y=mx+b: Understanding Algorithmic Approaches to Stock Comp Expense October 24, 2013 Dan Moody Sr. Product Manager, E*TRADE Corporate Services

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1 y=mx+b: Understanding Algorithmic Approaches to Stock Comp Expense October 24, 2013 Dan Moody Sr. Product Manager, E*TRADE Corporate Services

2 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.

3 The E*TRADE FINANCIAL family of companies provides financial services that include trading, investing, related banking product and services to retail investors, and managing employee stock plans. Employee stock plan solutions are offered by E*TRADE Financial Corporate Services, Inc. Securities products and services offered by E*TRADE Securities LLC, Member FINRA/SIPC. E*TRADE Financial Corporate Services, Inc. and E*TRADE Securities are separate but affiliated companies. The laws, regulations and rulings addressed in this presentation and by the products, services and publications offered by E*TRADE Financial Corporate Services, Inc. are subject to various interpretation and frequent change. Product descriptions and instructions in this presentation are general in nature and are not intended to replace documentation and instructional materials distributed by E*TRADE Financial Corporate Services, Inc.

4 Define/understand the lifecycle of a grant Discuss ASC 718 (fka FAS 123R) guidance on applicable to each stage of a grant s lifecycle. Understand what tasks are performed and reports run in EE/EEO at each stage of a grant s lifecycle.

5 Compensation Expense

6 Over the Requisite Service Period (ASC ) The compensation cost for an award of share-based employee compensation classified as equity shall be recognized over the requisite service period. The requisite service period is the period during which an employee is required to provide service in exchange for an award, which is often the vesting period.

7 Final Cost Recognized (ASC ) The total amount of compensation cost recognized at the end of the requisite service period for an award of share-based compensation shall be based on the number of instruments for which the requisite service has been rendered (that is, for which the requisite service period has been completed).

8 Variable Legend,

9 Algorithm Basics

10 Establishing a Framework When does expense begin? Is the Grant Date a day of expense? If it is, then Vest Date Grant Date + 1 If it is not, then Vest Date Grant Date Vest Date = Grant Date becomes a Special Case When does expense end? On the Vest Date? The day before the Vest Date?

11 Establishing a Framework (CONTINUED) What happens first, vesting or cancellation? If the Cancel Date = Vest Date, are the shares earned or should the shares be forfeited and the expense reversed? Guiding principle: Good things happen in the morning, and bad things happen at night By this principle, the shares are earned before they are cancelled when Cancel Date = Vest Date If you answered that the shares are already earned on the vest date, did you answer that expense ends the day prior to the Vest Date? If not, are you being consistent?

12 Similarities Among Most Algorithms Total Expense is recognized by the final Vest Date When Cancel Date = Vest Date, shares are considered vested and expense is not reversed When using Multiple, aka FIN 28, amortization of expense before applying forfeiture rates

13 Minor Algorithmic Differences Grant Date counted as a day of expense Vest Date counted as a day of expense Cumulative catch-up when vesting begins prior to grant date Expense acceleration booked in a single period or amortized evenly over time

14 Fundamental Algorithmic Differences Implementation of Straight-Line Application of Forfeiture Rates Because these are the two largest drivers of differences in expense algorithms, we will focus our attention primarily on these two topics.

15 Math Refresher

16 Special Properties of Right Triangles Tangent of an angle is equal to the opposite leg divided by the adjacent leg

17 Cartesian Plane A line may be expressed as below:

18 Using Integrals Integrals calculate the area under a function A

19 The Cartesian Plane

20 Looking at Comp Expense in the Cartesian Plane Working in the Cartesian Plane: allows us to evaluate expense visually Lends useful tools to simplify calculations In order to use the Cartesian Plane: Plot time on the x- axis Plot total expense on the y-axis

21 Degenerate Case of Straight Line Starting at Origin :

22 Piecewise Analysis

23 Because Straight Line is Never Straight m =.90 m =.86 m =.81 ASC 718 requires the use of forfeiture estimates As soon as you introduce forfeiture rates into straight line expense, it s no longer straight m =.95 NOTE: even though straightline isn t straight, we are going to consider it straight for simplicity s sake in some examples that follow throughout this presentation

24 Because. Life Happens LOAs can cause gaps in expense These gaps force the line to be broken into pieces, requiring a separate y = mx + b formula to represent each piece of the line.

