INCENTIVE PLAN SERIES Long-Term Incentive Plans Michael Sherry, Managing Director Sandra Pace, Managing Director 650 Fifth Avenue, 33 rd Floor, New York, New York 10019 www.shallpartners.com (212) 488-5400
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Long-term incentives are awards earned and paid based upon achievement of goals over a period exceeding one year Align executive / shareholder interests Goals may be based on stock price or business performance Typically equity-based, but a small number of firms use cash Create wealth Purpose / Objectives Attract, retain and motivate Provide competitive pay opportunities based on performance Focus participants on critical performance criteria -2-
Average Pay Mix - Top 200 CEOs Base Salary 16% Long Term Incentives 62% Annual Incentives 22% Source: Based on a recent study by SH&P of the top 200 U.S. public companies. -3-
Appreciation vehicles Stock options Stock-settled appreciation rights (SARs) Time-vested full value vehicles Restricted stock or restricted stock units (RSUs) Performancevested vehicles Typically full-value awards performance shares or performance share units (PSUs) Can also be performance-vested options or performance cash plans (LTIPs) -4-
Performance-based awards are nearly universal amongst Top 200 Companies About one-half of companies use stock options and restricted stock 93% 54% 48% Stock Options Service-Based Restricted Stock Performance-Based LTI -5-
Most companies use a portfolio approach to granting LTI, with the use of two or more vehicles being the most common approach 55% 20% 22% 1 Vehicle 2 Vehicles 3+ Vehicles 0 Vehicles Performance-based represents the largest award type in terms of LTI value mix 4% 21% 17% 62% Options Restricted Stock Performance Vested -6-
The majority of companies utilize options and performance-based awards as part of their LTI program Restricted stock and performance-based awards is the second most common approach to granting LTI 1 Vehicle 2 Vehicles 3+ Vehicles 30% 23% 22% 18% 1% 2% 2% Options R/S LTIP Opts. & R/S Opts. & LTIP R/S & LTIP R/S, Opts. & LTIP -7-
The right to purchase shares of company stock at a specified price (exercise price) during a specified period of time (term) Pros Alignment w/ shareholders Easy to communicate Leverage Fixed expense Cons Not viewed as performance-based by some Not tied explicitly to company financial performance Dilution; stock-settled SARs are less dilutive than options Expense recognized even if option expires worthless -8-
Options Term Schedule Options Vesting Type Options Vesting Schedule 2% 1% 5% 1% 5 Years 6 Years Cliff 10% 90% Step 1 2 0% 0% 7 Years Years 3 4 34% 55% 92% 8 Years 5 10% 10 Years 6+ 1% -9-
The grant of shares (or the promise to grant shares in the case of RSUs) contingent on meeting the requisite service period Pros Cons Strong retention value and popular with employees Alignment with shareholders Less dilutive Easy to communicate Fixed expense Viewed negatively as pay for pulse Not tied explicitly to company financial performance No leverage - 10 -
Restricted Stock Vesting Schedule Restricted Stock Vesting Type 1 1% Years 2 3 4 5 1% 8% 22% 68% Step 73% Cliff 27% 6+ 0% -11-
Shares (or the promise to receive shares in the case of PSUs) contingent upon achieving associated performance goals and meeting the requisite service period Pros Strong focus on performance Alignment with shareholders; popular with advisory firms Fixed expense may be subject to reversal if performance goals are not met May be less dilutive Cons Challenges in setting performance criteria Poor goal setting may lead to perception that they are less valuable Reversal of expense is not possible for awards earned based on market conditions (stock price/tsr) - 12 -
Performance Period Additional Vesting 1 3% 5% 2 3% 3 87% 4 4% 2% 2% 2% 5+ 2% 1 Year 2 Years 3 Years 4 Years -13-
Payout Type Threshold & Maximum Payout %s Options 1% Cash + Stock 6% Stock + Options 1% Average Median Cash 10% 179% 200% Stock 83% 39% 50% Threshold Maximum -14-
Performance Metrics Performance measures should be aligned with business strategy Reflect the key drivers of corporate and shareholder value Create clear line of sight for key employees that focuses their efforts and maps their accountability Absolute metrics Dependent upon ability to predict future performance May not be viewed positively by shareholders Relative metrics Can serve as plugs when absolute performance is difficult to predict Possibility of payouts for negative/poor performance that is merely less poor than that of some comparators - 15 -
