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GK Partners Newsletter MAY 2001
MERGERS AND ACQUISITIONS:
10 Key Questions on Compensation
by the Staff of
Although the current market environment has impacted the viability of certain public offerings and other equity financings, the ongoing occurrence of mergers, acquisitions and recapitalizations is a fact of business life. Compensation Committees and Boards are often called upon to review and approve management incentive plans in the context of such events. Reviewing the reasonableness and effectiveness of incentive compensation, and assessing its potential impact on the success of the deal, is a difficult task that companies and their Boards cannot avoid.
In all transactions, senior management and key employee retention and motivation is of great concern to investors, Directors, and of course, to the management personnel themselves. Typically, annual cash incentives are linked to the achievement of earnings and cashflow objectives (e.g. EBITDA) thereby enabling the company to meet its working capital and debt service requirements. The issue of long-term equity incentives is somewhat more complex. Clearly, it is desirable that a management team be well motivated to increase shareholder value. This is true in both public and private company scenarios. In structuring a merger, acquisition or recapitalization, addressing the issue of management employees' "stake in the business" can be the linchpin of a successful transaction.
The following represents a checklist of major issues to be considered in implementing a highly effective management stock incentive program in the context of a transaction. The best answers to these question are, of course, contingent on the specific facts and circumstances of each deal. A well-thought-out approach to each issue will ensure that the equity incentive program has a positive and strategic long-term impact.
1. What percentage of the company is currently owned by management employees and what kind of equity opportunities were available prior to the transaction?
2. How much additional equity (if any) is appropriate for management in the light of the company's new objective, and the dilution concerns and desired financial returns of the new owners/investors?
3. What form should new or additional management equity take? -- e.g., stock options, stock grants, purchase opportunities, performance-based awards or a combination -- it is essential to consider the behavioral impact, as well as the tax and accounting implications to both the company and the participants in selecting the type of incentive to be used.
4. How much personal financial risk should employees be required or permitted to take if they participate along with outside investors? If stock purchases are permitted, how will management's stake be financed?
5. How will company equity be valued going forward? At "book" or at "market" -- by formula or by appraisal -- and what impact will management actually have on share value?
6. What increments in equity value is expected over time? How will such company value accrete? What are the best and worse case scenarios? How will these scenarios affect the value of management's stock holdings?
7. What level (if any) of earnings impact resulting from stock incentive compensation can be tolerated? Should the program be structured to provide low or no incremental dilution and/or charge to earnings?
8. Is a further public market, major redeployment of assets or other exit strategy planned? If so, when and what "step-up" in value might occur at that time?
9. How much liquidity will management have in the event of a further private sale, public offering, liquidation or other disposition of the business? What type of buy-back, come-along or resale provisions should be made?
10. Should there by any additional key employee protection in the event of a future change-in-control (e.g., employment agreements. stay-put arrangements, severance benefits, etc.)?
Essential elements of any long-term compensation program include the opportunity for meaningful rewards based on results, and fairness to employees and shareholders alike. Thus, it is of particular importance that the compensation design issues raised by this checklist be carefully considered by the company and its advisors. Furthermore, the appropriate documentation and effective communication of the program's objectives and features will greatly enhance its usefulness. Qualified third-party consulting professionals can be very helpful in effectively designing, implementing and communicating the terms of such a program, and in addressing the questions and concerns of employees and investors alike.
© 2001 GK Partners Inc.
GK Partners White Paper APRIL 2001
UNDERWATER STOCK OPTIONS
by the Staff of
Even in the current environment, stock options continue to be the most widely-accepted and prominent feature of most long-term incentive compensation programs. As reported in "The 2000 Top 250 Study of Long-Term and Stock-Based Grant Practices for Executives and Directors" by Frederick W. Cook & Co., Inc. (a New York-based consulting and research firm), it is not surprising to find that 99% of the 250 largest U.S. companies continue to use stock options as their primary form of long-term management incentive compensation. Some of the principle advantages of stock options (which account for their continuing popularity) are: 1) They are generally well-understood and well-accepted by management personnel and non-executive employees alike; 2) They are inherently responsive to value creation by providing incentive compensation which recognizes and rewards increases in company value; 3) They generally create no charge to company earnings for compensation expense (assuming "fixed" accounting treatment under APB 25); 4) Non-qualified options permit the Company to take a tax deduction for compensation expense at the time of option exercise (even though no compensation expense has been booked from an accounting perspective); and 5) Options generally encourage employee retention and long-term strategic thinking. Despite these traditional advantages, however, we recognize the potentially demoralizing effect of stock option grants which are underwater (and which remain underwater) for some extended period of time. To mitigate these effects, it is important that the Company continue to administer its stock option program in a timely and motivational manner, and to communicate the potential future benefits of current and past awards alike.