25 Because Performance Service Period End Dates Move Prospective Change Slope Moving the Service Period End Date can cause kinks in the line These kinks force the line to be broken into pieces, requiring a separate y = mx + b formula to represent each piece of the line. Original Slope

26 Effect of Piecewise Analysis on an Expense Algorithm Piecewise functions are typically represented in programming language using nested if / then statements An effective general solution to the problem can bypass the need for if/then statements Evaluating expense as a series of piecewise functions adds the ultimate power and flexibility in performing compensation expense calculations

27 Implementing Straight Line Challenges of the Double Floor Provision

28 The Double Floor Provision (ASC ) An entity shall make a policy decision about whether to recognize compensation cost for an award with only service conditions that has a graded vesting schedule in either of the following ways: a. On a straight line basis over the requisite service period for each separately vesting portion of the award as if the award was, insubstance, multiple awards b. On a straight line basis over the requisite service period for the entire award (that is, over the requisite service period of the last separately vesting portion of the award). However, the amount of compensation cost recognized at any date must at least equal the portion of the grant date value of the award that is vested at that date.

29 Double Floor with a Grant (Back-Loaded) 100% 60% 30% 10%

30 Double Floor with a Grant (Front-Loaded) 100% 90% 70% 40%

31 Double Floor - Violating Both Floors 100% 70% 50% 30%

32 Possible Solution Path 1 100% 70% 50% 30%

33 Possible Solution Path 2 100% 70% 50% 30%

34 Possible Solution Path 2 100% 70% 50% 30%

35 Possible Solution Path 2 100% % 70% % 50% % 30% %

36 Possible Solution Path 2 100% % 70% % 50% 30% % %

37 Possible Solution Path 2 100% 70% 50% 30%

YEAR 1 Forfeiture Percentage Per Tranche 5% Expense Per Tranche.

38 Double Floor & Weighted Average Forfeiture Percentage Assume a grant of 4 shares, vesting 1 share per year over 4 years worth $1 per share YEAR 1 Forfeiture Percentage Per Tranche 5% Expense Per Tranche.95 Cumulative Expense % % %

39 Double Floor & Weighted Average Forfeiture Percentage m =.86 m = m = m =.95 m = % %

40 Double Floor & Weighted Average Forfeiture Percentage % %

41 Double Floor & Weighted Average Forfeiture Percentage % %

42 Double Floor & Weighted Average Forfeiture Percentage % %

43 Double Floor & Weighted Average Forfeiture Percentage m = m =.8811 m = m =.90 m = m =.95 m = m = % %

44 Forfeiture Rates & Expense Algorithmic Approaches

45 Forfeiture Estimate (ASC ) An entity shall base initial accruals of compensation cost on the estimated number of instruments for which the requisite service is expected to be rendered. That estimate shall be revised if subsequent information indicates that the actual number of instruments is likely to differ from previous estimates.

46 Forfeiture Rate vs. Forfeiture & Expense Percentage Forfeiture Rate Forfeiture Percentage Expense Percentage

47 Conversions CONVERT 1 1 e.g. 5% forfeiture rate over 4 years % 1 e.g. 5% forfeiture rate over 4 years % CONVERT e.g forfeiture % over 4 years % e.g expense % over 4 years %

48 Systematic Approaches to Expense & FR Forfeiture Reversal at Vest Date Can give smooth expense through vest date Forfeiture Reversal at Forfeiture Date, Dynamic Expense Percentage Can give smooth expense through vest date Forfeiture Reversal at Vest Date, Back Out Expense Manually Double Dipping Forfeiture Reversal at Forfeiture Date, Static Expense Percentage Double Dipping

49 Forfeiture Reversal at Vest Date (Static Expense %) Expense Percentage formula Uses a forfeiture rate to arrive at an expense percentage Applies expense deflator to each individual grant. Deflator computed from the time of grant static If a new rate is entered, a new deflator is computed from the time of grant and a cumulative catch up is applied.

