Greg Callow Matt Faulkner Dana Gies Mary Mumcuoglu Marcel Nugent Tracey Weiler

1. Stock Options & Management Compensation Greg Callow Matt FaulknerDana Gies Mary MumcuogluMarcel Nugent Tracey Weiler Management Compensation • motivate employees to high levels of performance, • help retain executives and allow for recruitment of new talent, • base compensation on employee and company performance, • maximize employee’s after-tax benefit and minimize employee’s after tax cost, and • use performance criteria over which the employee has control. Stock Options Defined …securities issued by a company that carry the right, but not the obligation, to buy a certain amount of shares in the company at a predetermined price… Lessons Learned • No longer reserved for executive suite • Still popular, even after the dot-com crash • Can be expensive to exercise • Two common types of plans • Nonqualified stock options • Qualified, or “incentive” stock options (ISOs) • It’s usually smart to hold options as long as you can • There may be compelling reasons to exercise early • Stock options aren’t your only option for compensation

2. Stock Options & Management Compensation Greg Callow Matt Faulkner Dana Gies Mary Mumcuoglu Marcel Nugent Tracey Weiler

3. Agenda • Learning Objectives • General Overview • Controversy • Accounting Treatment • Lessons Learned • Questions

4. Learning Objectives • Gain understanding of stock options and management compensation • Recognize the differences between past and current accounting treatment of stock options • Become familiar with stock option implications as they relate to employee and employer

5. Management Compensation Purpose: • motivate employees to high levels of performance, • help retain executives and allow for recruitment of new talent, • base compensation on employee and company performance, • maximize the employee’s after-tax benefit and minimize the employee’s after-tax cost, and • use performance criteria over which the employee has control.

6. How many of you have stock options in your company? How many of you would like to have stock options in your company?

7. Types of Plans • Direct Awards of Stock • Compensatory Stock Option Plans (CSOPs) • Employee Stock Option Plans (ESOPs) • Stock Appreciation Rights Plan (SARs) • Performance-Type Plans • Incentive Stock Options – ISO • Nonqualified Stock Options - NQS

8. Stock Options Defined …securities issued by a company that carry the right, but not the obligation, to buy a certain amount of shares in the company at a predetermined price… • The strike price is typically set near the market price of the stock on the day the option is granted • Employees must typically wait a specified vesting period before being allowed to exercise the option

9. Stock Option Motivations The idea behind stock options: • To motivate employees…increase performance • To offer uncapped potential gain through increased stock price • To allow companies to retain talent in the early years • To foster a culture of employee ownership • To align incentives between the employees and shareholders of a company

10. Long term growth Investment growth Seek what is in the best interests of the company Bonus based on short term results such as earnings growth Seek what is in the best interests of themselves Shareholders vs. Managers Stock options attempt to better align interests of employees with shareholders by maintaining a long term growth potential

11. In Practice • Closely-held companies often issue stock options • IPO driven • Public companies • Some industries, it has become standard practice such as in high-tech From 1997 to 2002, use of stock options in Canada more than doubled from 25% to 59%

12. Can anyone think of the main reasons for what was good in theory, but ended up being bad in practice?

13. The Good vs. The Bad • Focus remained on quarterly performance rather than on long term • Were allowed to sell stock after exercising options • What do you think about amending option plans to require employees to hold their shares for a year or two after exercising them? • Tax laws allowed managements to manage earnings by increasing the use of options instead of cash wages • If a company wished to maintain its EPS growth rate and they thought it might be difficult to do so, they could implement new option programs thus reducing growth in cash wages.

14. The Ugly • Option abuse has 3 major adverse impacts: • Oversized rewards given by servile boards to ineffective executives • In earlier years, BODs allowed executives to exercise and sell stock with less restrictions than those placed on lower-level employees • Repricing options rewards underperformers at the expense of the common shareholder • Repricing “out of the money” options in order to keep employees from leaving • Who will reprice the shareholders’ shares?

