Capped Stock Awards: The Next Generation

Capped Stock Awards: The Next Generation Wednesday, February 20th, 2013 Dan Kapinos, Radford / Aon Hewitt Jon Burg, Radford / Aon Hewitt

Agenda What are Capped Awards? Options Shares Performance Shares Governance Considerations Tax Considerations Accounting Considerations Case Studies

What are Capped Stock Options? Capped Stock Options or Stock Appreciation Rights (SARs) are an appreciation vehicle that can limit the total payout delivered in the future at some multiple For example, assume a grant of 300 stock options with a strike price of $10 and a 300% payout cap, the payout curve looks like this

What are Capped Shares? Capped Shares can collar the payout that you want delivered in the future For example, assume a grant of 100 shares and a 300% payout cap, the payout curve looks like this

What are Capped Performance Shares? Capped Performance Shares limits the dollar value delivered in the future at the end of the performance period • For example, assume a target grant of 100 shares that can range from 0% of target to 200% of target • The cap is a function of both the # of shares delivered, and the future stock price • Summarizes a 500% payout cap • Assumes maximum vesting of 200% occurs at a stock price of $17 (a 70% appreciation)

Strategic Reasons for Capped Awards Lowers accounting expenses without lowering perceived value to participants Leverage and upside opportunities similar to those of options Efficient use of shareholder resources Capped upside potential mitigates windfall gains Beneficial from a risk management perspective Puts an upper bound on realizable pay Likely to be more important as annual Say on Pay votes drive evolution in pay for performance paradigms But, doesn’t incentivize performance above the cap Management also not penalized if share price subsequently dips below the cap Holding requirements after achievement of cap can ensure that executives remain focused on sustained stock price performance

Strategic Reasons for Capped Awards (cont.) Capping executive pay generally well-received by shareholders and other external observers But limits on upside stock price performance are also viewed negatively When coupled with a stock appreciation right (“SAR”) vehicle, awards have additional benefits Limits share usage/dilution Caps dilution at a known level Executive not out-of-pocket for exercise price Company doesn’t receive cash associated with exercise Important note: SARs should be settled in stock; cash settled SARs remain very unattractive from an accounting perspective

Board and Governance Considerations What is an appropriate cap? Depends in part on rationale behind the cap (windfall gains, accounting expense, shareholders) Importance of modeling out future scenarios, particularly at upper ranges of the cap Communication and perception of cap Internal audiences Management doesn’t participate in share price appreciation above the cap External audiences Prior to Committee approval and adoption, should review sample disclosure language showing how the award will be disclosed in public filings

Board and Governance Considerations (cont.) Anticipated behavior when cap is reached Board should understand potential exit scenarios and how these will be perceived, particularly by external audiences Consideration should be given to what happens if the cap is achieved on an unvested award Are additional vesting or holding requirements necessary / appropriate? Accounting implications Are you getting the most bang for your buck? Particularly important when award contains performance-vesting features As with all equity awards, are you confident that the valuations you are reviewing will be held up following audit?

Board and Governance Considerations (cont.) Unless award is premium-priced (at least 25%) or also contains additional performance vesting provision, award not generally viewed as a performance-based vehicle by ISS Also, ISS calculates its own valuations for equity awards – may or may not agree with the company’s valuation of the award

Grant Considerations Carefully consider whether to use the capped or uncapped valuation for purposes of converting desired dollar value of award to units on the date of grant Perception / Fairness If program participants perceive cap as unachievable, concerns over disconnect between valuations are mitigated Benchmarking Disclosure in CD&A and related compensation tables Dilution Accounting expense

All bullets on this slide are courtesy of Baker & McKenzie Tax Issues with Capped Awards – U.S. Capped SARs – taxed before exercise if is vested and cap is reached Should consider automatic exercise upon Cap Company can then withhold from exercise proceeds/shares Ensures that taxable event to employee matches timing of tax deduction to employer Should discuss capability of equity administration system Capped Options - Likely taxed only at exercise, but no official guidance Capped Shares & PSUs – No special issues due to cap