50 Forfeiture Reversal at Vest Date (CONTINUED) Mirrors the FAS 123R Illustration Proper implementation requires the user to estimate and track forfeitures on a pool by pool basis On the Vest Date: estimated expense compared to actuals, trued up

51 Forfeiture Reversal at Forfeiture Date (Dynamic Expense %) Expense Percentage formula Uses a forfeiture rate to arrive at an expense percentage Applies expense percentage to each individual grant. Expense Percentage compounds rate from the end of each reporting period, hence dynamic If a new rate is entered, a new deflator is computed from the time of grant and a cumulative catch up is applied

52 Forfeiture Reversal at Forfeiture Date (CONTINUED) Every grant remaining recognizes slightly more expense each period until it vests Increase in expense offsets reversals of expense for forfeited grants On Vest Date: only grants that have not been forfeited remain lim 1 1

53 The Stair Step Effect of Double Dipping The Stair Step Effect Assuming 5% Forfeiture Rate m =.86 m = m = m =

54 FR at Vest: Cliff-Vest Grant/Tranche-Level View Forfeiture deflated expense accrued evenly over time through the vest date 2 On vest date, if grant did not forfeit, additional expense recognized immediately 3 On vest date, if grant did forfeit, full expense accrued to date is reversed immediately If the forfeiture percentage is correct, the sum of 2 for all grants remaining is equal to 3 for all grants forfeited

55 Forfeiture Reversal at Forfeiture Date. Cliff Vest Grant / Tranche Level View 1 Forfeiture deflated expense accrued exponentially over time through the vest date On vest date, if grant did not forfeit, no additional expense recognized 2 During each reporting period, slightly more expense is recognized for each grant to reflect that the grant has less time to forfeit 3 Expense accrued for grants that forfeit is reversed in the period in which the grant forfeits If the forfeiture rate is correct, the sum of 2 for all grants remaining is equal to 3 for all grants forfeited

56 At Forfeiture vs. At Vest Cliff Vest Grant / Tranche Level View.

57 At Forfeiture vs. At Vest Graded Vesting Assuming 5% Forfeiture Rate m =.86 m = m =.95 m =

58 At Forfeiture vs. At Vest Graded Vesting with True Ups for At Vest Assuming 5% Forfeiture Rate m = m =.86 m =.90 m =

59 At Forfeiture vs. At Vest Pool Level View. In a perfect world: assuming that a company pegs its forfeiture rate or percentage to the decimal and forfeitures occur uniformly over time both True-Up at Forfeiture and True- Up at Vest produce a deflated expense matching the final actual expense and accrue that expense evenly over the service period

60 Calculating Forfeiture Rates for Each Method

61 Assumptions for Examples Two Identical Pools (Year 1 Pool, Year 2 Pool) Year 1 Pool Year 2 Pool 10,000 Shares (100 grants with 100 shares) Value $1.00 per share 10,000 Shares (100 grants with 100 shares) Value $1.00 per share Cliff Vest in 4 Years Cliff Vest in 4 Years

Forfeiture Rates for Examples Company believes it has a long term share weighted employee turnover rate of 10% and does not expect to change this

62 Forfeiture Rates for Examples Company believes it has a long term share weighted employee turnover rate of 10% and does not expect to change this estimate for several years YEAR Actual Experience for Each Pool by Year POOL 1 POOL % 9.75% 15% 27.75% % % % %

63 Forfeiture Reversal at Vest Date - Example Apply the 10% forfeiture rate to both pools On a weighted average basis, 10% is correct (10K 5%, 10K 15%) Do not make any adjustments to rate estimate Pool 1 At Vest Year Accrual $ 1, $ 1, $ 1, $ 1, True Up 1, Year Total 1, , , , Running Total 1, , , , Pool 2 Accrual 1, , , , True Up (1,340.94) Year Total 1, , , Running Total 1, , , , Year Total $ 1, $ 3, $ 3, $ 4, $ Running Total $ 1, $ 4, $ 8, $ 13, $ 13,365.12

