Top 10 executive compensation ideas to use in
today’s environment
Eric Gonzaga, JD
Managing Director
Executive Compensation Practice
eric.gonzaga@gt.com
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Learning objectives
• Be aware of how the current environment may be affecting your
executive pay programs
• Identify executive pay strategies that you may be interested in
considering in the current environment
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2
Agenda
Top 10 executive compensation ideas
1.
2.
3.
4.
5.
6.
7.
Consider changing bonus plans
Assess the right mix of cash and equity awards
Consider repricing strategies for underwater options
Assess whether plans should foster executive retention
Grade your compensation practices against emerging standards
Update your compensation benchmarking
Consider taking advantage of low stock prices and uncertain future
tax rates
8. Consider restricted share plans
9. Consider whether to continue deferred compensation plans
10. Plan for parachute payments in future transactions
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3
1. Consider changing bonus plans
Does the company’s bonus plan reflect the current economic
environment?
• Cash bonus plan design features may need to change
– Amount of the bonus leverage
– Performance metrics
• Should a percentage of bonus be withheld once performance metrics
are satisfied?
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1. Consider changing bonus plans
Focus on long-term performance goals
• Adjust mix of short-term and long-term performance metrics
– Short-term: Is increased revenues of X% each year right?
– Long-term: Improve shareholder value by managing risk
• Enterprise risk management
• Metrics based on how the company would like to emerge from the
current economic environment
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Example of how a company could change its
bonus plan
• Begin with pay philosophy (Compensation Discussion and Analysis)
• Revise key performance metrics
– Reconsider X% growth in revenue (too short-term focused goal)
– Replace with a goal that promotes diversification of revenue
streams
• Establish performance periods that are greater than 1 year
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Example of how a company could change its
bonus plan
• Pay the bonuses over a multiyear schedule
– Include a clawback feature
• Ensures long-term growth was not sacrificed for short-term
results
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7
Agenda
Top 10 executive compensation ideas
1.
2.
3.
4.
5.
6.
7.
Consider changing bonus plans
Assess the right mix of cash and equity awards
Consider repricing strategies for underwater options
Assess whether plans should foster executive retention
Grade your compensation practices against emerging standards
Update your compensation benchmarking
Consider taking advantage of low stock prices and uncertain future
tax rates
8. Consider restricted share plans
9. Consider whether to continue deferred compensation plans
10. Plan for parachute payments in future transactions
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8
2. Assess the right mix of cash and equity awards
What is the typical mix of cash and equity awards?
• Is there a difference in the mix between public and private?
– The difference is due to lack of marketability or desire to restrict
ownership of closely-held company stock
• Should private companies consider a different mix if an exit strategy is
in place (i.e., sale or IPO)?
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2. Assess the right mix of cash and equity awards
Design considerations
• Short-term (cash) vs. long-term (equity) incentives
• As “green shoots” sprout, make adjustments to award levels
• Timing is everything: with stock values at historic lows, increased equity
grants may be appropriate
• Consider linking awards to executive ownership guidelines
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Accounting and tax considerations with equity
awards
• Financial statement issues to consider
– ASC 718 (formerly SFAS 123(R))
– Performance vs. service vesting
• Code Section 409A
– Issues of establishing fair market value for private companies
– Need for third-party valuation
• Payroll withholding and reporting requirements
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11
Agenda
Top 10 executive compensation ideas
1.
2.
3.
4.
5.
6.
7.
