Restricted stock: the case for total shareholder return;

Companies that adopt market-based and

performance-based vesting conditions under FAS
123(R) can better reward high-level employees and
create shareholder value--without increasing
accounting costs--say three professionals.
Title Annotation: executive compensation
Author: Suzman, Peter
Date: Dec 1, 2006
Words: 2577
Publication: Financial Executive
ISSN: 0895-4186

In the wake of adopting FAS 123(R), some companies have shifted away from exclusively
granting stock options toward exclusive use of restricted shares or a combination of the two.
From 2003 to 2005, the prevalence of S & P 500 CEOs receiving both stock options and
restricted share awards increased from 33.5 percent to 42.2 percent, according to an Equilar Inc.
survey.

Clearly, companies are searching to improve equity plans by looking at a combination of options
and restricted shares. However, for many senior executives there are better vehicles than simply
a combination of these two familiar alternatives. Companies that design awards with market-
based and performance-based vesting conditions under FAS 123(R) can better reward high-level
employees and create shareholder value without increasing accounting costs.

[ILLUSTRATION OMITTED]

In particular, under the former standard, APB 25, shares that vest based on market conditions
("market-based" awards) were subject in the U.S. to variable accounting. FAS 123(R) has
eliminated this unfavorable accounting treatment. As a result, U.S.-based companies are joining
those in the U.K. and Continental Europe in recognizing the advantages of market-based awards
over service-based awards.

Companies like Time Warner Inc., Pfizer Inc., Campbell Soup Co., Duke Energy Corp. and
Viacom Inc., among many others, are awarding or will be awarding market-based shares as part
of long-term incentive plans to senior executives. The number of companies granting market-
based and performance-based shares is expected to grow dramatically as companies seek to
better align executive compensation to shareholder returns.

Equity-based compensation strategy usually involves six considerations: keeping accounting

costs under control; minimizing the variability of accounting costs; providing perceived value to
employees; retaining employees; creating incentives for employees to increase share value; and
limiting the complexity of plan administration. The following analyzes why market-based shares--
as a key component of long-term compensation to high-level employees--can further these
objectives.

Market-based Share Awards

The two most common market-based share awards have the following structure:
Absolute awards, for which vesting depends on a company's own stock price or total shareholder
return. This is usually structured as a price or return target or hurdle.

Relative awards, for which vesting depends on a company's total shareholder return (TSR) rank
relative to a set of pre-defined peers, or an index of companies in a relevant industry or broader
market. TSR is defined as the return on the company's stock, assuming reinvestment of
dividends.

An example of an absolute award is one where shares are granted when the stock price is $20,
and vest immediately upon the stock price averaging $25 for 30 consecutive trading days at any
time within two years.

A relative award, in contrast, might vest at the end of two years, with the number of vested shares
depending on the company's TSR rank among its peers as follows: beginning with a fixed target
of 10,000 shares, if the company TSR as compared to the TSR of its peers is below the 25th
percentile, then no shares vest; above the 25th percentile, an interpolated amount vests
beginning at 50 percent of the target and capping out at 200 percent of target. Table 1 on this
page shows the payout schedule using 15 peer companies.

With a relative TSR award, the number of shares that the employee will receive varies, depending
on actual relative performance; however, the accounting cost to the company remains fixed
throughout the term of the award.

Companies can apply market-based vesting conditions to a diversity of vehicles including

restricted stock, restricted stock units, stock options or stock-settled stock appreciation rights
(SARs). The key factor in designing an absolute market-based award is appropriately setting the
target price levels. The key factors in designing a relative market-based award are the choice of
payout schedule and relevant peer group. Companies can vary the payout schedule with more or
less differentiation, based on TSR rank.

For example, a flatter schedule might range from 50 percent to 150 percent, according to TSR
rank; a steeper schedule might range from 0 percent below the 50th percentile to 300 percent at
or near the top. When the schedule is flatter, the award has more of the characteristics of a
service-based restricted share award. A steeper schedule makes the award more option-like,
though the underlying driver is relative rather than absolute stock performance.

The peer group for a relative market-based award could be a custom index of a few competitors,
an off-the-shelf industry index such as the S & P media index or the entire set of companies in a
broad market index, such as the S & P 500. Using appropriate sensitivity analysis, companies
can fix the accounting cost up front, and compare the effects of choosing optimal target prices for
an absolute award, or payout schedules and peer groups for a relative award.

