Time to Invest Some Sweat Equity in your TSR Plan #NASPP26

Time to Invest Some Sweat Equity in your TSR Plan #NASPP26

Speakers Nathan O Connor Equity Methods nathan.oconnor@equitymethods.com David Bixby Pearl Meyer David.Bixby@pearlmeyer.com John Roe Institutional Shareholder Services John.Roe@issgovernance.com #NASPP26

Agenda Introduction The Shareholder Viewpoint on Relative TSR Improving Relative TSR-Centric Plans Hybrid Awards: A Viable Alternative Performance Metric Selection Award Mechanics Peer Group Selection Goal Setting Wrap Up #NASPP26 3

Introduction Continued to push for more performance-based accountability in LTI programs For many companies the first step is a heaping helping of relative TSR but is that really the best approach? Increasingly the answer we hear from companies and their investors is No TSR does have its merits as a long-term performance measure but let s take a step back and think about how it could be applied more thoughtfully either on its own or in concert with other measures that may be more appropriate for your organization Disclaimer: ISS is not an authorized retailer of Relative TSR LTI programs #NASPP26 4

Setting Up the Problem Executives want more value, shareholders want more performance, and the comp committee just wants everybody to be happy. We ll be in serious trouble if we lose this executive team Compensation Committee Our say on pay is trending below 90% - we can t let that happen Executives Grant me more given the low line of sight you re giving me Our performance is stellar given our starting point don t you dare compare us to Peer ABC Proxy Advisors/ Shareholders Your pay for performance isn t where it needs to be Why should you payout when we re not we want to see more TSR #NASPP26 5

The Shareholder Viewpoint on Relative TSR (Through the eyes of ISS) #NASPP26 6

Shareholder viewpoint: The problems with Relative TSR Time period: TSR is a great long-term metric but long-term is the key. For your large and influential shareholders, long-term may be defined as across one or more business cycles not three years. Business cycles typically last 6-7 years Affected by both macroeconomic factors and company-specific issues Not all companies within an industry at the same point in the cycle Hard to adjust for these factors in the short-term #NASPP26 7

Shareholder viewpoint: The problems with Relative TSR The mechanics of relative TSR programs can generate strange results Over-reliance on relative TSR (more than 50% of the LTIP weight) Above-target payouts with negative absolute TSR Target payout earned for mediocre performance Large payout leverage in some cases exceeding 200% Separate performance comparator groups #NASPP26 8

First, a Public Service Announcement ISS has stated this for years, including on page 6 of our 2012 Pay for Performance white paper: Note that ISS does not advocate that companies use TSR as the metric underlying their incentive programs; on the contrary, shareholders may prefer that incentive awards be tied to the company s short- and long-term business goals. #NASPP26 9

What does ISS look for in LTIP goals? Metrics and weights appropriate for the business, the executive, and shareholders; designed to drive long-term value creation Goals set in a way that motivates strong performance and avoiding both step-over or impossible goals Explanation of clear linkages between metrics, weights, goals, and long-term business strategy Transparency around the metric selection, weighting, and goal-setting processes #NASPP26 10

Does that mean that ISS and shareholders are against Relative TSR? NO! ISS is fine with using Relative TSR, when used appropriately and transparently ISS prefers to see a relative performance measure in a compensation program, and relative TSR can fill that need (as long as weighting is at least 15% and can both enhance and impair payouts) #NASPP26 11

Live Polling Question Have you added a relative TSR program or made changes to your TSR plan in the last three years as a result of shareholder feedback? A. We have added a relative TSR component to our LTIP B. We have made changes to goals or plan mechanics in response to (or anticipation of*) shareholder feedback C. Everything is copacetic with our relative TSR plan D. Relative TSR does not play a role in our LTIP *Includes anticipation of shareholder feedback because an issue was raised in an advisory firm report #NASPP26 12

