DESIGN A SUCCESSFUL COMPENSATION SYSTEM

1. DESIGN A SUCCESSFUL COMPENSATION SYSTEM August 17, 2004

2. TODAY’S DISCUSSION • Compensation Philosophy • What is a comp philosophy? • Why do we need one? • How to develop one for your company • Compensation Systems • What makes them successful? • Four fundamental components • Program design examples • After the Design – What’s Next • Tips for effective administration • Managing change

3. COMPENSATION PHILOSOPHY • What is a compensation philosophy? • Articulates what the company believes about how its employees should be treated financially • Provides guiding principles for designing cohesive compensation programs • Lays out what is important to the company • Communicates a consistent and clear message • Should be backed up by the company’s actions

4. COMPENSATION PHILOSOPHY • Your stated philosophy should reflect the company’s intentions and set expectations for employees. Example statements: • Efforts will be recognized, but results will be rewarded. • Employees with the greatest level of sustained performance receive the greatest rewards in pay. • Solid performers will be targeted at 50th percentile. Top performers will be targeted at 75th percentile. • By linking pay opportunities to clearly outlined individual performance objectives, we offer every employee an equal chance to succeed. • All employees should share in the financial success of the company. • Our compensation programs are globally focused, locally competitive. • We want all employees to think like owners, which is why we award stock options to every employee.

5. COMPENSATION PHILOSOPHY • Why do you need an explicit compensation philosophy? • Managers might be making compensation decisions that are not in the best interests of the company as a whole • There may be an implicit philosophy that isn’t consistent across the company • Look at employee communications over the years • Informally survey top managers of the company • What do the current compensation programs look like and what do they “say” about the company’s beliefs? • Does the corporate culture offer any clues?

6. COMPENSATION PHILOSOPHY • How do we develop a compensation philosophy? • Interview senior management and Board of Directors • Business objectives, current and future • Desired employee behaviors to accomplish those objectives • Competitive environment and desired positioning • Recruiting or retention issues • Pay elements and desired mix • Outline current rewards programs • Where are we now? • Where do we want to be? • How do we get there?

7. COMPENSATION PHILOSOPHY • Example: Comp Philosophy Worksheet

8. COMPENSATION PHILOSOPHY • When might your compensation philosophy change? • Leaving start-up phase • Major change in your business model • Business and headcount growth that outpaces expectations • Following a merger or major acquisition

9. COMPENSATION SYSTEMS • What is a successful compensation system? • Supports the company’s compensation philosophy • Enables the company to compete for the talent it needs to be successful • Provides sustainable compensation programs • Allows the company to meet its financial goals • Flexible enough to accommodate changes in the company or marketplace • Motivates and rewards complementary objectives over the short and long term

10. COMPENSATION SYSTEMS • Four fundamental reward categories make up the typical compensation system: • Base Salary • Annual Incentives • Long-Term Incentives • Benefits & Perquisites Base Salaries Benefits & Perquisites Total Rewards Annual Incentives Long-Term Incentives

11. BASE SALARY • Being Competitive • What does “competitive” mean? • Winning the talent contest • Winning the business contest • How do you know if your company is competitive? • Surveys of compensation for your particular industry • Association websites or studies • Outside offers made to employees • Making counter-offers • Exit interviews • New hire salary history

12. BASE SALARY • Being Competitive • When is it okay to pay above competitive? • Check your company’s performance • Losing mission critical employees or prospects • Remember, base salary decisions are difficult to undo • What if you can’t afford competitive base salaries? • This is where a bonus plan can make a difference • Do you have any kind of equity compensation to offer? • What about other rewards? • Quality-of-life: flex time or every other Friday off • Career development: training or education allowance • Corporate culture and work atmosphere

13. BASE SALARY • Staying On Target • Put some structure around salaries • Group jobs together with similar market salaries and internal value • Set a minimum, midpoint, maximum range for each grouping • Low end of range: inexperienced or newly promoted employees • Middle of range: fully-competent employees with consistent performance • Upper end of range: superstars who are experts at their job and show sustained overachievement

14. BASE SALARY • Example: Salary Structure

15. BASE SALARY • Staying On Target • Conduct an annual review of base salaries • Ensures we stay on the mark for our desired positioning • Helps us win the talent we need to be successful • Credibly reassure employees that salaries are keeping up with the market • Credibly reassure management that we are responsibly managing our compensation dollars

16. BASE SALARY • Staying On Target • Systematic merit and promotional increases • Links individual performance review to salary progress • Enables precise management of increase budgets; less guesswork • Gives managers tools to assess trade-off decisions • Minimizes abuse of promotions

