelIllustration comparing closed-form Black-Scholes model with a traditional binomial model (present value of future cash flows)

Topic 718 RequirementsValuation – Monte Carlo SimulationPrinciples of Monte Carlo simulation are akin to The Price Is Right game PlinkoFuture stock prices are randomly simulated up or down at each time period Plinko right or left at each pegEnding price used to determine whether award vests and the value of that awardProcess is repeated to ensure a wide distribution of resultsFair Value = Vesting Percentage x Simulated Price x Present ValueSimple average of all simulation results

ISS Valuation vs. AccountingAdobe Systems DEF14A 3/1/2012

WorldatWork’s ModelInitiated comment in 2009 with goal of a standardized valuation method to be used by allCover story in April 2011 Workspan - great deal of interest by practitioners and several large survey firmsAt the end of 2011, several firms were attempting to implement the WorldatWork/GEO standard LTI model in their data collection systems for 2012, but they failed to meet their own deadlinesWorldatWork anticipates that at least one or two firms will again attempt to include a standard LTI model for 2013Association is actively encouraging further discussion, toward a standard LTI valuation model that be in addition to (not replace) other models

Re-emerging MethodologiesIntrinsic valueWhat the award is actually worth…but when?Realized valueWhat the award was worth when exercised (options), vested (RS and PS), or paid (cash LTI)Realizable valueWhat the award would be worth (right now) if fully paid outCaptures intrinsic valueEliminates bias of unexercised options

Intrinsic Value: Proxy Statement TableCitigroup DEF14A 3/8/2012

Intrinsic Value: Proxy Statement ChartCEO Equity GrantsGrant Date Fair Value vs. Intrinsic Value as of 12/31/2011

Realizable Pay: Supplemental Filing

Emerging Effects on ValuePerformance featuresIntroduced in reaction to RSUs = PSUsExtended to stock optionsStock ownership guidelinesIntroduced in early 1990sEmbedded in proxy advisory voting guidelinesClawbacksIntroduced in Sarbanes-OxleyEnhanced in TARPExtended in Dodd-Frank – awaiting SEC rules

How Do These Affect Value?Performance featuresTypically viewed as a discount by participantsReported at target in GPBA (with a footnote for max)Often create an accounting expense greater than targetStock ownership guidelinesTypically viewed as a discount by participantsNo models consider in LTI valueOften moot due to one-time RSU grants accompanying new guidelinesWhich are often excluded from proxy and survey values!ClawbacksTypically viewed as a discount by participantsUnquantifiable due to uncertain circumstances and timing

Emerging Effects – Relative TSRSample fair value result based on the following:3-year performance periodAssumes $20 current price, 3% risk-free rate, and no dividend yieldPayout based on percentile rankSummary of simulation resultsNote that this result is 115% of face!

Emerging Effects – Absolute TSR3-year performance period; RSU vests if the stock price exceeds the Stock Price HurdleAssumes $20 current price, 3% risk-free rate, and no dividend yieldBut what about Market Stock Units? Those are Absolute Performance SharesExpect Market Stock Units to be approximately 120% of face, depending on terms

Emerging Effects – Truncated Terms and CapsShorter Contractual Terms of 7 Years or less became popular in 2006Look for Capped Options to come next …

Emerging Effects - ClawbacksASC Topic 718 does not allow for a reduction for claw-backsIFRS 2 requires a reduction in the valuation of Claw-backsCompanies are only going to reduce the fair value of equity for the probability of violating non-compete or non-solicit provisions, not for misconductSimplistic Example: Requires assumptions about termination, the probability of competition, and the length of the non-compete provision. The example below reflects a 1-year non-competeDiscount = 1 – (Termination Rate)*(Probability of Competing)Longer non-competes would get greater reductions in fair value

What To Do?Confirm your current internal methodologiesStock options and SARsTime-vested stock grants (e.g., RSUs)Performance-vested stock grants (e.g., PSUs)Multi-year Non-equity Incentive awards (e.g., Cash LTI)Confirm your survey and consultant methodologiesReverse engineer and normalize valuesNote how vastly different this new analysis is from anything you’ve done before!Compared to proxy tablesCompared to consultant’s analyses

Then…Determine your Compensation Committee consultant’s methodologiesResearch your Compensation Committee members’ other Board memberships, and repeatEducate your CEO/CFO/GC/VPHR Provide empirical and analytical support for your executives’ trip to the Compensation CommitteeDevelop a position on LTI competitiveness, and the impact on total compensationManage those numbers behind-the-scenes to be instantly prepared for a say-on-pay challenge, lawsuit, stock price crash, employee whining, etc.

32Contact InformationFred Whittlesey, CEPPrincipal Consultant206.388.9068fred@compensationventuregroup.comwww.compensationventuregroup.comBlog: payandperformance.blogspot.comTerry Adamson, CEPPartnerAon Hewitt Consultingtadamson@radford.com215.255.1802