LongTerm Performance Incentives for Executives Longterm Performance Incentives

Long-Term Performance Incentives for Executives Long-term Performance Incentives Reward Executives for achieving superior long-run performance that provides above average returns to shareholders. Long-term incentives encourage executives to take risks with firm assets leading to shareholder gains that they might otherwise avoid. – Example: Investing in a risky project that leads to a radical innovation that changes the rules of competition. MBAO 6600 - Executive Compensation

Types of Long-term Performance Incentives (Source: R. Bernstein, 1998: Foundation for Enterprise Development) Types of Long-term Incentives for Executives • Performance-based • Non-Performance-based – Founders’ equity – Restricted stock tied to Executive tenure - golden handcuff – Stock options given as a Recruiting Bonus MBAO 6600 - Executive Compensation

Types of Long-term Performance Incentives (Source: R. Bernstein, 1998: Foundation for Enterprise Development) Performance-based LT Incentives for Executives • Vested Stock Bonus - An award of stock given to executives to reward specific performance. – Outright Award – Taxable to employee based on full market value at the time of the grant – Deductible to employer at same time and same amount MBAO 6600 - Executive Compensation

Types of Long-term Performance Incentives (Source: R. Bernstein, 1998: Foundation for Enterprise Development) • Restricted Stock Bonus - an award of stock that has further restrictions that must be satisfied before the stock can be owned. – Requires that the executive must stay with the company during a vesting schedule or meet some specific performance goals. – Taxable to employee when restrictions are removed – Deductible to employer at same time and same amount MBAO 6600 - Executive Compensation

Types of Long-term Performance Incentives (Source: R. Bernstein, 1998: Foundation for Enterprise Development) • Stock Option Plans - gives the executive the right to purchase company stock in the future at a price that is fixed at the date of the grant. – Value of options not reported on accounting records – Options given to executives dilute value of stock owned by other shareholders – “Strike price” of stock options are set at time of grant and may be set at market price of stock on day of grant, or some other price of the stock. – Stock options are given a period when they can be exercised which in most cases is around 10 years. MBAO 6600 - Executive Compensation

Types of Long-term Performance Incentives (Source: R. Bernstein, 1998: Foundation for Enterprise Development) Types of Stock Option Plans • Incentive Stock Option (ISO) – Limits on number, length, price and who may participate – Non-taxable to executive until stock is sold and then taxed at capital gains rate of taxes. – No corporate tax deduction MBAO 6600 - Executive Compensation

Types of Long-term Performance Incentives (Source: R. Bernstein, 1998: Foundation for Enterprise Development) • Non-Qualified Stock Options (NSO) – Flexible to apply compared to ISO – Taxable to employee at exercise date • Taxed as ordinary income if sold when options exercised; taxed as capital gains if held for more than 12 months. – Corporate tax deduction at exercise date • Most high technology firms use non-qualified stock options for flexibility and tax reasons. MBAO 6600 - Executive Compensation

Types of Long-term Performance Incentives Stock Appreciation Rights (SARs) and Phantom Stock - cash based plans that simulate stock perf. • Advantages – long-term incentive without issuing stock; less complex from legal perspective – does not dilute voting control – avoids admin. & regulatory complexities, more flexible designs • Disadvantages – no real ownership provided to executive – company must book value of outstanding SARs or phantom stock as compensation expense periodically MBAO 6600 - Executive Compensation

Types of Long-term Performance Incentives • Stock Appreciation Rights (SARs) – SARs mirror stock options - receives cash difference between strike price and market value of stock – No investment on part of executive required – Gives executive “feel” of ownership without giving up control to executive MBAO 6600 - Executive Compensation

Types of Long-term Performance Incentives • Phantom Stock – Phantom stock mirrors stock bonuses – Executive receives units of value in firm, tied to value of stock appreciation – Results in a cash distribution MBAO 6600 - Executive Compensation

Improving the Relationship between Stock Options and Performance (Source: A. Rappaport, 1999, Harvard Business Review) Problems with Stock Option Plans: 1. Windfall effects - between 1995 -1997 there was a 100% increase in stock indexes resulting in huge gains for below average performers. 2. Fixed price options are problematic - poorly related to strategic performance goals 3. Downside on options is minimal MBAO 6600 - Executive Compensation

Improving the Relationship between Stock Options and Performance (Source: A. Rappaport, 1999) Proposed Solutions 1. Premium priced stock options – price must exceed a premium above market on day options are granted, such as 25% or 50% above market price: used by Monsanto, Colgate-Palmolive 2. Indexing: – tie options to an index of competitors or market index such as S & P 500 – “in the money” when index is exceeded – discount value of options when index is not reached – more indexed options needed than fixed to encourage execs to bear greater risk MBAO 6600 - Executive Compensation