A Plethora of Performance Perplexities
Jim Vincent, CEP – E*TRADE Corporate
Services
© 2012 E*TRADE Financial Corporation. All rights reserved.
This presentation contains confidential information and may not be disclosed without
E*TRADE Financial Corporation’s written permission.
The information contained in this presentation has been prepared by
Equity Methods, Compensia, and E*TRADE Financial Corporate
Services, Inc., each of whom are responsible for their own content.
E*TRADE Financial Corporate Services, Inc. does not recommend or
endorse these companies or their product and service offerings.
The laws, regulations and rulings addressed by the products, services,
and publications offered by E*TRADE Financial Corporate Services, Inc.
are subject to various interpretations and frequent change. E*TRADE
Financial Corporate Services, Inc. does not warrant these products,
services, and publications against different interpretations or
subsequent changes of laws, regulations and rulings. E*TRADE
Financial Corporate Services, Inc. and its affiliates do not provide legal,
accounting or tax advice. Always consult your own legal, accounting and
tax advisers.
© 2012 E*TRADE Financial Corporation. All rights reserved.
This presentation contains confidential information and may not be disclosed
without
E*TRADE Financial Corporation’s written permission.
1
Performance Grants – What are they?
© 2012 E*TRADE Financial Corporation. All rights reserved.
This presentation contains confidential information and may not be disclosed without
E*TRADE Financial Corporation’s written permission.
2
Overview – types of performance grants

By combining different design elements, the variations of performance-based equity plans are seemingly endless
Vehicle
•Restricted Stock / Units
•Stock Options
Vesting Type
•Performance only
•Time + performance (contingent)
•Time + performance (accelerated)
Performance
Metrics
•Financial Performance
•Strategic Milestone
•Stock Price Performance
Performance
Period
•Annual
•Multi-Year
Goal Setting
•Relative
•Absolute
3


×
Design objectives and alternative long-term incentive programs
Time-Vested Equity
Design Objectives
= Meets
= Somewhat Meets
= Does Not Meet
Performance Shares (by Metric)
RSUs
Stock
Options
Financial
Goals
(Absolute)
Financial
Goals
(Relative)
Relative
TSR
Provide immediate retention value

×
Varies1
Varies1
Varies2
Meet ISS’ standards for performance-based pay
×
×



Link pay to stock price / shareholder return
×
+
×
×

Address “rising tides” criticism

×


+
Provide “durability” in volatile markets

×
×
+
+
Link pay to achievement of business plan
×
×
+

×
Avoid need for long-term goal setting


×


Avoid metrics that are redundant with bonus plan


×
×

Provide substantial upside for strong performance
×




Minimize unproductive dilution

×



Preserve tax-deductibility under 162(m)3
×




Accounting expense can be reversed if goals are not met
×
×


×
Accounting expense is fixed “up front”


×
×

1. Retention value depends on the perceived likelihood of meeting performance goals
2. Retention value depends on specific design (e.g. floor on # of shares that may be earned, payout level for meeting/trailing index, etc)
3. Assumes program does not have a “floor” and program otherwise meets 162(m) criteria
4
PERFORMANCE SHARES
Performance-based equity design elements
Parameter
Performance Share Program Design Elements
Participation

Typically seniors executives….but varies significantly
Vehicles

Restricted Stock / Units
Stock Options

Vesting Type
Performance
Metric
Vesting Type

Award becomes vested upon….
Performance

Achievement of specified objective (typically within specified time frame)
Time + Performance

Achievement of specified objective and completion of time-based vesting
Time or Performance (i.e. Accelerated)

The earlier of a) achievement of performance goal or b) specified date
In general, metrics can be classified in three groups:
Item
Performance
Period / Vesting
Financial Performance

Revenue or Income / Margin (Operating, Net, or EPS)
Strategic Milestone

Quality objectives or product milestones
Stock Price Performance

Stock price / total shareholder return

Performance is generally measured over one to four years

Performance periods may overlap (i.e., a new period begins each year) or run consecutively (i.e., a new period begins when the
previous period ends)

Additional vesting (after the performance period) is commonly used with shorter performance periods
Goal Setting
Payout Range
Examples
Measure

Description
Absolute

Performance vs. pre-established goals
Relative

Performance vs. pre-determined comparator group or index
Payout opportunity typically ranges from 0% to 150-200% of target (Varies significantly with program design)
5
Other considerations

Goal setting (what level of performance yields threshold / target /
maximum payout)