With the volatility of the equity markets during the past year, and in light of the dramatic effect of reported earnings (and short-term earnings expectations) on the discounted market value of many companies' stock prices, the subject of "underwater" stock options has resurfaced with a vengeance. In 2000 and 2001, both new and old economy companies saw their stock prices decline significantly, causing both older (vested) option grants and newer (unvested) option grants to be in an underwater situation. This has been in the case in both traditional industries, and in technology-based companies that have relied heavily upon stock options as an alternate means of compensation and where many employees have accepted lower cash compensation in favor of stock options. Despite layoffs, the demand for the most talented employees and the need to provide competitive pay opportunities has remained high. Companies are therefore increasingly facing the actual and perceived loss of incentive and retention value in their employee stock option programs. In one survey of 100 technology companies by iQuantic (a West Coast-based consulting and research firm), more than 80% of survey respondents reported that at least some of their outstanding stock options were underwater. We should remember, however, that the vast majority of these options have a ten-year term, and that stock options were always intended to be a "long-term" incentive that would produce compensation value over extended periods of time in response to stock value appreciation.
Unlike shareholders and other investors, management and professional employees often have a substantial portion of their net worth and earning power subject to the price performance of one company's stock. Some managers and employees are unable to diversify their portfolios and lessen their market risk as most prudent individual and institutional investors would do as a matter of sound investment practice. When stock value is adversely affected by general market conditions or other factors (which may be uncontrollable by the Company in the short term), this can easily result in stock options that are substantially "underwater". Depending on many variables (including the vesting requirements and term of these options), these underwater options may undermine the effectiveness of a company's overall policy to provide competitive and motivational compensation opportunities to its key employees. The morale impact of a low stock value must, therefore, be taken into consideration.
Whereas previously, the strategic and selective repricing of stock options was viewed (in many quarters) as being an acceptable business practice, significant changes in FASB-generated accounting rules (effective as of the end of 1998) have made stock option repricing generally unacceptable to publicly-held companies in terms of both financial impact and corporate governance considerations. This is not necessary the case among privately-held businesses. The normally-understood purpose of stock option repricing is to restore a reasonable and motivational compensation opportunity to stock option participants in those circumstances where external, uncontrollable conditions have created a situation in which such options are not likely to provide any future incentive value. This has the effect of restoring the originally intended compensation opportunity without creating the additional dilution caused by large numbers of new or additional stock options granted at the current fair value. This type of action is usually based upon an objective analysis of the history of stock option grants and stock value, and is typically ratified by a company's Board of Directors to ensure that it is reasonable and consistent with shareholders' interests. Given the current, punitive accounting treatment of modified and/or repriced stock options, relatively few public-company Boards are willing to assert that a repricing action is in the best interests of all shareholders. However, even in the current environment, repricings are not unheard of and repricing is a strategy (among various other techniques) that may legitimately be given consideration by private companies (and even by some public companies under unique circumstances). While we are not generally proponents of option repricing, we do recognize the marketplace's acceptance of its limited application. Some will argue that no option should ever be repriced; that at the time an option is granted, a contract is created between participating employees and shareholders such that the employees should never benefit unless the stock price rises above the original strike price. Others will argue that by refusing to even consider repricing, a company is driving talented employees into the hands of competitors who can offer more reasonably price options-at-market to their new employees. And a company with underwater options also finds itself in the unusual and inequitable situation where its current employees are holding underwater options, while its newly-hired employees are not. In most cases, however, we believe that a straight one-for-one repricing is ill-advised and not in the best interests of a company or its shareholders.