Improving Relative TSR Centric Programs #NASPP26

What should you consider if you need to build a Relative TSR plan? Rationale: Explain to shareholders why relative TSR is appropriate for the company Relative vs. Absolute TSR: Do we need gates capping payouts if absolute TSR is negative? What is Target?: Is peer median challenging enough or should it be higher? How Does it Fit in Your Broader Comp Plan? Offset Relative TSR LTIP with short-term financial goals #NASPP26 14

Using Absolute TSR as a Modifier Using Absolute and Relative TSR in tandem can address external and internal concerns: is plan design fair to shareholders and employees at threshold and maximum? Consider implications for realized value at each end of curve Test implications of design changes for expected/reported grant value Simple Cap Approach Simple Collar Approach Matrix Style Approach Payout (% of Target) 250% 200% 150% 100% 50% Enhanced payout at maximum for positive TSR and 100 th Percentile TSR 0% 0%ile 25%ile 50%ile 75%ile 100%ile XYZ Percentile Rank TSR 0% TSR < 0% 250% 200% 150% 100% 50% TSR 15% 0% 0%ile 25%ile 50%ile 75%ile 100%ile XYZ Percentile Rank TSR 0% TSR < 0% 350% 300% TSR 15% 250% 200% TSR 0% 150% 100% 50% TSR < 0% 0% 0%ile 25%ile 50%ile 75%ile 100%ile XYZ Percentile Rank #NASPP26 15

Hybrid Awards: A Viable Alternative #NASPP26

Hybrid Award Design Objectives Hybrid award metric selection requires the balancing of two primary objectives: Line of sight: perceived recipient control over outcome. Metrics with high line of sight typically measure inputs Link to shareholder value creation: closeness to results that shareholders value most. These metrics usually measure outputs Examples of hybrid award metrics and where they fall on the spectrum include: LINE OF SIGHT Cash Flow (Operating, Free) Return Metrics (ROA, ROE, ROIC) Earnings (EBITDA, EPS) Relative TSR LINK TO SHAREHOLDER VALUE CREATION #NASPP26 17

Hybrid Awards: Performance & Market Conditions Combined A hybrid award that is gaining traction in the market: the performance and market award The payout is combined, and often you must hit multiple targets to receive payout These types of hybrid can lead to complicated downstream implications, depending on design Additive Payout Simpler fair value; may involve admin system complications Multiplicative Payout Modifier approach; may involve significant accounting and admin complications 125% + 200% Market Condition Perf Condition 125% x 200% Market Condition Perf Condition 325% Additive Payout 250% Multiplicative Payout #NASPP26 18

Hybrid awards can get fun quickly Additive What is the relationship between the performance and market conditions? Multiplicative Multiplier Approach Matrix Approach Does the product of the maximum upside of the performance and TSR conditions exceed the overall payout cap? Will there be multiple fair values? Is the performance target known for all the tranches? Multiple Performance Tranches Does an accounting grant date exist? Is a linear interpolation of the fair values necessary? Are the performance conditions separate for each tranche or are they combined? Is the minimum payout on the performance tranches greater than zero? #NASPP26 19

Live Polling Question If your company grants hybrid awards, how do the conditions interact? A. The performance and market conditions are additive or independent B. The performance and market condition outcomes are multiplied to arrive at the final payout C. The market condition is a modifier (small impact) to the performance condition outcome D. My company does not issue hybrid awards Reminder: Market conditions depend on stock prices (like relative TSR). Performance conditions include other financial or operational measures. #NASPP26 20

Hybrid Award Constructs: Comparing Payouts Choosing between the additive construct and the multiplicative construct can result in different degrees of leverage, as shown in the payout matrix below: Revenue Performance Good (150% payout) Bad (60% payout) Relative TSR Performance Good (125% payout) Bad (75% payout) Multiplicative: 188% Multiplicative: 75% Additive: 138% Additive: 93% Multiplicative: 113% Multiplicative: 45% Additive: 113% Additive: 68% Key takeaway: Multiplicative designs are more leveraged. Payout is higher when overperforming, but lower when underperforming. #NASPP26 The caveat: All of this is very customizable to desired outcomes. 21