64 Forfeiture Reversal at Forfeiture Date - Example Apply the 10% forfeiture rate to both pools On a weighted average basis, 10% is correct (10K 5%, 10K 15%) Do no make any adjustments to rate estimate Year At Forfeiture Accrual $ 1, $ 2, $ 2, $ 3, True Up (177.69) (521.31) (1,073.50) Pool 1 Year Total 1, , , , Running Total 1, , , , Pool 2 Accrual 1, , , , True Up (505.74) (1,129.12) (1,981.45) Year Total 1, , , , Running Total 1, , , , Year Total $ 1, $ 3, $ 3, $ 3, $ 1, Running Total $ 1, $ 5, $ 8, $ 12, $ 13,365.15

65 Forfeiture Reversal: at Forfeiture vs. at Vest Pool 1 At Vest Year Accrual $ 1, $ 1, $ 1, $ 1, True Up 1, Year Total 1, , , , Running Total 1, , , , Pool 2 Accrual 1, , , , True Up (1,340.94) Year Total 1, , , Running Total 1, , , , Year Total $ 1, $ 3, $ 3, $ 4, $ Running Total $ 1, $ 4, $ 8, $ 13, $ 13, Pool 1 At Forfeiture Year Accrual $ 1, $ 2, $ 2, $ 3, True Up (177.69) (521.31) (1,073.50) Year Total 1, , , , Running Total 1, , , , Pool 2 Accrual 1, , , , True Up (505.74) (1,129.12) (1,981.45) Year Total 1, , , , Running Total 1, , , , Year Total $ 1, $ 3, $ 3, $ 3, $ 1, Running Total $ 1, $ 5, $ 8, $ 12, $ 13,365.15

66 Forfeiture Reversal at Vest Date Revisited The Pool-by-Pool Approach Let s revisit the Forfeiture Reversal at Vest Date method. This time, we re going to make some changes: We re going to implement the pool by pool analysis, still under the assumption of a forward looking forfeiture rate of 10% for both Pools We ll analyze historical forfeiture experience, then add our forward looking estimate to the historical forfeiture percentage

67 Forfeiture Reversal at Forfeiture Date Dynamic Percentage Because only non forfeited grants remain in the expense over the service period: True Up at Forfeiture requires an answer to the question What percentage of shares do I expect to forfeit on an annual basis i.e. the algorithm needs the forfeiture rate formula 1

68 Forfeiture Reversal at Vest Date Because ALL grants (forfeited or not) remain in the expense from grant to vest: True Up at Vest requires an answer to the question How many shares do I expect to vest i.e. First find the forfeiture percentage, then back into the rate Look forward and reason back 1 formulas 1 1

Compute the current percentage of shares forfeited 2.

69 Forfeiture Reversal at Vest Date Pool-by-Pool Estimate Process : 1 1 For EACH Pool Compute Forfeiture % Estimate Future Forfeiture% Compute Forfeiture Rate 1 1 % 1. Compute the current percentage of shares forfeited 2. Estimate how many additional shares are expected to forfeit on top of those already forfeited 3. Back into the rate that yields the appropriate percentage

70 Forfeiture Reversal at Vest Date Revisited The Pool-by-Pool Approach After Year 1, we notice that only 5% of Pool 1 have actually forfeited, but we still expect at 10% turnover rate. What rate should we input into an expense algorithm to more closely reflect our expectations? 5% : % Compute Forfeiture % Estimate Future Forfeiture% Compute Forfeiture Rate : : 5% %. %

71 Forfeiture Reversal at Vest Date Revisited The Pool-by-Pool Approach Using the same methodology, we can find rates to use for Pools 1 & 2 in Years 2 through 4. (Year 1 is a given and the same for both.) Forfeiture Rates Used for Each Pool by Year YEAR POOL 1 POOL % 8.77% 7.53% 6.27% 10% 11.28% 12.54% 13.78%

72 Forfeiture Reversal at Vest Date Example Changing our forfeiture rate by pool, backing into the rate from the expected percentage based on history of the pool significantly improves Forfeiture Reversal at Vest Date Year At Vest New Method Accrual $ 1, $ 1, $ 2, $ 2, True Up Pool 1 Year Total 1, , , , Running Total 1, , , , Pool 2 Accrual 1, , , , True Up (307.06) Year Total 1, , , Running Total 1, , , , Year Total $ 1, $ 3, $ 3, $ 3, $ Running Total $ 1, $ 5, $ 8, $ 12, $ 13,365.12

Forfeiture Reversal: at Vest Old vs. at Vest New Pool 1 Pool 2 At Vest Year 1 2 3 4 5 Accrual $ 1,640.25 $ 1,640.25 $ 1,640.25 $ 1,640.25 True Up 1,584.06 Year Total 1,640.25 1,640.25 1,640.25 3,224.