Plan mechanics, such as:
• Selection of comparator group / index (for relative measures)
• Calculation of TSR / stock price averaging period (for relative TSR
plans)

Treatment upon termination or Change-of-Control
© 2012 E*TRADE Financial Corporation. All rights reserved.
This presentation contains confidential information and may not be disclosed
without
E*TRADE Financial Corporation’s written permission.
6
Case Study

Competing objectives for the program included:
• Linking pay to achievement of multi-year business plan
• Linking pay to stock price
• Providing immediate retention value
• Concerns over ability to set multi-year goals

Solution: a hybrid program combining relative TSR and net income (vs. multi-year plan)

An example of how such an award may operate:
• Grant of 100 RSUs
• 3-year performance period
• Payout depends on net income relative to a target and relative TSR
• The maximum payout depends on the recipient excelling across both dimensions
of performance
7
Valuation and Accounting for performance
grants
© 2012 E*TRADE Financial Corporation. All rights reserved.
This presentation contains confidential information and may not be disclosed without
E*TRADE Financial Corporation’s written permission.
8
Best practices in getting ASC 718 right

Regardless of the complexity of the award, understand the chaotic process the rollout of these
awards typically follows:
• “Fire drill” compensation committee exchanges with the board consultant – a lot of verbal
dialogue, emails, and powerpoints
• Drafting of grant agreements by a party substantially removed from the design process
• Assignment of responsibility for compliance (administration, valuation, reporting) to
someone else wholly removed

Clearly isolate all key award terms and conditions
• Types of targets, performance period(s), service periods, treatment of dividends,
performance measurement calculation, etc.

For each material award provision, document how you will handle it both administratively and
in the context of ASC 718. For example:
• Service period not aligned to performance period
• Interaction between performance condition and market condition
9
Best practices in getting ASC 718 right (Cont’d)

If a market condition is present, be sure the external auditors sign off on the final valuation
report before beginning to accrue expense

In addition to evaluating the structure of financial reports, evaluate and test how downstream
settlement activity will be handled
• Qualifying termination rules
• Standard settlement activity

Establish a policy for handling off-cycle grants, including estimation of grant-date fair value
and potential adjustments to the performance period(s)

Establish a policy for addressing diluted EPS implications in light of contingently issuable
shares concept in ASC 260
10
Too many possible combinations and permutations of design levers
Award Lever
Examples
Performance condition, market condition, or some combination
of both
• EPS (performance condition); TSR (market condition)
• Payout based on EPS modified by TSR performance
Linkage of performance target to a payout multiplier or vesting
timing
• Payout ranging between 0 – 200% of target units
• Vesting occurs when FDA approval is obtained
Single or multi tranche awards
• Single tranche where payout tied to 2011 EPS
• 3 tranches corresponding to 2011, 2012, and 2013 EPS
Synchronization of performance period to service period
• Perform period ends 12/31/2012; service period ends 12/31/2013
Length of performance period
• One, two, or three years are all common
Use of absolute or relative performance targets
• Payout tied to TSR relative to S&P 500
• Payout tied to 125% stock price appreciation
Relative targets linked to specific firms or a broad index
• TSR relative to S&P 500 or relative to company A, B, C, and D
If a comparison index, stacked ranking or shareholder return
relative to index
• Tiered payout based on percentile rankings
If a comparison index, “open” or “closed” index
• Initial members in the index may change over time
Interplay of special termination rules and performance
criteria/timing
• Pro-rata acceleration but payout depends upon final performance
• Payout immediately at termination at target
162(m) compliance decisions
• Use of objective criteria that can be calculated by 3rd party
• Timing in which performance goals are set relative to grant date
Selection of RSU, RSA, SAR, or NQSO as award type
• Performance award structured as an RSU vs RSA
Payout vehicle is in equity, cash, or some combination
• Payout in equity in US; payout in cash in other countries
Special adjustment to payout multiplier
• Pure modification – at least 8 distinct types
• Downward discretion by compensation committee
Tax withholding methodology / other tax issues
• Timing of taxable event at grant or at vest
11
Valuation of MSU – More than just a couple of inputs

The purpose of a Monte Carlo simulation is to estimate the expected payoff (i.e., cost of the
instrument) as of the measurement date

Conceptually, this involves modeling the many different potential payout outcomes into the
future, discounting them back to the present, and taking an average
• No different from what is being done by Black-Scholes formula on a plain vanilla stock
option
• However, on a plain vanilla stock option, only the company’s own stock price needs to be
modeled into the future