Majority of companies use one or two performance metrics in LTI plans (74%) Differs from annual incentive plans where the use of three performance metrics is most common 10% 16% 36% 1 Metric 2 Metrics 3 Metrics 4+ Metrics 38% -16-
Metric Prevalence 59% 55% 46% 20% 17% 16% 10% Profit/Earnings TSR/Stock Price Returns Other Financial Revenues Cash Flow Other Non Financial Median Metric Weightings 50% 50% 50% 32% 33% 40% 23% Profit/Earnings TSR/Stock Price Returns Other Financial Revenues Cash Flow Other Non Financial -17-
Relative TSR One of the most prevalent performance metrics used among LTI programs Pros Cons Relative performance useful when absolute performance is difficult to predict Viewed favorably by shareholders and shareholder advisory firms Not directly within management s control Phoenix effect can penalize steady performers Selecting the right comparator group is critical Expense recognized even if award is not earned - 18 -
Majority of companies using TSR use it on a relative basis Small percentage of companies use Absolute TSR or both Absolute and Relative TSR 22 companies use Relative TSR as a modifier TSR Usage Both 2% Absolute 7% Relative 91% - 19 -
Relative TSR comparison 55% use a custom peer group Median number of peers in group 14 40% use an Index Of which 61% use the S&P 500 5% use both an Index and peer group Relative TSR - Group Compared Against Both 5% Index 40% Peer Group 55% - 20 -
ISS Guidelines ISS Pay for Performance Tests Relative Degree of Alignment (RDA) Multiple of Median (MOM) Pay-TSR Alignment (PTA) Compares the percentile ranks of a company s CEO pay and TSR performance, relative to an ISS-developed peer group, over the prior three-year period Expresses the prior year s CEO pay as a multiple of the median CEO pay of its comparison group for the most recently available annual period Compares the trends of the CEO s annual pay and the change in TSR over the prior five-year period 2018 Update Financial Performance Assessment (FPA) Used as a secondary screen; when the traditional 3 screens above result in a low concern, may change the result to medium concern if financial performance is weak. Conversely, a medium concern may change to low if financial performance is strong Analysis compares relative ranking (versus ISS selected peers) of three-year CEO pay to three-year financial performance; metrics and weightings will be industry specific -21-
Glass Lewis Guidelines Glass Lewis Pay for Performance Tests 3-Year Weighted Average of Total Compensation for CEO and Top 5 Executives Performance Metrics (3-Year Weighted Average) Total Shareholder Return Change in Operating Cash Flow EPS Growth Return on Equity; Return on Assets Rank Company vs Peers Performance Compensation Assign Grade Based on Relative Positions of Rankings P>C by 60 to 100% =A C>P by 30 to 59% = D P>C by 30 to 59% =B C>P by 60 to 100% =F P>C or C>P by 0 to 29%=C -22-
Tax Cuts and Jobs Act of 2017 Early versions of this bill had drastic changes to the treatment of equity and deferred compensation These have been removed from both the House and Senate versions House and Senate versions both make major changes to Section 162(m) Performance-based exception for compensation paid over $1M would be eliminated CFO returned to group of covered employees Potential effects Return of subjective metrics / discretion Potential pushback from shareholders / other groups -23-
Pitfalls to avoid Pay for performance misalignment Majority of equity awards not performance-based Increasing target LTI award in year of poor corporate or stock price performance Payouts of awards in years where TSR has declined Payment of dividends on unearned or unvested shares Size/concentration of awards Large sign-on/retention awards or other one-off awards outside of the annual program CEO and other proxy officers receive out-sized portion of grants measured as a percentage of NEO awards to all employee awards Performance Metrics Discretion usually viewed negatively. Double-dipping by using same performance metric for both short term and long term Single, non-relative metric likely problematic Design parameters 1-year performance periods in a long term incentive plan Large/uncapped upside potential No ownership guidelines or holding requirements No clawback policy Change in Control Avoid single trigger vesting of equity awards. Significant concern for shareholders and advisory firms. - 24 -
Key considerations in Long-Term Incentive Plan Design Align with strategy Balance is crucial Reevaluate on a regular basis Understand the ramifications of change Assess risk Communicate, communicate, communicate Don t simply follow the herd -25-
Michael Sherry Managing Director msherry@shallpartners.com Sandra Pace Managing Director space@shallpartners.com www.shallpartners.com -26-