06 OLD Year Total $ 1,640.25 $ 3,280.50 $ 3,280.50 $ 4,864.56 $ 299.31 Running Total $ 1,640.25 $ 4,920.75 $ 8,201.25 $ 13,065.81 $ 13,365.12 Year At Vest New Method 1 2 3 4 5 Accrual $ 1,640.

73 Forfeiture Reversal: at Vest Old vs. at Vest New Pool 1 Pool 2 At Vest Year Accrual $ 1, $ 1, $ 1, $ 1, True Up 1, Year Total 1, , , , Running Total 1, , , , Accrual 1, , , , True Up (1,340.94) Year Total 1, , , Running Total 1, , , , OLD Year Total $ 1, $ 3, $ 3, $ 4, $ Running Total $ 1, $ 4, $ 8, $ 13, $ 13, Year At Vest New Method Accrual $ 1, $ 1, $ 2, $ 2, True Up Pool 1 Year Total 1, , , , Running Total 1, , , , NEW Pool 2 Accrual 1, , , , True Up (307.06) Year Total 1, , , Running Total 1, , , , Year Total $ 1, $ 3, $ 3, $ 3, $ Running Total $ 1, $ 5, $ 8, $ 12, $ 13,365.12

74 Forfeiture Reversal: at Forfeiture vs. at Vest New Year At Vest New Method Accrual $ 1, $ 1, $ 2, $ 2, True Up Pool 1 Year Total 1, , , , Running Total 1, , , , Pool 2 Accrual 1, , , , True Up (307.06) Year Total 1, , , Running Total 1, , , , Year Total $ 1, $ 3, $ 3, $ 3, $ Running Total $ 1, $ 5, $ 8, $ 12, $ 13, Pool 1 At Forfeiture Year Accrual $ 1, $ 2, $ 2, $ 3, True Up (177.69) (521.31) (1,073.50) Year Total 1, , , , Running Total 1, , , , Pool 2 Accrual 1, , , , True Up (505.74) (1,129.12) (1,981.45) Year Total 1, , , , Running Total 1, , , , Year Total $ 1, $ 3, $ 3, $ 3, $ 1, Running Total $ 1, $ 5, $ 8, $ 12, $ 13,365.15

75 Forfeiture Vest Forfeiture Forfeiture Reversal on Vest Date Forfeiture Reversal on Forfeiture Date Easy in Spreadsheets Can smooth expense in certain circumstances Potential for large upward swings on Vest Requires rate by pool & demographic groups Difficult in Spreadsheets Smooths expense with automatic reassessments By Design, no large upward swings on Vest Requires single rate by demographic group

76 Weighted Unamortized Expense

77 Unamortized Expense Calculation Details 2

78 Unamortized Expense A Moving Target 100% 100%

79 Calculating Wgt Avg Unamortized Expense Daily Weighted Basis 1. Sum the Unamortized Expense from each day 2. Sum the total number of days in the period 3. Calculate: 1

80 Wgt Avg Unamortized Expense Simplistic Approach Daily Weighted Assume a grant worth $ with a daily expense of $2.00 (vests over 365 days). Let s find Wgt. Unamortized Expense for a period of 5 days, starting from the grant date

81 Wgt Avg Unamortized Expense An Arithmetic Sequence You may notice that summing the Unamortized Expense is simply an arithmetic sequence of the days remaining times the daily expense : :

82 Wgt Avg Unamortized Expense An Integral A

83 Wgt Avg Unamortized Expense An Integral A

84 Wgt Avg Unamortized Expense An Integral A 0 5

85 Q&A

86 Contact Dan Moody Sr. Product Manager, E*TRADE Corporate Services

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