In a relative TSR award, additional details need to be carefully modeled
• Volatility of granting company AND volatilities of peers
• Correlation between granting company’s stock returns and those of each of the peers
• Expected dividend stream of granting company and each of peers
• Specific payout triggers
• Open versus closed index – entry and exit of peers from index

As a general rule, the more variables, the more testing that is needed to ensure:
• All pertinent terms are properly incorporated in the valuation model
• Valuation results are stable – the model will generate similar results if run repeatedly

Other possible drivers of a change in value
• Movement in share prices between initial valuation date used for planning purposes and
final grant-date valuation
• Be careful in how award quantities are communicated during planning process because
those quantities may change
© 2012 E*TRADE Financial Corporation. All rights reserved.
This presentation contains confidential information and may not be disclosed
without
E*TRADE Financial Corporation’s written permission.
12
Performance period alignment to service period
Service required past the end of the performance period end date
Service inception date /
Grant date / Performance
period start date
(1/1/2012)
Performance
period end date
(12/31/2013)
Service completion
date
(3/31/2014)
Performance period begins prior to the service inception and grant date
Performance
period start date
(1/1/2012)
Service inception
date / Grant date
(3/15/2012)
Service completion date
/ Performance period
end date
(12/31/2013)
Requisite service period ends before the end of the performance period end date
Qualifying termination events
Service inception date / Grant
date / Performance period
start date
(1/1/2012)
Qualifying
termination date
(9/14/2012
Performance period
end date
(3/31/2014)
13
Service inception date alignment to performance period

Grant Date and Service Inception Date are frequently the same, but not always.
• Don’t follow your intuition, follow the accounting guidance
• See FAS 123R, Paragraph A79

Start by identifying the grant date, and remember each tranche can have a separate grant date
(and, ditto, a separate service inception date)

Then determine the service inception date in relation to the grant date
• Formally defined as the start date of the requisite service period
• Can precede the Grant Date if:
― An award is authorized; and
― Service begins before a mutual understanding of the terms is reached; and
― Either of the following is true:
― Terms do not include a substantive future requisite service condition that exists at the
grant date; OR
― Award contains a market or performance condition that if not satisfied during the
service period preceding the grant date and following the inception of the arrangement
results in forfeiture of the award
• Can occur after the grant, although theory is ambiguous
Service inception
date
(1/1/2012)
Grant date
(3/15/2013)
Service completion date
/ Performance period
end date
(12/31/2014)
© 2012 E*TRADE Financial Corporation. All rights reserved.
This presentation contains confidential information and may not be disclosed
without
E*TRADE Financial Corporation’s written permission.
14
Hybrid awards and the quest for bifurcation

If performance and market conditions require substantially different accounting treatment, then a
natural problem exists when accounting for an award that contains both a performance condition and
a market condition
•
•
Is it a fixed expense pattern because of the market condition?
― What about the FASB Resource Group Meeting notes where it was concluded that the presence of a
market condition amidst other conditions requires the full expense to be taken?
Or, does the performance condition enable some form of variability in accruals?

It depends on the terms and conditions of the award

Determine whether the conditions are independent or interdependent

Potential approaches are
•
•
Bifurcated award
Application of performance condition multipliers to a fair value that reflects impact of market condition
TSR Ranking
Payouts Based on TSR and Net Income
© 2012 E*TRADE Financial Corporation. All rights reserved.
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without
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> 80th
1.00
1.10
1.50
1.75
2.00
60th - 79th
0.75
0.85
1.25
1.50
1.75
40th - 59th
0.50
0.60
1.00
1.25
1.50
20th - 39th
0.10
0.20
0.60
0.85
1.10
< 20th
0.00
0.10
0.50
0.75
1.00
< 80%
80% - 89%
90% - 99%
100% - 110%
> 110%
Net Income as a % of Plan
15
Multi-Tranche awards and defining requisite service period

Although straight-line attribution is prohibited when dealing with performance conditions or market
conditions, the use of graded attribution does not necessarily imply “accelerated” expense recognition

Consider the following example:
•
•
90 RSUs, 3 tranches
Successive 1-year service inception dates and grant dates
―
•
Targets are set at the beginning of each fiscal year
$50 fair value
$500
$500
$500
SID
GD
SCD
$750
$750
SID = Service Inception Date
SCD = Service Completion Date
GD = Grant Date
SCD
SID
GD
$1,500
SID
GD