Capped Awards - Accounting Considerations Generally, capped awards are treated no differently under ASC Topic 718 than uncapped awards. However, a capped award (Options, Shares, or Performance Shares) is inherently worth less than an uncapped award ASC Topic 718 requires the consideration of all of the terms and conditions of the award Therefore, it will require Monte Carlo simulation to determine the fair value of capped awards (in some limited cases, adjustments to a binomial model or Black-Scholes model may be sufficient)

Capped Options – Expected Valuations Reduction in valuation under ASC Topic 718 is largely a function of your expected volatility, and more volatile companies can expect a larger discount • Intuitively, note that the reduction increases as the volatility increases and the cap level gets reduced • For example, a company with an expected volatility of 60% and a 300% payout cap could anticipate a reduction in the accounting valuation of approximately 21%

Capped Shares – Expected Valuations Reduction in valuation under ASC Topic 718 is largely a function of your expected volatility, and more volatile companies can expect a larger discount • Intuitively, note that the reduction increases as the volatility increases and the cap level gets reduced • For example, a company with an expected volatility of 60% and a 300% payout cap could anticipate a reduction in the accounting valuation of approximately 13%

Capped Performance Shares – Expected Valuations Reduction in valuation under ASC Topic 718 is largely a function of your expected volatility, and more volatile companies can expect a larger discount • Shares can range from 0% to 200% • Intuitively, note that the reduction increases as the volatility increases and the cap level gets reduced • For example, a company with an expected volatility of 60% and a 400% payout cap could anticipate a reduction in the accounting valuation of approximately 25%

Capped Options:Value Considerations Since a capped option is less valuable (21% in our example), what if we granted more options to reflect for the takeaway to the participant: Base Case: Assume 300 uncapped options with a strike price of $10 Scenario 1: Assumes, 300 capped options are granted with a 300% payout cap (i.e. when the stock price gets above $30, no further value is delivered) EXAMPLE: Uses a 300% payout cap and a 60% volatility

Capped Options: Value Considerations (cont.) Scenario 2: Accounting value neutral such that the total accounting value of the capped options is the same as the uncapped options (i.e. You get MORE options!) Scenario 3: Shared reduction in cost such that 50% of the accounting reduction is shared between the employee and the company 21% represents the discount because of the cap

Capped Options:Value Considerations (cont.) • What would you choose? 300 uncapped options or 380 capped options • The capped options are more valuable until a $36 stock price is exceeded • The capped options will be more valuable 93% of the time

Capped Options:Value Considerations (cont.) We have only illustrated the consideration of value for stock options. However, shares and performance shares have a very similar effect. Anecdotally, I believe that the majority of participants would select more capped awards, rather than the uncapped awards if given the choice, as my impression of the loss in perceived value of the cap is minimal.

Capped Performance Shares (prevalence) Below are several companies that have implemented them and their associated SEC filings:

Urban Outfitters – Case Study Grants of Capped Restricted Awards Background / Rationale Grants of Capped SARs Background / Rationale International Considerations Communication Challenges Other Institutional Shareholder Reaction (if any)

Urban Outfitters – Case Study • Founded in Philadelphia, PA in 1970 • Went public in 1993 (NASDAQ: URBN) • FY’12 revenue: $2.5B+ • Five Brands: • 400+ stores in North America and Europe • Sell worldwide via Direct-to-Consumer

Urban Outfitters – Case Study • Equity is an integral component of our compensation strategy • “Anti-Cash” philosophy, preferring aligned performance over “I’m still here” • FAS123R altered granting behavior • High volatility/”expensive” valuations required creative instrument design