Three 1-year periods vs. one 3-year period Tranche 1 Targets established Accounting grant date Performance determined Payout made Financial Metric(s) TSR Modifier Tradeoff: longtermness for goal visibility Method 1: One 3-Year Performance Period FY 2017 FY 2018 FY 2019 Tranche 3 Tranche 2 Tranche 1 Method 2: Three 1-Year Performance Periods Fin. Metric(s) Time vesting TSR Modifier Fin. Metric(s) Time vesting TSR Modifier Fin. Metric(s) TSR Modifier FY 2017 FY 2018 FY 2019 #NASPP26 22

Performance Metric Selection #NASPP26 23

Picking the Right Alternative Measure Relative vs. Internal/Absolute Advantages Relative Measures Address cyclicality Easier goal setting Challenges Poor line of sight Requires meaningful peer group Absolute/Internal Measures Better line of sight Can drive specific behaviors More challenging goalsetting Vulnerable to industry cycles #NASPP26 24

Using Hybrid Awards: Complexity vs Practicality Hybrid awards can be an effective way to achieve balance within reason Standalone metrics Most common Easier to communicate Even if one measure underperforms participants can earn something Matrix approach Should participants earn anything if one measure is completely missed? Can also provide enhanced payout for outstanding achievement in multiple areas Is increased complexity necessary? Increasing relative or absolute performance Increasing absolute EPS performance Relative TSR 50% Absolute EPS 50% 0% 0% 100% 100% 200% 200% Increasing relative TSR performance 0% 50% 100% 50% 100% 150% 100% 150% 200% #NASPP26 25

Other metrics don t always correlate with TSR TSR Percentile Rank 100% AMZN 80% 60% 40% 20% 0% Will the new metrics give the same answer as TSR? SPLS NFLX GPC ORLY KORS 0% 20% 40% 60% 80% 100% Average Return (ROIC, ROA, ROE) Percentile Rank The upshot: know what matters most for your company without cherry-picking Percentile Rank Percentile Rank Percentile Rank 100% 50% 0% 100% 50% 0% 100% 50% 0% #NASPP26 26

Award Mechanics #NASPP26 27

Peer Selection The problem: picking the right peer group for relative performance External perspective Why is the performance group different from the group you use to set pay levels? Setting pay against high payers and measuring performance against laggards? Internal perspective How do we balance objectivity with customization Are the companies we compete against for talent the same ones we compete against for business or investors? Is our compensation peer group large enough to buffer against unexpected changes? #NASPP26 28

Live Polling Question Is the peer group you use for performance the same as the group you use for compensation benchmarking? A. Yes our compensation peer group is our performance group B. No we use a custom performance group that better reflects our [competitors for investor dollars/competitors for business/capital structure ] C. No we use an established industry index for performance D. Relative performance? Ha! We are peerless it s absolute performance all the way for us! #NASPP26 29

Hybrid Award Peer Lists Category Peer Group Source Considerations Index 1 2 Peer Group Selection Possibilities Broad market index (e.g. S&P 500) Specialty market index Can reference relative performance of index constituents or index level What if a firm is dropped from the index, but still traded? How are new entrants to the index handled? M&A or spin-out activity that affects the index? Tips, Trends, Practices Decide whether to be specific or intentionally vague in plan document Decide how generous or balanced to be to recipients Codify, automate, and test the calculations can be material Synchronize ASC 260 process with executive compensation process M&A and spin-out activity? Competitors 3 Hand-picked list Treatment of bankruptcy? Small group = high sensitivity #NASPP26 30

Different peer groups have different purposes Who are we compared against when pay-forperformance is measured? Peer group 1: Compensation Benchmarks Who do we compete with for talent? Peer group 2: Pay-forperformance Comparison Peer group 3: Relative TSR Award Payout Who do we compete with for market return? (Our focus) #NASPP26