A Closer Look at Restricted Stock

Economic factors on three levels generally drive the price of stock, and therefore, the payout of
restricted share awards: 1) the broader market; 2) the relevant industry; and 3) the specific
company. Over any given period of time, the effect of factors in the broader market and/or
relevant industry can crowd out the specific company factors. Consequently, the stock of a
company with problems, including poor management, could appreciate when the market soars.

Conversely, the stock of a company that is very well managed could decline when the overall
market declines or the industry suffers a downtrend. Therefore, service-based restricted share
awards by themselves cannot meet the objective of long-term incentive plans of tightly linking
management performance to the creation of shareholder value.

Further, the signal that Wall Street gets from a company favoring service-based restricted shares
over options or market-based shares is a lack of internal enthusiasm for the future return on the
company stock. Indeed, when Microsoft Corp. declared its intention to move from options to
restricted stock in July 2003, Business Week noted: "The new pay plan is a tacit admission that
Microsoft isn't the growth stock it used to be."

Relative Performance Best Matches Payout to Performance

How can a company mitigate the effect of general market or sector performance on
compensation? The answer lies in using a metric of company performance relative to peer
company performance. A company can use internal performance metrics or market-based
metrics as the basis for comparison to its peers.

Internal performance metrics include operating income, net income or return on equity or capital
employed. Comparison across companies can be difficult or impossible due to the dependency of
internal metrics on company size, the cost and structure of capital, company-specific accounting
methods, strategy and management policy.

Internal metrics can also be volatile and dominated by non-recurring events, such as a write-off
related to an acquisition. Additionally, FAS 123(R) requires that companies reexamine internal
performance metrics each reporting period and evaluate if targets will be met. As the probability
of targets being met changes, so can the compensation cost, which creates the potential for
significant earnings variability, particularly near the end of the service period.

In contrast, market-based metrics are the direct measure of value creation. Relative market-
based metrics, such as company TSR relative to the TSR of peer companies, directly measure
how investors change their relative valuation of the company over a period of time. A market-
based award using relative TSR can be thought of as an indexed stock award that can pay off
extremely well in the best case. On the other hand, all is not lost in a bear market so long as the
company does not perform substantially worse than its peers. Of course, shares are limited or
forfeited if the company substantially underperforms its peers.

Like service-based restricted shares, options also link to economic factors on the same three
levels: broader market, relevant industry and specific company. The option payoff can be
extraordinary if the stock soars, but it can be zero if the stock fails to appreciate. Due to the
implicit leverage of an option, the swings in value are exaggerated relative to the underlying
stock. The volatility of option returns is much higher than that of service-based restricted shares
and significantly higher than that of typical market-based restricted shares.

For traditional option awards, as well as restricted share awards, the effect of factors in the
broader market and/or relevant industry can crowd out the specific company factors.
Consequently, some of the volatility of the award is not company-specific.

If the TSR is in the 75th percentile among peers, then the payout to the employee will always
dominate the payout from service-based restricted shares. It will also dominate the payout from
an option unless the stock appreciates more than 50 percent in absolute terms over three years.

Accounting Cost Variability

FAS 123(R) distinguishes between three basic types of equity awards: service-based,
performance-based and market-based. All three types are valued at the date of grant and then
amortized over the requisite service period. But there are important differences in the variability of
the subsequent amortization.

* Pure service-based awards have some moderate amortization variability related to the
estimated forfeiture rate over the contractually-defined service period. The estimate almost
always needs to be adjusted before the end of the service period. If one performs the true-up
regularly, the expense corresponding to broad-based awards can be fairly predictable. The
expense corresponding to high-level employees is more variable, because such grants are larger
and made to only a few individuals whose turnover rate is less predictable.

* Pure market-based awards, whether absolute or relative, have the least variability of the three
types. One values the award once and for all at the grant date, and amortizes the expense over a
"derived" requisite service period. Pursuant to paragraph A60 of FAS 123(R), the derived service
period is the median time from grant date to vest date taken over the set of stock price scenarios
that satisfy the market condition.

The only source of variability in the amortization is from the possibility of vesting prior to the end
of the derived service period. In this case, the remaining unamortized expense is recognized
immediately upon vesting. Amortization costs are not modified if shares fail to vest due to the
market condition or if more shares than the target number ultimately vest.

This is because the probabilities associated with market-based vesting conditions are already
taken into account in determining the grant date fair value. Often, service requirements are used
as an additional condition in conjunction with market-based vesting. This, again, creates the
potential for moderate amortization variability related to estimated forfeitures and subsequent
true-up.

