MBAO 6600 Executive Compensation

1
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.

2
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

3
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

4
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

5
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.
  

6
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

7
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.

8
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

9
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

10
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

11
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

12
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