Consider changing bonus plans
Assess the right mix of cash and equity awards
Consider repricing strategies for underwater options
Assess whether plans should foster executive retention
Grade your compensation practices against emerging standards
Update your compensation benchmarking
Consider taking advantage of low stock prices and uncertain future
tax rates
8. Consider restricted share plans
9. Consider whether to continue deferred compensation plans
10. Plan for parachute payments in future transactions
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12
3. Consider repricing strategies for underwater
options
Approach
Description
Advantages
Options-forOptions
Cancellation of
underwater options
with immediate regrant of new options
• Employees maintain
control of taxable
event
• Some reduction in
overhang
• Potential remains for newly
issued options to go
underwater
• May not be perceived
positively by employees if
stock options have not
provided value
Options-forStock (restricted
stock or RSUs)
Cancellation of
underwater options
with immediate regrant of restricted
stock/units
• Eliminates potential
future underwater
options
• Greater reduction in
overhang
• Employees lose control of
taxable timing
• Reduced upside vs. stock
options
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Disadvantages
13
Example of an option-for-stock exchange
Value-for-value exchange of options for restricted
stock
Employer has 1 million underwater options outstanding
• FMV at grant was $10M, fair value (for book purposes) of options was
$5M
• FMV of the stock now is $2M
• Zero current benefit to the employees
• Upon valuation, it is determined that the current fair value of the
underwater option is 1/5 of the current value of the company's stock
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Example of an option-for-stock exchange
Value-for-value exchange of options for restricted
stock
• For every 5 options surrendered, the employees receive 1 share of
restricted stock
– 5-for-1 exchange ratio is based on the current fair value of the
options compared to the current fair value of the stock
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Example of an option-for-stock exchange
Value-for-value exchange of options for restricted
stock
Benefits of the exchange
• Employees receive stock with value in exchange for options with no
value
• Strong retention incentive for $0 additional compensation cost over
what has been or will be booked
– $0 compensation cost = $5M fair value of restricted stock, less $5M
current fair value of the options
• Company reduces overhang by 800K shares
– 1 million options retired in exchange for 200,000 restricted shares
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16
Agenda
Top 10 executive compensation ideas
1.
2.
3.
4.
5.
6.
7.
Consider changing bonus plans
Assess the right mix of cash and equity awards
Consider repricing strategies for underwater options
Assess whether plans should foster executive retention
Grade your compensation practices against emerging standards
Update your compensation benchmarking
Consider taking advantage of low stock prices and uncertain future
tax rates
8. Consider restricted share plans
9. Consider whether to continue deferred compensation plans
10. Plan for parachute payments in future transactions
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17
4. Assess the need for plans to foster
executive retention
Executive retention will be critical in an improving economy
• Especially for companies that have experienced:
– Pay freezes
– Reductions in executive pay
– Underwater options
– Suspensions in section 401(k) plan matching contributions
• Underwater options can be a disincentive to stay
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Foster executive retention
• As the economy improves, executives will consider other opportunities
to enhance their pay with other organizations
• To address retention, companies will need to:
– Identify those executives that may be at risk
– Review alternative retention programs
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Retention programs
• Examples of retention programs:
– Restricted stock awards
– SERPs
– Cash compensation tied to years of service
– Retention cash bonus
• Program features
– Extended payout schedules
– Vesting schedules
– Must be employed on payment date to receive payment
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20
Agenda
Top 10 executive compensation ideas
1.
2.
3.
4.
5.
6.
7.
Consider changing bonus plans
Assess the right mix of cash and equity awards
Consider repricing strategies for underwater options
Assess whether plans should foster executive retention
Grade your compensation practices against emerging standards
Update your compensation benchmarking
Consider taking advantage of low stock prices and uncertain future
tax rates
8. Consider restricted share plans
9. Consider whether to continue deferred compensation plans
10. Plan for parachute payments in future transactions
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21
5. Grade your compensation practices against
emerging standards
Why should companies strengthen compensation governance?
Avoid backlash on executive pay practices
• Regulators, SEC, IRS, State Attorneys General
• Volatile stock market easily influenced by public perception and media
criticism
• Bad employee relations in Employee Free Choice Act environment
• Optimal strategic compensation programs in a recessionary environment
Be proactive so when new rules go into effect,
the company is prepared.
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Emerging governance expectations and
requirements – let’s talk risk!
• Let the independent compensation committee drive a deliberate, formal
and documented process, led by a committee chair who is experienced
in administering compensation programs
• Ensure that all decision makers spend ample time to understand the
executive compensation program, including the risks associated with
any pay-for-performance metrics
• Review compensation programs on a frequent basis throughout the
year to ensure the programs are consistent with the continually
changing business environment
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Emerging governance expectations and
requirements – let’s talk risk!