17. BASE SALARY • Example: Merit Increase Matrix

18. ANNUAL INCENTIVES • A well-designed annual incentive plan should meet several objectives: • Provide a systematic approach to incentive pay that links company and individual (or team/department) performance • Allow employees to benefit financially when company meets or exceeds its short-term goals • Support and reinforce the financial planning and goal setting process • Strengthen and support the individual performance management system • Use company’s cash wisely • Not a fixed cost like base salaries • Provides cash awards only when company performs well • Limits cash payments when company does not perform well

19. ANNUAL INCENTIVES • Example: Annual Incentive Plan • Here is an example of a simple, three-step annual incentive plan. For this plan, there are three things that determine annual bonus payouts. • Let’s walk through the mechanics of a plan like this. Distribute Bonuses Based on Individual Performance Evaluate Company Performance Establish Total Company Bonus Pool 1 2 3

20. ANNUAL INCENTIVES • Example: Annual Incentive Plan • Establish target incentive levels for participants • Each participant is assigned a target incentive award expressed as a percent of base salary. • If base salaries are below competitive, we might use incentive targets that are higher than competitive. • For private companies that don’t have stock options to offer, we might also use higher than competitive incentive targets. • *Incentive targets for illustration only*

21. ANNUAL INCENTIVES • Example: Annual Incentive Plan • Define company performance objectives • Two key measures used to create an award payout matrix • Net income or net income growth year-over-year • Revenue or revenue growth year-over-year • Pre-tax profits • New or repeat customers • Payout matrix defines the relationship between the performance targets and the resulting bonus pool funding • Determine minimum company performance required to fund the bonus pool, the target performance level, and the maximum or cap

22. ANNUAL INCENTIVES • Example: Annual Incentive Plan • Define company performance objectives • A hypothetical payout schedule is shown below. • At target company performance, the bonus pool will be funded at 100% of each participant’s target incentive percentage. • To reach the minimum performance threshold, this company needs to achieve 80% percent of both targeted revenue growth and pre-tax profits. • *Payout schedule for illustration only*

23. ANNUAL INCENTIVES • Example: Annual Incentive Plan • Determine bonus pool • Once the company has assessed its overall performance at the end of the plan year, target incentives are adjusted upward or downward using the matrix. • If this company achieves 95% of its profit goal and 105% of its revenue goal, the “initial” incentive awards will be funded at 95.3% of target. • *Payout schedule for illustration only*

24. ANNUAL INCENTIVES • Example: Annual Incentive Plan • Assess individual performance • Early in the year, managers and employees set three to five performance objectives for the employee (or team/department). • To be eligible for an award at the end of the year, employees must perform at a level equal to or greater than “Meets Objectives”. • Poor performers don’t receive an award, even if company meets goals. • Each level of performance has an associated multiplier that is used in the final award calculation.  THRESHOLD

25. ANNUAL INCENTIVES • Example: Annual Incentive Plan • Calculate incentive awards

26. LONG-TERM INCENTIVES • The goal is to design a well-balanced set of programs that motivate and reward complementary objectives over both the short term (one year) and long term (three-to-five years). • Two categories of long-term incentives • Cash-Based • LTI cash • Performance units • Stock appreciation rights • Equity-Based • Stock options • Restricted stock • Stock appreciation rights

27. LONG-TERM INCENTIVES • Cash-Based Incentives • Require ability to set long-term company and individual goals (3 to 5 years) • Goals are often expressed relative to industry or peer company performance on various measures: • Growth • Revenues • Profitability • Total return to shareholders • Good performance linkage, but potential drain on cash flow • Provide a retention hook longer than the annual incentive plan • Enable private companies to compete with stock option grants

28. LONG-TERM INCENTIVES • LTI Cash Plans • Long-term cash-based plan, designed to pay out after 2-3 years based on attainment of performance measures. • Plans generally have overlapping cycles, which maintains the retention value of the plan from year to year and does not create a "down year" after the first 3-year period, as payouts are made each year after the first plan cycle is complete. • Year 1: Plan Cycle 1 starts. • Year 2: Plan Cycle 2 starts, Plan Cycle 1 continues. • Year 3: Plan Cycle 3 starts, Plan Cycle 2 continues, Plan Cycle 1 pays out. • The plans can use internal metrics, external metrics, or both to determine payouts.

