June HCM Viewpoint. Options, ever less an option in compensation strategy?

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1 June 0 HCM Viewpoint Options, ever less an option in compensation strategy?

2 Widely accepted as the market practice until the late 90 s, Option Plans have lost their popularity. This is due to several good reasons, including inherent valuation complexity, low perceived value for the participant, weak retention element and potential dilution, as regularly pointed out by opponents. In this HCM Viewpoint, we explain a Market practice: Regulatory pressure squeezes options out of business An analysis of the Top 00 companies in Switzerland and the Global 0 companies internationally, shows that ever less companies continue to use Stock options today, for both executive compensation and board compensation. As far as executive compensation is concerned the trend is to use Shares and Performance shares in particular, mainly due to the long-term performance component and the leverage effect often from an operative measure the latter provides. This observation is in line with the Proxy advisors Performance shares most important tool for management, Blocked shares for board members In addition, the impact of the dilution effect inherent to the issuance of Stock options is important as the level of conditional capital is increasingly being scrutinized by investors. In the last four AGM sessions amongst the Swiss Top 00 companies, the increase of conditional capital with regard to employee share-based plans was rejected in 0 proven solution to solve the dilution impact issue, the use of Net Share Settlement. In addition, we discuss the advantages of alternatives to Option Plans, such as Blocked shares or Performance shares, as ways to better align, retain and motivate board members and employees. typical recommendations that performance conditions should be embedded in compensation plans. Board members compensation on the other hand should not be tied to similar operating measures as management s compensation, but rather look at the long-term value creation of the company. This is primarily the reason why Proxy advisors recommend board members compensation not to be performancebased and why they generally ban option-based compensation for non-executive board members. percent of the cases. In addition, Proxy advisors, in an attempt to track the overall cost of remuneration plans, sometimes also set clear guidelines with regard to the level of conditional capital. Ethos, for example, recommends in its Proxy Voting Guidelines that the capital reserved for executive incentive plans should not exceed % of issued capital. There are alternatives to solve the issues Identified Issues Dilution effect Executive compensation Board members compensation Potential remedies Use of Net Share Settlement Use of Performance shares Use of Blocked or HCM Hostettler & Company

3 LTI instruments at Swiss Top 00 companies Executive Committee Board of Directors Debt instruments / carried interests Deferred cash Blocked shares Performance shares Stock options Vested options Unblocked shares Blocked shares Performance shares Stock options Figure : Recent trend in LTI design used by Top 00 companies in Switzerland LTI instruments at Global 0 companies Executive Committee Board of Directors Debt instruments / carried interests Vested options Deferred cash 8 6 Unblocked shares 0 6 Blocked shares 4 4 Blocked shares Performance shares 9 9 Performance shares Stock options Stock options 03 0 Figure : Recent trend in LTI design used by Global 0 companies Study based on the publicly disclosed remuneration reports of the top 00 listed companies in Switzerland. Study based on the publicly disclosed remuneration reports of 0 European and US companies, which are components of the STOXX Europe Large 00 Index and STOXX USA 0 Index. HCM Hostettler & Company 3

4 Neat way: Net Share Settlement A Net Share Settlement allows a company to reduce the dilution impact generated through the issuance of Stock options, while preserving the value for the employee and enabling him to keep an ownership incentive, which a simple cash-settlement would not allow. How does it work? Instead of exercising the options by paying the strike price and receiving an equivalent number of shares, an employee receives an amount of shares equivalent to the intrinsic value of his options without having to first pay the Strike Price. That way, the company ultimately needs to provide less shares to the employee, reducing the level of its conditional capital, while the employee s net worth remains the same. Our experience shows that, within reasonable assumptions and market conditions, using a Net Share Settlement enables a company to reduce its level of conditional capital to one third. Net Share Settlement: Paying the intrinsic value with stocks Stock price CHF 00 CHF 0 CHF Intrinsic value of the option Year Current Situation: In 0, the Employee is granted 3 options with a Strike Price of CHF 00. At expiration (00), the stock is worth CHF 0. Standard Settlement: Employee pays the Strike Price of CHF 300 and receives 3 shares worth CHF 40 with a net worth of CHF 0. «Net Share Settlement»: The Intrinsic Value of the option is paid out in stocks. The settlement for the transaction is calculated as follows: CHF 0 x 3 = CHF 0 / Stock Price = 0 / 0 = share The employee receives «only» share but he does not have to pay the Strike Price for it. Equivalent net worth for the employee Figure 3: Illustration of a Net Share Settlement Performance shares or Shares provide better incentive Given the high uncertainty around payout of Stock options, this instrument tends to suffer from a lower perceived value from participants. In addition, because the payout is asymmetric, the motivation, retention and alignment elements vanish when the options are deeply underwater and it becomes clear for the participant that it will be impossible to exercise them. As we can see in Figure 4, only when the overall performance is very positive, Stock options provide the highest payout, while Performance shares and Shares display a robust payout profile across a broader range of performance outcomes. 4 HCM Hostettler & Company