• Evaluate necessity of severance, change-in-control, and gross-up
payments, with consideration of avoiding, phasing out, or reducing
• Annually review the independence of the compensation consultant
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24
Agenda
Top 10 executive compensation ideas
1.
2.
3.
4.
5.
6.
7.
Consider changing bonus plans
Assess the right mix of cash and equity awards
Consider repricing strategies for underwater options
Assess whether plans should foster executive retention
Grade your compensation practices against emerging standards
Update your compensation benchmarking
Consider taking advantage of low stock prices and uncertain future
tax rates
8. Consider restricted share plans
9. Consider whether to continue deferred compensation plans
10. Plan for parachute payments in future transactions
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25
6. Update your compensation benchmarking
Why should you be concerned about benchmarking?
New benchmarking data are available
• Includes new data on total compensation and pay mix
• Evidence of how compensation practices have changed between 2007
and 2009
– Practices have changed greatly, with various alternatives on the
table
– 2008 surveys are not reliable
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Why should you be concerned about benchmarking?
• Business strategies are becoming better defined for long-term growth
– Likewise, compensation practices should become better defined
• Opportunity to improve morale of executives and refocus them
– Ensure talented executives are paid market rates and rewarded at
above-market rates only for above-market performance
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Other considerations for benchmarking
• Companies should recognize that market values have changed
– For some job positions, the market rate has decreased
• Companies need to pay a reasonable amount of compensation
– Defend to regulatory agencies
– Media attention associated with executive compensation
– Incentivize and retain key executives
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28
Agenda
Top 10 executive compensation ideas
1.
2.
3.
4.
5.
6.
7.
Consider changing bonus plans
Assess the right mix of cash and equity awards
Consider repricing strategies for underwater options
Assess whether plans should foster executive retention
Grade your compensation practices against emerging standards
Update your compensation benchmarking
Consider taking advantage of low stock prices and uncertain
future tax rates
8. Consider restricted share plans
9. Consider whether to continue deferred compensation plans
10. Plan for parachute payments in future transactions
© Grant Thornton LLP. All rights reserved.
29
7. Consider tax strategies to take advantage of
low stock prices and uncertain future tax rates
Consider exercising nonqualified stock option now
Executives should measure the costs and benefits of exercising vested
stock options before a possible increase in tax rates.
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Example of a nonqualified stock option
• In 2009, executive holds vested stock options:
– Aggregate exercise price is $600
– Aggregate fair market value (“FMV”) of the stock is $900
• Executive intends to sell the stock in 2011 and she believes the FMV of
the stock will be $1,200
• Highest marginal tax rates and capital gains rates:
2009
2011
Income tax
35%
39.6%
Capital gains
15%
20%
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Example of a nonqualified stock option
• If the executive exercises in 2009 and sells in 2011:
– Income tax in 2009 is $105 ($300 income X 35% tax rate)
– Capital gains tax in 2011 is $60 ($300 capital gain X 20% tax rate)
– Total tax paid is $165
• If the executive exercises in 2011 and sells in 2011:
– Income tax in 2011 is $237.60 ($600 income X 39.6% tax rate)
– No capital gain
– Total tax paid is $237.60
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Example of a nonqualified stock option
• Benefit: $132.60 of lower taxes
• Cost: The opportunity cost associated with the $600 paid to exercise
the options in 2009 and the $105 of tax paid in 2009
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33
Agenda
Top 10 executive compensation ideas
1.
2.
3.
4.
5.
6.
7.