As alternatives to straight one-for-one repricing (which have largely been squelched by current FASB accounting rules and shareholder fairness concerns), a number of other marketplace compensation strategies have emerged with respect to the handling of underwater stock options. These included such approaches as: 1) "Economic repricing" which generally results in the replacement of underwater stock options with a much smaller number of new options priced at-market - this technique results in variable accounting for the repriced options (the effect of which is mitigated somewhat by the fact that the replacement grant generally involves many fewer options) - extensively used prior to the December 1998 FASB change of accounting rules, this technique is considered by some to be more palatable from a shareholder perspective since it is generally based on the Black-Scholes present value of the replacement grant and typically does not result in any higher present compensation value; 2) Voluntary employee cancellation of underwater options followed more than six months later with a new grant of options at the (then) current market price -- this high-visibility technique has been used by several large companies (most notably Sprint Corporation) and it remains to be seen whether the marketplace (and the accounting profession) will ultimately be sympathetic to its use - we should note that a wholesale option exchange program has the added exposure of potentially being deemed a "tender offer" by the SEC with the attendant disclosure and filing requirements; 3) Truncation of outstanding stock option terms - this technique is considered a "material modification" to the original option grant and can therefore result in variable accounting - however, if the option term is sufficiently shortened, the accounting exposure can be time limited; 4) New grants of options-at-market with shorter option terms and shorter vesting of the right to exercise - this has thusfar been the most popular method of addressing the problems created by underwater options - however, it does require adequate reserves in the option program's shareholder-approved allocation of shares and will increase the number of options outstanding (i.e., option "overhang") and potential shareholder dilution; 5) New grants of options-at-market with price-vesting (rather than time vesting) requirements - this method give new option grants the potential to vest much more quickly than traditional option grants if the company's stock value recovers in the short-to-medium term - the effect on employee morale is generally very positive in that it gives participants the opportunity to experience "paper gains" in the relatively short-term to offset the demoralizing effects of currently underwater options; 6) More frequent granting of smaller numbers of options (including semi-annual and quarterly option grants) at fair value strike prices - this technique does not necessarily result in a higher total number of options granted, but does take advantage of stock value fluctuations throughout the year; and 7) Other techniques which combine some of the features described above. Given the challenges of the current environment, successful companies must be thoughtful and (within reason) creative in addressing the motivation and retention of their key employees. © 2001 GK Partners Inc.
Directorship AUGUST 1998
STOCK OWNERSHIP GUIDELINES:
Good, Bad or Indifferent?
As corporate Boards and their advisors work to implement reasonable cash and stock incentive plans for the senior executives and key employees of the companies which they serve, their focus is often on the use of those tools and techniques which are most popular or creative. While the effective use of various equity participation approaches is an important topic, the rationale for requiring certain levels of management ownership in conjunction with these compensation techniques is a directly-related, but distinct matter.
This article is intended to present some of the principal reasons for encouraging management employees to own the stock of the companies
they work for while suggesting some Board-level concerns about such policies. In visiting this topic, it is important to note the current business climate and marketplace sentiment with respect to employee ownership. Many companies have asserted their belief that significant management stock ownership creates an important economic linkage between professional managers and the other shareholders in whose interest they are supposed to be working. It is hard to argue this self-evident point. The more important question is whether management's participation is in a form which places these key employees in the same risk/reward position as investing shareholders, or whether their participation is on the upside only. As anyone who has invested in or owned a business knows, real ownership is a distinctly double-edged sword. The management ownership issue is the marketplace's legitimate expression of a desire to place executive-level employees on the same economic footing as their shareholders. Just as shareholders insist on diversification in investment portfolios, they prefer that the management guardians of their investments be significantly invested themselves. But what level of ownership is optimal?
It is not an original thought to suggest that we have entered an "age
of accountability" insofar as corporate governance is concerned. The management teams and Boards of public companies are increasingly responding to the insistence of various constituencies (including institutional investors, securities experts and regulators) that they set goals, measure performance and reward only those actions which provide strong financial results and create value appreciation. Insofar as the administration of executive compensation is concerned, this represents a sea-change because the philosophy of "pay-for-performance" (which has long been widely espoused) is becoming the reality of "pay-for-results". When instances of pay for non-performance are uncovered, critics are quick to focus their attentions on the companies in question. Management compensation excesses are no longer just buried in rhetoric. They are clearly identified, widely reported upon by the media and openly discussed. Therefore, the "quid pro quo" between performance objectives and rewards has become the most important element in any company's incentive compensation program. However, the narrow focus of most cash incentive plans does not encourage a long-term or strategic orientation. Cash plans pay for short-term performance which reinforces
a focus on immediate financial results.