29. LONG-TERM INCENTIVES • LTI Cash Plans • Setting performance goals three years in advance can be difficult. • These plans typically require a cash outlay, which can be intimidating for companies with limited cash. However, the cash impact can be managed by: • Designing self-funding plans with payout contingent upon earnings, among other performance measures. • Discounting the value delivered to reflect the lack of market risk to the employee. • Paying the awards in stock (typically net of taxes) rather than cash.

30. LONG-TERM INCENTIVES • Performance Unit Plan • Long-term performance plan denominated in units and paid in cash. • Employees earn “units” based on the attainment of company defined performance goals over a given performance period. • Either the value of the units or the number of units to be granted is determined prior to start of the performance period. • Performance period is generally greater than 2 years and less than 5 years. • Eligible employees must remain with the company for the duration of the performance period to earn the units. • Employee is taxed when the units are earned and the company receives an equivalent value tax deduction.

31. LONG-TERM INCENTIVES • Performance Unit Plan • Example: • Target award of 10,000 units dependent on 3 year profit and revenue growth versus goal • Actual award can range from 0 to 20,000 units depending on performance • Unit value is fixed at $10.00 • Performance exceeds the goals at the end of the period, and the employee earns 15,000 units • At a $10 per unit value, the employee receives $150,000 in cash

32. LONG-TERM INCENTIVES • Performance Unit Plan • Advantages: • Links company and employee performance with long-term payouts • Can pay out in cash or shares • Disadvantages: • These are generally complex plans and communication may be difficult • A weak performance review process may create a sense of ambiguity on vesting conditions

33. LONG-TERM INCENTIVES • Stock Appreciation Rights • Right to receive appreciation of stock price over specified base price, paid in either cash or stock. Like options, except that rather than paying to exercise the option, the participant is paid the gain in either cash or stock. • Advantages: • Can mimic options without using shares • For employees in countries with significant regulatory or tax burdens on options • Accounting charge equals only the appreciation in the stock’s value • Disadvantages: • May involve cash cost to company, if gain is paid in cash rather than shares • Relatively complex and may be difficult to communicate to employees

34. LONG-TERM INCENTIVES • Equity-Based Incentives • Allow employees to benefit financially from the creation of long-term value in the company • Opportunity for significant cash gains • Provide a retention hook for key employees • Another way to reward employees who contribute to the company over the long term • Can get employees thinking like shareholders • Challenging to link individual performance directly to stock price

35. LONG-TERM INCENTIVES • Stock Options • New accounting pronouncements regarding stock options are causing companies to rethink their equity compensation strategies. • Financial Accounting Standards Board (FASB) • Released long-awaited exposure draft on equity compensation • If adopted, effective date for most companies would be next year • Companies would recognize an accounting expense for stock options on their income statements • Now determining how companies would calculate that expense • Black-Scholes model: currently most common method • Lattice models: FASB’s preference

36. LONG-TERM INCENTIVES • Stock Options • The results of Presidio Pay’s recent Pulse Survey suggest a delay in making decisions. • Majority of the companies have not made any changes to their equity compensation practices • None of the surveyed companies are planning on expensing stock options prior to FASB’s deadline • Many companies anticipate eventually making some changes, such as: • Reducing stock option grants across all employee groups • Limiting participation in equity incentives below the manager level • Attaching performance criteria to vesting conditions • Granting some form of restricted stock

37. LONG-TERM INCENTIVES • Stock Options • Before making decisions about future stock option usage, look at the big picture. • Why did we start giving employees stock options in the first place? • Create an ownership culture • Deliver compensation or create wealth • Recruit and retain employees • What are the challenges associated with expensing? • Achieving the original goals of the option plan • Reducing the impact on company financials • Are options still practical? • Can you accomplish your goals with fewer stock options? • If not, is a complete change in the type of equity incentive feasible?

38. LONG-TERM INCENTIVES • Company Considerations • Financial modeling • Multi-year economic impact of various equity incentives • Compare various valuation methodologies, using a variety of vesting and stock price performance scenarios • Project overhang, run-rate, and share usage over a three to five year period • Detailed review of plan documents • Make sure current or proposed plans provide sufficient share reserves and allow necessary plan features to implement desired strategy • Reaction by the Board of Directors • Compensation Committees are becoming much more involved in the broad based compensation strategy

39. LONG-TERM INCENTIVES • Employee Considerations • Understand how new programs or changes to existing programs will impact employees • Are you accomplishing your intended goals for your employees? • Review the effect various equity incentives will have on specific employees’ compensation levels relative to historical and/or competitive pay levels • Review tax burdens that may be imposed on employees • Remember the perception issue • Programs should be consistent with the communicated compensation philosophy • Communicate well in advance of implementation, providing details on why changes were made