SCD
Year 1
Year 2
Year 3
$500
$1,250
$2,750
Depending on the terms and conditions, this award could just as easily follow an even expense pattern
(which would cause the amortization schedule to resemble straight-line) or an accelerated pattern
16
Managing performance and time goals
© 2012 E*TRADE Financial Corporation. All rights reserved.
This presentation contains confidential information and may not be disclosed without
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17
Biggest challenges with managing performance and time goals

Matching performance grant setup with expense attribution

Make sure goal tracking is flexible

Communicating goals and goal status clearly to participants

Differentiating performance awards from time based RSA/RSU grants
© 2012 E*TRADE Financial Corporation. All rights reserved.
This presentation contains confidential information and may not be disclosed
without
E*TRADE Financial Corporation’s written permission.
18
Matching goals with expense attribution

Multiple scenarios in ASC 718 (FKA FAS 123R paragraphs A79 – A85)

You want flexibility between a single grant date, performance period
end date, and vest date
• Set up and tracking differs greatly from time based RSA/RSU
• How can you handle all performance scenarios?
• Find out what you need and where performance awards may goal
― Issuers – focus groups
― Internal – Comp committee, HR

Immediate feedback was that multiple goals and time periods needed
to be accommodated

Needed capacity for more than one goal per grant

Goals with individual, distinct targets that may be independently
achieved

Goals that combine targets – result may be a combination of
attainment from multiple targets
© 2012 E*TRADE Financial Corporation. All rights reserved.
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19
Matching goals with expense attribution
Employee
Employee 1
Employee 1
Employee 1
Employee 1
Employee 1
Employee 1
Target
Target $
60% 360,000
60% 360,000
60% 360,000
60% 360,000
60% 360,000
60% 360,000

Expense
Accrual %
150%
150%
100%
100%
100%
100%
Grant
PV
Grant
Target Estimated Stock Lock
Date Stock Adjustme Date Fair
Goal
total
In Price
Price
nt
Value
progress award ($)
100% 540,000
$23.07
23.07
(1.34)
21.73
100% 540,000
23.07
23.07
(1.34)
21.73
100% 360,000
23.07
25.38
25.38
100% 360,000
23.07
25.38
25.38
100% 360,000
23.07
27.91
27.91
100% 360,000
23.07
27.91
27.91
Grant
Date
2010
2010
2011
2011
2012
2012
Vest Date
Shares
Granted
2014
2013
2014
2013
2014
2013
3,901
3,901
2,601
2,601
2,601
2,601
In this example, the % for expense accrual and Target process are
separated to provide better flexibility. For example, you may want share
count to be at the max, diluted EPS to be measured at target, but expense
to reflect a possible 50% over achievement of goal.
© 2012 E*TRADE Financial Corporation. All rights reserved.
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without
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20
Matching goals with expense attribution
Initial design allowed for this scenario
Service inception date /
Grant date
Performance period
end date
Service completion
date
Added the ability to manage multiple goals per grant, regardless of whether goals were interdependent or not
Goal 1
Goal 2
Goal 3

Design also allowed for flexiblity to assign different service dates to each
goal

Expense attribution accelerated or straight line? Not all companies view this
the same
21
Combining time and performance grants

Why would you accrue using straight line multiple goals over a period
of years?

Example: Simultaneous goals over multiple years
• Do you then have multiple service inception dates?
• Do you have multiple grant dates?
• Will the goals (and valuation) for years 2 and 3 be known in year
1?

Example: Consecutive goals over multiple years
© 2012 E*TRADE Financial Corporation. All rights reserved.
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22
Combining time and performance goals

Continued to meet with focus groups

Feedback provided suggested the following scenarios needed to be
covered
• Performance period is prior to grant date, then followed by a
service date
• Performance Period is after grant date, but followed by multiple
service dates with more flexibility on straight line vs. accelerated
accrual
Grant Date
Performance period
end date
Service Inception
Grant Date
Vest 1
Vest 1
Vest 2
Vest 3
Vest 2
© 2012 E*TRADE Financial Corporation. All rights reserved.
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23
Lessons learned: Combining time and performance grants

Allow for Straight line or accelerated accrual
• As long as expense accrual follows one of the stated examples in
ASC 718

Allow for flexible scenarios
• Goals that combine performance, market, and time factors
• Multitple time factors/consecutive vesting