Consequently, equity ownership is generally believed to be the solution
to short-term decision-making by encouraging a long-term outlook and by reinforcing forward-thinking and constructive management behavior. The need to think and act in a broader, longer-range context is the cause of growing trend among companies to formally require their top employees to be invested in the stock of businesses which they run. While existing equity incentive plans (including stock option, restricted stock and other equity award plans) have created tremendous management equity ownership potential, they have not been particularly successful in achieving significant levels of actual management stock ownership. A higher level of such ownership would presumably cause management to more fully appreciate the priorities, concerns and outlook of their shareholders. The results of a number of recent studies show that a significant percentage of America's largest public companies have implemented so-called "management stock ownership guidelines" as corporate policy. This percentage is growing steadily and we anticipate that a majority of the larger companies will institute such policies in the next several years. By requiring key managers to have a portion of their personal wealth invested in the stock of the companies which they manage, an appropriate balance between financial risk and compensation rewards is established. It is our view, however, that there is a fairly narrow band between too little financial risk and too much risk. Naturally, this will vary from person to person and from company to company. By having the greater portion of their personal financial assets invested in company stock, a management team could (in certain circumstances) be dissuaded from making various capital investments or from implementing those strategies that would have the most beneficial effect on the company's long-term prosperity as a going-concern. Board's certainly need to consider and understand the effect of large management shareholdings on mergers and acquisitions activity or stock buyback programs. Are these the best use of the company's capital resources? They should, for example, consider whether such ownership will influence management's judgment and desire to enter into or resist certain business combinations. In other words, we believe that in the legitimate effort to encourage a reasonable amount of management share ownership, some companies have inadvertently create circumstances which may be counterproductive or may increase the possibility of management acting in an overtly self-interested way.
To summarize, the principal philosophical and practical reasons for implementing ownership guidelines in a public company environment are:
1) To achieve a mutuality of financial interest with other shareholders; 2) To encourage longer-term thinking and strategic decision-making; 3) To achieve a balance between financial risk and potential compensation rewards; 4) To reinforce the sense of teamwork and partnership among key employees; 5) To address the interest of institutional and individual investors regarding management's commitment and outlook for the future; 6) To acknowledge the legitimate marketplace concern about management accountability and appropriate compensation. These are powerful reasons to insist that an appropriate level of management ownership be achieved and sustained.
While doing so, however, companies and their Boards should be cognizant of the important variables that will influence their definition of optimal levels of management ownership. These include management ownership history, current levels of shareholdings, potential ownership upon the exercise of outstanding stock options and/or vesting of other stock awards, levels of cash compensation and stock price volatility. These factors should be supplemented by an understanding of the financial profile of management personnel in context of their industry, corporate culture and investment sophistication. By taking all of these factors into consideration, Boards and Compensation Committees will more wisely influence and direct corporate policy in the area of required stock ownership. The wisdom of this policy will then be more clearly seen as promoting the best interests of all shareholders. © 1998 GK Partners Inc.
Directorship APRIL 1995
The Compensation Committee
In recent days, we have heard and read much about the issue of reasonable executive compensation in the "new age of corporate accountability." The burden of responsibility for administering management pay programs in public corporations has historically fallen upon the Compensation Committee of the Board of Directors.
For the most part, these committees have taken their responsibilities seriously and made their decisions fairly. However, the independence of these committees has been in question, and even when the Committee has acted independently, its decision process has often been informal. Inadequate documentation of the information received by the Committee and of its deliberations is also a frequent problem. This article intends to address these concerns by offering a few simple suggestions regarding the structure and functioning of an effective Compensation Committee. Hopefully, these ideas will be useful to those serving on Boards and to those responsible for supplying directors with needed information.
The primary objectives of the Compensation Committee of the Board are threefold:
To provide guidance and direction for all executive compensation and benefit programs affecting officers and other key employees of the corporation;
To review all Board fee arrangements, and other compensation and benefit programs for directors; and
To make recommendations to the full Board of Directors concerning these programs and individual compensation actions thereunder.
The primary function of the Committee is to assure an internally consistent and externally competitive executive compensation program in order to attract and retain qualified executives and Board members, and to provide incentives for the attainment of corporate business objectives.
The actions of the Compensation Committee should be consistent with the company's overall business strategy and compensation policy. Subject to the reservation by the Committee of the approval of the specific individual actions discussed below, the day-to-day administration of the executive compensation and benefits program should be the responsibility of the company's management team (through its human resources function).