Consider changing bonus plans
Assess the right mix of cash and equity awards
Consider repricing strategies for underwater options
Assess whether plans should foster executive retention
Grade your compensation practices against emerging standards
Update your compensation benchmarking
Consider taking advantage of low stock prices and uncertain future
tax rates
8. Consider restricted share plans
9. Consider whether to continue deferred compensation plans
10. Plan for parachute payments in future transactions
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34
8. Consider restricted share plans
• Time-based vesting drives retention
• Performance-based vesting drives increased performance
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Example restricted share plans
• Retention incentive: Initial grant that vests at the end of a 3-year
period provided that the executive is still employed
• Performance incentive: Additional restricted share grants
– Grant conditioned upon meeting performance goals; or
– Vesting is conditioned upon meeting the performance goals
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Section 83(b) elections may be attractive to
executives when stock values are low
Factors to consider
• Consider the current stock value and determine the probability that the
value will increase vs. decrease before the stock vests
• Consider the executive’s estimated marginal tax rate at the time of
vesting versus at grant date
• Consider the opportunity cost associated with the cash used to pay the
taxes up front
• Consider potential for job loss before vesting
After considering these factors, an executive can make an educated decision of
whether to make a Section 83(b) election.
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37
Agenda
Top 10 executive compensation ideas
1.
2.
3.
4.
5.
6.
7.
Consider changing bonus plans
Assess the right mix of cash and equity awards
Consider repricing strategies for underwater options
Assess whether plans should foster executive retention
Grade your compensation practices against emerging standards
Update your compensation benchmarking
Consider taking advantage of low stock prices and uncertain future
tax rates
8. Consider restricted share plans
9. Consider whether to continue deferred compensation plans
10. Plan for parachute payments in future transactions
© Grant Thornton LLP. All rights reserved.
38
9. Consider whether to continue deferred
compensation plans
Potential increases in tax rates may drive changes in deferred
compensation
• May be better to pay tax now at lower rate than later at a higher rate
• Executives may consider suspending 2010 deferral elections
– Decision must be made by Dec. 31, 2009
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9. Consider whether to continue deferred
compensation plans
Consider terminating deferred compensation plans and paying the balance
in the plan
• Must consider section 409A issues
– Payout may not occur until 12 months after the plan termination
– Full balance of the plan must be paid in full within 24 months after
plan termination
– Must terminate the plan and all like plans for all employees
– May not start new plans for 3 years
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40
Agenda
Top 10 executive compensation ideas
1.
2.
3.
4.
5.
6.
7.
Consider changing bonus plans
Assess the right mix of cash and equity awards
Consider repricing strategies for underwater options
Assess whether plans should foster executive retention
Grade your compensation practices against emerging standards
Update your compensation benchmarking
Consider taking advantage of low stock prices and uncertain future
tax rates
8. Consider restricted share plans
9. Consider whether to continue deferred compensation plans
10. Plan for parachute payments in future transactions
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41
10. Plan for parachute payments in future
transactions
• The current economic conditions and credit crunch contributed to a
decline in the number of corporate transactions
– Transactions were delayed, but may occur in the future
• Rules under section 280G apply when there is a change in control
• Tax consequences of excess parachute payments under section 280G
– 20% excise tax is imposed on the employee
– Employer may not deduct the expense
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10. Plan for parachute payments in future
transactions
• Excess parachute calculation
– Do total parachute payments exceed 3 times the base amount?
• Base amount is the average W-2 compensation over past 5
years
– If yes, excess parachute payment equals the total parachute
payments less 1 times the base amount
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Planning for a change in control and parachute
payments
• Private companies: Obtain 75% shareholder approval of payments
that will be made in connection with a change in control
– Severance payments
– Transaction bonuses
• Increase the base amount
– Exercise stock options
– Pay annual bonuses early
• Accelerate the vesting of SERP plans and stock options
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Planning for a change in control and parachute
payments
• Stipulate in compensation plans that amounts paid upon a change in
control may not be paid if they would result in excess parachute
payments
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Our presenters will now answer your questions.
Top 10 executive compensation ideas
1. Consider changing bonus plans
2. Assess the right mix of cash and equity awards
3. Consider repricing strategies for underwater options
4. Assess whether plans should foster executive retention
5. Grade your compensation practices against emerging standards
6. Update your compensation benchmarking
7. Consider taking advantage of low stock prices and uncertain future
tax rates
8. Consider restricted share plans
9. Consider whether to continue deferred compensation plans
10. Plan for parachute payments in future transactions
© Grant Thornton LLP. All rights reserved.
46
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