40. LONG-TERM INCENTIVES • Restricted Stock • Grant of stock that is restricted from sale until it is vested. If vesting requirements are not met, stock is forfeited. • Why to use • No cost to the employee • Stock retains some value even if the stock price declines • Fixed and precise accounting cost; no estimates • Need less shares than options to satisfy total value delivered • Why not to use • Retention tool with little incentive value (“pay for pulse”) • Employee taxed at vesting • No risk to employee

41. LONG-TERM INCENTIVES • Example: Restricted Stock • The following chart illustrates the impact to the employee of replacing stock options with restricted shares. Given the assumptions and methodology for determining an equivalent value, replacing 7,500 stock options with 2,000 restricted shares would provide an employee with the same value after four years.

42. LONG-TERM INCENTIVES • Example: Restricted Stock • The final outcome of this exercise leads to a number of conclusions. • Company • Expense on restricted stock grant less than expense on stock options • Using fewer shares will reduce dilution • Turnover from underwater stock options disappears • Employee • Employee receives same value at the end of four years given moderate stock price growth • Maintains the ownership mentality that options provided • Time-based vesting creates an incentive to stay with company • Option value will eventually surpass the restricted stock value if the stock price shoots way up, but the risk is much lower

43. BENEFITS & PERQUISITES • Benefits & Perquisites • This is one area of missed HR “marketing” opportunity. Few employees know the actual dollar cost to the company of their benefits, which typically add another 30% in value to the total rewards package. • Health and welfare protection • Helps attract employees, especially those looking to cover family members • Most companies subsidize the cost of health insurance • Retirement programs • Assist employees in saving for retirement • Provide a current tax benefit • 401(k) plans are the predominate retirement vehicle • ESPP • Profit sharing

44. BENEFITS & PERQUISITES • Benefits & Perquisites • Miscellaneous perks • Not just for executives • Car allowances • Gym membership or subsidy • Free or discounted company product • Employee cafeteria or snack room goodies • Flexible schedules • Telecommuting • Nursing mothers room

45. AFTER THE DESIGN • Tips for effective administration • Articulate career paths • Helps retain key employees by demonstrating clear opportunities for growth and financial progression • Establish consistent titling criteria to accurately reflect expected contribution (and compensation) levels within the company • Acknowledges levels of contribution • Rewards exceptional performers with meaningful titles • Give managers tools and training they need • Manager buy-in is the key to positive employee perception • Believing you are treated fairly and consistently is as important as believing you are paid well

46. AFTER THE DESIGN • Managing Change • Mergers & Acquisitions • Start now, because deals move fast and sometimes HR is the last to know • Make sure salary structures are current • Think about how to integrate annual incentive plans • Update equity plan projections: overhang, run-rate, projected share usage • Executive change-in-control agreements • Business Model Changes • Shift in jobs overseas • Moving from growth company to mature market

47. QUESTIONS?

48. KYLE HOLM • Kyle Holm is a Principal and Consultant with Presidio Pay Advisors, where he consults on the design of cash and stock-based compensation programs for a varied range of public and private companies. His work covers all elements of compensation including base salary, annual incentives, and long-term incentives with significant expertise in stock option allocation modeling. • Prior to co-founding Presidio Pay Advisors, Kyle held consulting positions with Watson Wyatt Worldwide and WestWard Pay Strategies. Previously, Kyle worked as a portfolio administrator for an investment management firm. • Kyle earned a bachelor's degree in finance from Santa Clara University. Kyle Holm • (415) 438-3401 • kyle@presidiopay.com

49. BROOKE GREEN • Brooke Green is a Principal and Consultant with Presidio Pay Advisors, where she provides consulting advice and implementation assistance to clients with compensation support needs. Her particular focus is on the design, communication, and execution of broad-based compensation programs within public, private and non-profit organizations. • Prior to co-founding Presidio Pay Advisors, Brooke was an independent consultant offering on-site compensation program design and launch assistance to Bay Area companies. Previously, she was a consultant for WestWard Pay Strategies in San Francisco, where she specialized in the evaluation and design of executive compensation and broad-based employee programs. She has served as an internal consultant to HR executives in telecommunications, technology, financial services, and non-profit organizations. • Brooke received an M.B.A. from the Cox School of Business at Southern Methodist University. She also holds a Bachelor of Arts from the University of Texas at Austin. Brooke Green • (415) 438-3403 • brooke@presidiopay.com