The Committee should consist of at least three outside (non-employee) directors of the company, appointed and reviewed by the Board of Directors on an annual basis. Directors with significant Board and Committee experience should be given strong consideration for this important assignment. Ideally, these Directors should be selected to avoid "interlocking" relationships between the company and other corporations on whose Boards the company's management sits.
Most members of the Committee can be reappointed for several years (since there is great value in continuity and experience in this essential area of corporate governance) with one member rotating off perhaps every three years. With each annual appointment of the Committee, the Board should select one member to be Chairman of the Committee. Or such selection may be delegated to the Committee itself. The selection of Committee Chairman is particularly important, since the results of the Committee's efforts are in direct proportion to the leadership and quality control exercised by the Chairman.
Variety of Tasks
The Committee performs a variety of very important tasks. It reviews and approves the compensation of each senior executive of the company and other key employees (often identified by an annual rate of base compensation which exceeds a predetermined threshold) taking into consideration both the company's results and individual performance, as well as any other factors that may, in the Committee's judgment, be appropriate. The Committee is responsible for reviewing management's recommendations for the granting of stock options and other equity awards under various stock plans. It also reviews and acts on management's recommendations for the award of cash incentive compensation under any of the company's short-term or long-term plans.
The Committee can commission the development of (and recommend to the full Board for approval) any new or modified stock incentive plan, short-term or long-term cash incentive plan, profit sharing or deferred compensation plan, and any other executive compensation vehicle.
In that connection, the Committee should (in consultation with management) specifically designate the participants, performance criteria, target awards, payout schedule and the like for all incentive compensation plans that it develops or oversees. In some companies, the Committee also takes the lead in managing and reviewing the company's executive development and succession planning programs.
Analyzes Market Factors
The Committee must be provided with such resources (including the use of outside consultants) as the Committee deems necessary for the detailed study of marketplace factors and for possible design changes in the company's compensation and benefit plans and programs. It should carefully assess whether any compensation or benefit arrangement with Board members (other than the normal payment of fees for Board service) creates a conflict of interest. It should also set guidelines for the terms of all employment and consulting agreements with managers and directors.
The Committee should meet regularly (two to four times a year) to review the company's progress toward the achievement of annual and strategic business goals. This becomes an even more important Committee function in the current political and economic environment, since the SEC proxy disclosure rules now require the Committee to report to shareholders in narrative language, the company's compensation policies and the specific rationale for the top management compensation decisions made during the previous year. Committee meetings are normally attended by the senior human resources executive of the company and members of his or her staff, as required.
The corporate secretary should also attend all meetings and keep accurate minutes thereof. The secretary should confer with management and the Committee Chairman (as required) to determine the agenda items for each meeting. Along with the meeting notice to Compensation Committee members, the corporate secretary should forward an agenda and backup material related to each agenda item.
Any of management's recommendations for compensation actions should be accompanied by sufficient data to permit the Committee to exercise its informed business judgment. The Committee must consider all such information, as well as the suggestions of management, to make its decisions pertaining to salary adjustments; awards of stock options and stock grants; incentive cash payments; and any other compensation that the Board may consider and approve. In reviewing proposed compensation plan changes, the Committee should take into consideration independent advice and information obtained from reputable consulting or research firms that are involved in the compilation and interpretation of data concerning executive compensation.
In lieu of an in-person meeting, actions of the Committee may be taken by the unanimous written consent of all Committee members. The Committee Chairman should contact the corporate secretary when an action needs to be taken. The corporate secretary should then prepare the appropriate written materials, and circulate them (with related backup data) to each Committee member for signature.
In the event the Chairman elects to convene a Committee meeting by telephone, he should advise the corporate secretary of the purpose of the meeting and request that he or she schedule the telephone meeting with all Committee members and any participating management personnel. The Chairman of the Compensation Committee should report to the Board of Directors all compensation actions taken (since its previous report) at the next regular Board meeting.
By adhering to these common sense principles and guidelines, the Compensation Committee will be a knowledgeable and effective resource to the Board, and will be able to effectively discharge its responsibilities in the best interests of the company, its shareholders and employees. The Committee's performance is being scrutinized by shareholders, industry analysts, competitors and regulators alike, and is increasingly important in assuring the fair and reasonable administration of executive compensation in today's corporate business environment. © 1995 GK Partners Inc.