Unintended consequences with peer lists Corporate action affecting peers Co. Event TSR % Rank Co 2 De-listed -100.0% 0% Co 5 N/A 0.8% 7% Co 8 N/A 12.5% 13% Co 12 N/A 14.8% 20% Co 1 N/A 16.2% 27% Co11 N/A 17.3% 33% Co 13 N/A 18.7% 40% Co 4 N/A 22.9% 47% CoABC N/A 23.1% 53% Co7 N/A 24.6% 60% Co 9 N/A 25.0% 67% Co 10 N/A 28.3% 73% Co 14 Spinnor 29.5% 80% Co 15 Spin from 14 36.1% 87% Co 3 Acquired 92.5% 93% Co 6 Acquired 112.2% 100% Merger, acquisition, spin-off, bankruptcy, index drop, index addition, LBO, etc. Co. TSR % Rank Co 5 0.8% 0% Co 8 12.5% 10% Co 12 14.8% 20% Co 1 16.2% 30% Co11 17.3% 40% Co 13 18.7% 50% Co 4 22.9% 60% CoABC 23.1% 70% Co7 24.6% 80% Co 9 25.0% 90% Co 10 28.3% 100% Semi-Closed % Rank Payout 75% 200% 50% 100% 25% 0% Closed 112% 180% #NASPP26 32

Goal Setting The problem: setting target performance at a level that is appropriately challenging External perspective Median performance for target payout? Meh. Target payouts for declining absolute financial performance? Internal perspective Is required level of performance aligned with the nominal target value of pay? Don t want to create a participation trophy But are we spending money on awards that are pointlessly challenging? Other issues what is the right long-term performance period? Everybody has won and all must have prizes. #NASPP26 33

Setting Supportable Threshold, Target, and Stretch Goals Market Peer Inference Bottom-Up Distribution Fitting How it works Base targets off analyst consensus expectations Apply discount and premium to back into threshold and stretch targets Analyze peer proxy payout data to see relative premium and discount given to stretch and threshold targets, respectively Link goals to internal business group expectations and organizational capabilities Build probability distribution from company and peer historical data Infer threshold, target, and stretch levels from distribution Challenges Threshold and stretch goals difficult to set May not align with internal business expectations Assumes effective peer goal May not align with internal business expectations Potential bias from padding/competing incentives Not market-based May not align with internal business expectations #NASPP26 34

Setting Goals Analytically Setting rigorous, supportable goals Baseline Internal forecasts/ FP&A Corroborate Historical data Simulation models Analyst estimates Finalize Stretch Target Threshold Goal Level How to Find Result Stretch Target Threshold 20% probability of achievement, based on actual industry data 50% probability of achievement, based on actual industry data 80% probability of achievement, based on actual industry data 4% 9% 14% Threshold Target Stretch $2.96 $3.20 $3.44 #NASPP26 35

Payout Slopes and Sensitivities Case Features Level Percentile Ranking Payout Fair Value Design 1 (Base Case) None Threshold 25 th 0% Target 50 th 100% Stretch 75 th 200% 126% Design 2 (Lower Payout) None Threshold 25 th 0% Target 50 th 100% Stretch 75 th 150% 112% Design 3 (Tougher Hurdles) None Threshold 35 th 0% Target 50 th 100% Stretch 85 th 200% 117% Design 4 (Absolute TSR Cap) If absolute TSR < 0, payout cannot exceed 100% Threshold 35 th 0% Target 50 th 100% Stretch 75 th 200% 121% #NASPP26 36

Wrap Up #NASPP26 37

Common Pitfalls to Avoid Don t over-engineer! Make sure you get bang for the buck Do participants understand plan? Do they know their role in influencing outcomes? External communication make sure you get credit! Clearly enunciate goals and outcomes Don t get cited for lack of transparency Realizable vs. grant-date pay Award mechanics and the award agreement Performance-based LTI does not function in a vacuum Don t forget the other tools in your utility belt #NASPP26 38

Questions? #NASPP26

Thank You #NASPP26