Other challenges/lessons learned about administering performance
grants

Don’t assume goals for participants will be 1: many
• Some companies tailor goals to the individual at the VP or Director
level
― Creates individual tracking for each tranche/each grant
• If using a system - allow for importing goal records – better suited
for broad based performance grants
• If using Excel – Group like goals together, so the changes you
make can be more systematic
• Realize non-market condition performance grants often are valued
on the grant date discount
― Make it easier to facilitate valuation
© 2012 E*TRADE Financial Corporation. All rights reserved.
This presentation contains confidential information and may not be disclosed
without
E*TRADE Financial Corporation’s written permission.
24
Communicating Goals
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25
Communicating goals

Communicating the Performance grant
• Have you granted a performance award that is understood by the
participant?
• Grant agreements – communicating the performance grant and
goals to achieve

Communicating progress
• How do you communicate progress?
• Should you communicate progress?
• How do they know whether they did well against their goal or not?

Communicating what they got and how much
© 2012 E*TRADE Financial Corporation. All rights reserved.
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26
Communicating the performance grant – A case study

My favorite goal:
• Company A wanted to high-level employees (Director and above) to
embrace their company brand
• An independent company was hired to measure (1-10) the effect
each had on the company brand
• PSU’s were granted to each employee, Director and above
― Goals were to measure the impact each had on “improving or
promoting the company brand”
© 2012 E*TRADE Financial Corporation. All rights reserved.
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without
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27
Case Study – Understanding the performance award you just granted

The Good news: PSU’s were easy to track!
• One single goal
• One cliff time period – one year
• Valuation provided by outside consultant

However, virtually none of the participants understood how they were
supposed to “improve or promote” the company brand

None of the participants understood how well – or not – they were
doing towards the goal
© 2012 E*TRADE Financial Corporation. All rights reserved.
This presentation contains confidential information and may not be disclosed
without
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28
Case study – Final thoughts

Make sure your goals are relevant to the work or targets that are
important to your company

Make sure your goals are easy to understand and the status can be
clearly communicated

If you hire a 3rd party to establish and measure a metric, make sure
the metric is more tangible than “company brand” or “employee
morale”
© 2012 E*TRADE Financial Corporation. All rights reserved.
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29
Communicating progress

If you can communicate progress, make sure your system can do that

Most systems don’t differentiate between an RSU and a PSU
• Understand the ‘mix’
― Combination of TSR, performance
― Combination of EPS and cost reduction

Make sure you SHOULD be communicating progress
• Some companies consider this material, non-public information
― Related to key company goals i.e. releasing a new drug

It’s typical for vendors to build performance awards off existing time
based functionality
• Participant view indistinguishable from time based grants
• Goal progress and attainment aren’t communicated the same way
• Goals may or may not be stated explicitly in the employee’s
brokerage account
© 2012 E*TRADE Financial Corporation. All rights reserved.
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30
Example of a performance grant
that looks like Restricted Stock and
is displayed along with Restricted
stock, making the two types of
grants indistinguishable.
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31
Creating a simple sub-heading
for Performance grants will help
your participants distinguish
them from time based Restricted
Stock
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32
Suggestion: By adding in
modeling tools on performance
grants, employees will be more
likely to be invested in the
ultimate outcome.
© 2012 E*TRADE Financial Corporation. All rights reserved.
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33
By displaying characteristics like the shares
achieved (vs. shares granted), % achieved
min/max payout, and Goal status you can better
communicate performance grant status to your
participants.
© 2012 E*TRADE Financial Corporation. All rights reserved.
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34
Communication: How much did I get?

Set up your systems’ automatic alerts differently
• Alerts for Performance grants are very different from time based
grants
― Remove alerts that say “you have upcoming vesting” if the goal
has no chance of being attained
― Alter language so it’s more relevant to a performance grant
rather than a time based grant
― Correspond alerts so that they make sense for performance
grants
• Goal attainment/non attainment
• Time achievement
• Payout (if different than vest)
© 2012 E*TRADE Financial Corporation. All rights reserved.
This presentation contains confidential information and may not be disclosed
without
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35
Final thoughts
© 2012 E*TRADE Financial Corporation. All rights reserved.
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36
Contact information
Erik Beucler (Slide owner, 2-7)
Compensia
408-907-4314
ebeucler@compensia.com
Nathan O’Connor (Slide owner, 8-16)
Equity Methods
480-428-1205
Nathan.OConnor@equitymethods.com
Jim Vincent, CEP (Slide owner, 17-35)
E*TRADE Financial Corporate Services
(866)789-0736 x 1018
jvincent@etrade.com
© 2012 E*TRADE Financial Corporation. All rights reserved.
This presentation contains confidential information and may not be disclosed
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37