* Pure performance-based awards have the most complex amortization. All such awards have an
embedded condition that requires quarterly review to determine whether the condition will
"probably" be met or not. For performance awards with a variable payout, one must determine the
most likely payout and update the "implicit" service period each quarter. The quarterly updates
raise the potential for swings in expense as a condition moves between "probable" and "not-
probable." If a swing occurs near the end of the implicit service period, the resulting variability
could be material, as nearly the entire grant could be expensed or reversed in a single quarter.

Although all awards require attention to the quarterly calculation of diluted earnings per share (no
dilution results from market-based or performance-based awards unless the award is dilutive and
the condition is met at the end of the reporting period) market-based and service-based awards
result in more predictable expense amortization, while performance-based awards require a
repeated assessment of probabilities and can potentially produce substantial variability.

In some respects, performance-based awards are analogous to the old APB 25 variable
accounting; instead of mark-to-market, based on changes in fair value, one must fair value the
award and mark to performance based on a fixed fair value.

* Combination awards. Typically, market conditions are set in combination with service
conditions. However, companies can also augment a market condition with a performance
condition. One approach is to structure the award so that the performance condition serves as a
"safety net" that ensures the vesting of some shares if either the market condition or performance
condition is met. If the company TSR ranks poorly compared with peers, but the performance
condition is met, then there is a compromise payout between that implied by the actual TSR rank,
and that implied by a median TSR rank.

[GRAPHIC OMITTED]

Valuation of Market-based Restricted Shares

Valuing awards with market conditions requires a lattice or Monte Carlo simulation model,
depending on the characteristics of the award. The correct way to value any market-based award
is the "contingent claim method." Here, the model generates payoffs along a set of possible future
share price paths and discounts the payoffs back to the grant date.
The contingent claim method integrates vesting and intrinsic value consistent with the modern
financial theory, such that the correlation between vesting and intrinsic value is taken into
account. Simply discounting today's share price by the probability of shares vesting fails to take
this correlation into account and results in valuation error. Volatility estimation for market-based
awards, with their typically short measurement periods--often under four years--is less
challenging than volatility estimation for longer option awards, leading to more precise fair value
estimation.

To help understand the payout possibilities associated with equity awards from both the company
and employee perspectives, Monte Carlo simulation models can be used to generate computer-
based payout distributions.

These models can forecast the risk and potential return of equity awards by generating millions of
future stock price scenarios that incorporate assumptions such as the stock price volatility of a
specific company or the correlations between the stock prices of various companies. Scenario
analysis of this type is a key component of both designing an award and communicating the
potential award payout to employees.

In conclusion, the main objective of equity-based awards is to maximize value to employees,

while motivating them to maximize value to shareholders. Companies should evaluate six criteria:
1) Compensation accounting cost to the company up front; 2) cost variability; 3) perceived value
to the employee; 4) the retention effects; 5) the incentives created by an award; and 6) the
administrative complexity.

For the same FAS 123(R) accounting cost and cost variability relative to restricted shares and/or
options, market-based relative TSR awards have the flexibility to maintain or increase perceived
value to employees, provide better incentives and similar retention effects and maintain
administrative simplicity.

Daniel Abrams (daniel.abrams@fas123solutions.com) and Peter Suzman

(peter.suzman@fas123solutions.com) are Partners with FAS123 Solutions. Allan
Cohen (allan.cohen@timewarner.com) is Executive Director of Financial Reporting and Assistant
Controller for Time Warner.

RELATED ARTICLE: takeaways

* Since adopting FAS 123(R), some companies have shifted away from exclusively granting stock
options toward exclusive use of restricted shares or a combination of the two, but there are other
alternatives.

* Plans with market-based and performance-based vesting conditions can award high-level
employees and create shareholder value without increasing accounting costs.

* The two most common market-based share awards are absolute awards and relative awards.

* Companies like Time Warner, Pfizer, Campbell Soup and Viacom will be awarding market-
based shares as part of long-term incentive plans to senior executives.
Table 1

TSR Performance Rank Relative to 15 Companies

in Peer Index Payout (% of Target)

1st 200.0%
2nd 185.7%
3rd 171.4%
4th 157.1%
5th 142.9%
6th 128.6%
7th 114.3%
8th 100.0%
9th 83.3%
10th 66.7%
11th 50.0%
12th or lower 0%
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Copyright 2006, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.