5 Payout in CHFk % 90% 8% 80% 7% 70% 6% 60% % 0% 4% 40% 3% 30% % 0% % 0% % Simulated share price at vesting in CHF / Statistical probability to achieve certain payout Restricted Share Units EBIT Driven Performance Share Units Stock Op ons Cash Equivalent 000 iterations, assuming a log-normal distributed share price based on a normal distributed annual return with a mean of 7.% and volatility of 34.0% (median historic volatility measured on a daily basis over 0-04, 3y rolling period); starting share price of CHF 80.0 (as of 0.0.0) and an expected dividend yield of.% (average 0-04), possible extraordinary dividend payouts and share buybacks are not taken into account for this example. Figure 4: Simulated payout for three basic alternatives: Performance Share Plan, and Option plan It s just not fun to be underwater In a Performance Share Plan, the number of shares an employee receives depends on the achievement of certain performance conditions (e.g., pre-defined EBIT or TSR level). The advantage of this instrument is that it incentivizes the outperformance through internal or external leveraging, while also keeping the motivation element of the instrument during periods of underperformance. It is therefore a useful and preferred incentive to motivate executives, while aligning their interests with those of the shareholders. Shares Performance shares Options Motivation Strengthened identification and ownership feeling Strengthened identification and ownership feeling Lower perceived value Retention Incentive more secured Service conditions in case of Reduced downside while keeping upside potential Only as long as not deeply out of the money Alignment Alignment given by ownership of shares Less embedded leverage Outperformance incentivized through internal and/or external leverage Strong alignment as long as the stock is not deeply underwater Asymmetric payoff can lead to higher risk-taking behaviors HCM Hostettler & Company

6 Share-based instruments better align and retain employees and board members Blocked shares are shares that are transferred to the participants at grant but blocked for a certain number of years. Because of this blocking period, the employee can typically benefit from a tax discount. are shares that are not fully transferrable until certain conditions (typically, continued employment during a Conclusion: No one size fits all Instruments such as Performance shares, Restricted shares and Blocked shares enable companies to overcome many of the issues faced by Option Plans. In some cases however, like for start-ups, fast-growing companies or companies relying on long-term technology development, the use of Option Plans can make sense. However, our certain period of time) have been met. The long-term alignment component with shareholders interests and the absence of performance leverage make both instruments appealing for the compensation of board members. experience shows that in compensation-related matters no single solution can fit all needs. It is therefore essential to address the company s culture, legacy, pay philosophy and pay strategy before starting the design of a compensation plan. ABOUT HCM HCM Hostettler & Company is a leading independent international advisory firm specializing in Governance, Finance, and Compensation with deep experience across various industries and in the advising of board, board committees, and HR, compliance and other control functions. HCM's partners, managers, consultants and analysts work in HCM s offices in Zurich, Geneva and Kiev, bolstered by our global partners in the US and Asia which allow us to reach all major markets and support companies of all sizes, from large multinationals and public institutions to mid-sized and smaller companies, including those preparing for an IPO. HCM is also active throughout Europe and in the Gulf countries. HCM is Chair of the Global Governance and Executive Compensation Network (GECN). HCM's mission is to support companies and other organizations tackle the ever important question: How to measure, steer and allocate value creation? We also cover risk and compliance as these also affect value. The "value question" is of core interest not only to Owners, Board of Directors and Senior Management, but also increasingly to institutional investors, proxy advisors, HR and control functions, regulators, and international standard setters. We have the expertise, passion, and closeness to leading market practices and stakeholder expectations to solve the most critical challenges of Corporate Governance and Board/Executive Compensation and their links to fundamental business topics such as company culture, owner strategy, business strategy, organizational structure, financial strategy, risk, compliance, regulation and communication. Our clients from multiple industries and from both the private and public sectors welcome our thought leadership, strategic and operational rigor, hands-on support and fact-based recommendations. Our advice is unbiased, practical and tailored to take into account the specific needs and culture of each of our clients. In the remuneration area, we cover the full value chain, from strategy, to governance framework, to implementation and communication. We support the successful alignment of incentives and their effective execution in line with the company s strategy and the regulatory and stakeholder requirements. We also have strong data mining and analytical capabilities and do risk-adjusted benchmarking as well as assessments for companies, public institutions, regulators and other parties, as well as help organizations prepare for such assessments. 6 HCM Hostettler & Company

7 ABOUT THE AUTHORS Dr. Stephan Hostettler has been active as an entrepreneur and consultant in Switzerland, the U.S, Europe and other international markets since 00. Prior to this, he worked in Switzerland for a major bank in the area of financial analysis and in the USA in consulting on corporate finance and corporate governance. Under his leadership, the consulting firm he founded has enjoyed sustained growth. His consulting work, his teaching at the University of St. Gallen, his research and publications, and his regular public commentary on current issues has established him as a thought leader on incentive compensation and value-based management. He holds a doctorate degree in finance. He is the author, among others, of the books "Das Value Cockpit" and "Managersaläre". Stephan.Hostettler@hcm.com Raphaël Lambin has over four years of professional experience in the fields of corporate governance, compensation, corporate finance and asset management. Before joining the team, Mr. Lambin worked for a Private Equity house where he was in charge of sourcing and analyzing investment opportunities in the Luxury Goods, Renewable Energy and Biotechnology areas. Mr. Lambin is a CFA Charterholder and holds a Master of Science in Finance from the universities of Lausanne, Geneva and Neuchâtel and a Bachelor in Business Administration from HEC Montréal (Canada). Raphael.Lambin@hcm.com HCM Hostettler & Company 7

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