15. The Ugly cont… 3. Increases dilution risk as more and more options are issued • EPS dilution from an increase in shares outstanding • Earnings reduced by increased interest expense • Management dilution – management spending more time maximizing option payout and financing stock repurchase programs than running the business

16. The Ugly cont… Options only align the interest of employees with shareholders if they are structured so that flipping is eliminated and the same vesting and selling rules apply to every employee, whether C-level or janitor

17. Accounting Treatment • To Expense or Disclose? • Should employers expense stock option costs in calculating net income? • Employers already disclose the cost in the notes to the financial statements and must show the potential impact on earnings. • Expensing options significantly reduces EPS • Companies can deduct for tax purposes • GAAP doesn’t require expense of options Study by Bear Stearns in ‘02 estimates that, had the fair value of stock options been expensed in 2001, aggregate diluted EPS for the S&P 500 would have been reduced 20% Similarly, according to Standard & Poor’s, expensing options would reduce reported 2004 earnings among the S&P 500 by 7.4% while the effect on many technology firms would be much greater. For example, in an August 2, 2004, press release, Intel reported that its second-quarter 2004 profit would have decreased 17% if it had expensed its stock options

18. Accounting Treatment cont… Expensing – voluntary Disclosure - mandatory Expensing – mandatory for public co.’s Expensing – mandatory for US co.’s Expensing – mandatory for private co.’s Fair value or disclose Pre 2002 Jan 1 2002 Jan 1 2004 Jan 1 2005 Aug 1 2005 S. 3870 a) scholes b) binomial US FSAB regulates No standard under GAAP ASB followed the US approach using the fair-value-based accounting method. In 2002, CICA Handbook Section 3870 set standards for the recognition, measurement and disclosure of stock-based compensation

19. Canada • Pre 2002 – no standard under GAAP • Jan. 1 2002 - CICA introduced section 3870 (Canadian Standard): Fair value of the stock options is determined and recorded as compensation expense over the vesting period of the option - starting 2002 • Jan. 1 2004 – mandatory expense for public companies • Jan. 1 2005 – mandatory expense for private companies

20. Cott’s NI before option compensation was $6.14 M in ’02 Including the impact of options decreased NI to a loss of $2.36 M, a decrease of ~140% Nortel reported a net loss of $5.631 B in ’02 Including the impact of options increased this loss to $7.13 billion, an impact of nearly 27% or ~$1.5 B Impact to Cott Corp. & Nortel

21. SFAS. No. 123 (US Standard) • Pre 1995 – choice was up to the company • Then in 1995, the initial proposal surfaced that would require companies to expense the total fair value of options. • There was strong opposition. • Status quo continued and they had a choice: • recognizing on the Income Statement or, • disclosing in a footnote • Amortize total fair value over vesting period of the stock options (SFAS 123 – Revised 2004) • August 1st 2005, required to recognize as an expense on the Income Statement

22. IFRS 2 (International Standard) • Requires all entities to recognize share based compensation as an expense • Fair value method is applied • Improves comparability of financial reporting around the world

23. Disclosure Current Regulations include: • Separate description of multiple plans • where companies have > one stock-based compensation plan • Which options-pricing model is used • Including underlying assumptions • Number and weighted average exercise price of options: • Outstanding at beginning and end of the year • Granted during the year • Exercised, forfeited or expired during the year • Exercisable at the end of the year

24. What potential solutions would you propose? Expensing is only one part, we also need: • ethical management • governance • controls • disclosure • “Expensing Options Solves Nothing”, William Sahlman. Harvard Business Review, Dec. ‘02

25. Accounting Treatment cont… • Real Debate centered around value • Fair value – option pricing models require many assumptions, all of which vary over time • Black-Scholes Model • Timing – when the actual expense is incurred • When awarded? • When exercised? The requirement of stock option expensing is the most controversial standard ever proposed in Canada and in the US (FASB).

26. Valuation • Pre S.3870 • Intrinsic approach • Record expense as the amount that the market price exceeded the exercise price at its grant date • Where market was not > exercise price, companies were not required to record impact • Post S. 3870 • Fair value, using any method • Black-Scholes • Binomial

27. Benefits from stock options are included in employment income in year in which they are disposed  favourable to employees Also popular with employers because there is no immediate cash cost  favourable to employers Taxation Taxation

28. Future direction • Eliminate options altogether • Direct award of stock would eliminate the value debate • Direct award of cash • To reduce the dilutive effect, implement stock repurchase programs

29. Weaknesses • Still not focus employees on long-term financial goals • Little corporate governance • Outside the scope of management controls  • Not immediate benefits

30. Strengths • Motivates and retains employees • Cash is infused into companies when employees exercise their options • Great upside (gain) benefit potential

31. It’s time to play Family Feud…

32. Lessons Learned • No longer reserved for executive suite • Still popular, even after the dot-com crash • Can be expensive to exercise • Two common types of plans • Nonqualified stock options • Qualified, or “incentive” stock options (ISOs) • It’s usually smart to hold options as long as you can • There may be compelling reasons to exercise early • Stock options aren’t your only option for compensation

33. Questions?