Urban Outfitters – Case Study • Capped SARs • First used for employee and new hire grants in 2009: • “500% Cap on Appreciation Proceeds” • Grant prices ranged from ~$28 to ~$35 • Term of seven or eight years, depending on grant • Exceeding cap would put URBN>$100/share • Time will tell … effectiveness of communication, as well as impact of cap

Urban Outfitters – Case Study • Capped PSUs • URBN Incentive Plan does not allow multi-year cash awards • Desire to mimic multi-year incentive plan through equity: • Performance-based • Market-aligned • Defined upside … similar to cash-based incentive plans • Complex, but clearly communicated to sophisticated population: “Limit on common shares registered at vesting…” • Tax efficiency for URBN and employees

Case Study: Genworth Financial, Inc. • Company Background: • Genworth Financial, Inc. (NYSE: GNW) is a leading Fortune 500 insurance holding company dedicated to helping people secure their financial lives, families and futures. Genworth has leadership positions in offerings that assist consumers in protecting themselves, investing for the future and planning for retirement -- including life insurance, long term care insurance, financial protection coverages, and independent advisor-based wealth management -- and mortgage insurance that helps consumers achieve home ownership while assisting lenders in managing their risk and capital. Genworth operates through three divisions: Insurance and Wealth Management, which includes U.S. Life Insurance, Wealth Management and International Protection segments; Global Mortgage Insurance, which includes U.S. and International Mortgage Insurance segments; and the Corporate and Runoff division. Its products and services are offered through financial intermediaries, advisors, independent distributors and sales specialists. Genworth Financial, Inc., which traces its roots back to 1871, became a public company in 2004 and is headquartered in Richmond, Virginia. • Award Guiding Principles: • Incentives should align executives with stockholder interests across multiple timeframes • Pay at-risk should reflect an executive’s impact on company performance • Pay opportunities should be competitive within relevant marketplace • Our structure should allow for the exercise of discretion, where appropriate • Incentives should support appropriate risk management practices Key Statistics

Case Study – Capped SARs As An Alternative To Traditional SARs orStock Options • Situation: • Historically mixed LTI vehicles (SARs/Options, RSUs, Perf. Plan) • Emphasis on traditional SARs for executive officers for stockholder alignment • High stock volatility increased grant expense, reducing the efficiencies of traditional SAR/option use • Black Scholes value was approximately 70-80% of stock price • Stock price levels drove desire to maintain a leveraged incentive that rewards price appreciation

Genworth – Key Guideposts To Finding A Solution • Stockholder Alignment / Maintain Pay for Performance • Leverage • Reward price increases • Higher-order metrics with strategic flexibility • Expense & EPS Impact • Full grant expense & loaded run-rate • Avoid expense line volatility (mark-to-market) • Competitive Opportunity • Impact on perceived value • Building long-term value also supports retention • Manage Share Pool • Diminishing pool • Efficient use of shares

Genworth – Capped SARs As The Solution • Evaluated alternatives such as mix with restricted stock units (RSU), performance stock units (PSU), market stock units (MSU) or cash. • Implemented Capped Stock Appreciation Rights (Capped SAR) • Time-vested, stock-settled SAR with a maximum per share value • Adding cap significantly reduced our Black-scholes expense given high volatility • Cap set high enough to achieve corporate goals while not materially reducing the participant’s perceived value/opportunity • Able to maintain significant leverage & alignment with price-appreciation

Capped SARs – Key Administrative Considerations • Why SARs not options? • It seemed easier…right to a value, not a right to purchase • Also less dilutive • Enforcing the cap • Auto exercise if cap achieved and vested, or if above cap when award vests • Re-tool SAR administrative process to ensure maximum value per share not exceeded • Tax withholding & global implementation • Statutory minimum rate • Defining FMV at exercise for SARs separately

Contact Information Dan Kapinos (215) 215-1874 dkapinos@radford.com Jon Burg (415) 486-7137 jburg@radford.com 32

Capped Stock Awards: The Next Generation