global equity effectiveness: a right brain perspective
DESCRIPTION
Global Equity Effectiveness: a right brain perspective, presented at the GEO International Conference (Amsterdam) June 15-17, 2011 Today, equity compensation has become an integral part of executive and employee compensation across the globe. As companies continue to widely use equity compensation, they are increasingly finding that being competitive is not enough. With increased pressure to maximize compensation offerings, companies are focusing on equity effectiveness. Despite overwhelming advances in technology and sophistication in financial modeling tools, today’s cost/benefit relationship of equity awards remains stubbornly unsatisfactory for all constituencies. Today, companies are starting to consider employee preferences when designing equity plans. A growing understanding of the impact of behavioral economics, workforce demographics and global work cultures is now challenging the dominance of technical accuracy. By taking a holistic view of the drivers of equity effectiveness, companies can optimizing the use of equity and, as a result, increase workforce engagement.TRANSCRIPT
Global Equity Effectiveness
A Right-Brain Perspective
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Seeking Equilibrium
• Equity effectiveness requires that companies find equilibrium in share utilization
• Effectiveness refers to both grant efficiency (tax/accounting/dilution) and motivational value
• Optimum utilization occurs when the incentive effect outweighs the cost (dilution and expense)
• This is the equilibrium point where the strongest correlation between share utilization and total shareholder return occurs
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Achieving Equity Effectiveness
• During the 1990’s, achieving balance was easy, with little or no concerns about:– Run rates
– Overhang
– Expense
– Allocation
– Motivation
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Achieving Equity Effectiveness
• In the years following the 2001-2002 recession, optimization was more difficult as economic pressure drove increased diversification in the use of equity plans
• Changes were felt across many participation levels and geographies
• For a long time, the solutions were simple…
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But no one expected….
• The 2008-2009 recession was unprecedented in:– The depth of its decline
– The duration of its decline
– Its global economic impact
• It also had a profound impact on equity compensation programs
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Why was this a surprise?
Are the foundations of global equity programs built on an anomaly?
Growth of $10 invested in the Total S&P500 Index starting in 1900
$1
$10
$100
$1,000
$10,000
$100,000
$1,000,000
1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020
Year
Rea
l S&
P 50
0 St
ock
Pric
e In
dex
Total Price Index(Dividends Reinvested)
Long-Term "Equilibrium"Total Return Index: 9.30%/Yr
The “birth“ of global equity
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CONVENTIONAL WISDOM/POTENTIAL DISCONNECTS
• An option awarded in March of 2009 with a strike of $4.00 is worth less than a March 2010 grant with a strike of $25.00
• Accountants vs. entrepreneurs
• Surveys are a reliable source of information for compensation comparison and planning
• Data vs. facts
• Equity grants are a powerful motivator
• Reciprocity vs. incentive
• “Stocks for the Long Run”
• Timing is everything
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Current State
• Shareholder dissatisfaction is high– Concerns about risk, dilution, and ownership have fueled
broad-ranging governance initiatives
• Employer dissatisfaction is high– Fueled by costs of administration, financial reporting,
compliance, and disclosure during a period in which employee returns from grants have declined or disappeared
• For employees, the motivational value is low– The payoff from a grant is often viewed as a “gift” that they
feel compelled to repay by working harder
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Understanding the Disconnect:
Right-Brain vs. Left-Brain
• Left-Brain is dominant:– Tax
– Accounting
– Compliance
• Right-Brain is dormant:– Perceptions
– Behaviors
– Culture
In the design and delivery of global equity programs:
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Left-Brain: What is an equity grant worth?
• We use complex models to calculate stock options
• But restricted stock is the face value at grant
• And performance shares are the possible delivered value
• So what is the total value at the date of grant?
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The Right-Brain is Driving Company Actions
0%
10%
20%
30%
40%
50%
Will dosomething;exploring
alternatives
More Perf.Shares than
Options
More ServiceRS/RSU than
Options
RelaunchESPP
ReplaceOptions with
cash
More PerfShares than
RS/RSU
Anticipated Changes for Upcoming Year
But actions are often reactions!
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Are these actions consistent with
employee perceptions?
Assumes ratio of 3 stock options for exery 1 restricted share
Value of Stock Options vs. Restricted Stock
$0
$1,000
$2,000
$3,000
$4,000
$5,000
$6,000
$7,000
$8,000
Grant 1 2 3 4 5 6 7 8 9 10
Stock Options Restricted Stock
Assumes ratio of 3 stock options for exery 1 restricted share
Value of Stock Options vs. Restricted Stock
$0
$20,000
$40,000
$60,000
$80,000
$100,000
$120,000
Grant 1 2 3 4 5 6 7 8 9 10
Stock Options Restricted Stock
Two employees
Same company
Different perceptions on value
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Why is perception important?
Perceived value is the key to employee engagement
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Value is tied to perceptions
• Behavior Finance proposes theories based on psychology to explain anomalies in the market.
• Behavioral finance assumes that the information structure and the characteristics of market participants systematically influence individuals' investment decisions as well as market outcomes.
• Behavioral finance seeks to better understand economic decisions and how those decisions affect prices, returns, and the allocation of resources.
To an employee, perception is reality
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How are perceptions formed?
• The three main themes in behavioral finance are:
– People often make decisions based on “rules of thumb”, not rational analysis.
– The way a problem is presented will affect the decision a person makes on how to act.
– There are behavioral explanations for observed market outcomes that are contrary to rational expectations and market efficiency.
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So at the date of grant, what is the
perceived value?
Assumes ratio of 3 stock options for exery 1 restricted share
Value of Stock Options vs. Restricted Stock
$0
$1,000
$2,000
$3,000
$4,000
$5,000
$6,000
$7,000
$8,000
Grant 1 2 3 4 5 6 7 8 9 10
Stock Options Restricted Stock
Assumes ratio of 3 stock options for exery 1 restricted share
Value of Stock Options vs. Restricted Stock
$0
$20,000
$40,000
$60,000
$80,000
$100,000
$120,000
Grant 1 2 3 4 5 6 7 8 9 10
Stock Options Restricted Stock
The answer is simple, it depends…
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Equity characteristics…
But, effectiveness for each individual is driven by their perceived value
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But what shapes perceived value?
• Personal biases and experiences
• Generational differences
• Global cultures
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Behavior and Personal Perceptions
• Mental Accounting and Consumer Choice– A new model of consumer behavior developed by Richard
Thaler using a hybrid of cognitive psychology and microeconomics.
– People mentally frame assets as belonging to either current income, current wealth or future income and this has implications for their behavior
– Mr. Smith is up $50 in a monthly poker game. He has a queen high flush and calls a $10 bet. Mr. Jones owns 1,000 shares of XYZ which went up today. He is even in the poker game. He has a king high flush and folds. When Mr. Smith wins, Mr. Jones thinks to himself, “If I had been up $50, I would have called too.”
– What are unvested grants really worth to your employees?
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Behavior and Personal Perceptions
• Hyperbolic Discounting:– Given two similar rewards, humans show a preference for
one that arrives sooner rather than later. They discount the value of the later reward by a factor that increases with the length of the delay.
– if all choices appear to be in the longer term, larger benefits will be chosen, even if these appear even later than the smaller benefit.
– If you were offered the choice between $50 now and $100 a year from now, most would ask for the $50. However, given the choice between $50 in nine years or $100 in ten years you would be likely choose the $100 in ten years.
– Application: What is more valuable to your employee s, a $10,000 restricted stock grant that vests in two ye ars, a $25,000 grant that vests in four years or a $50,000 grant that vests in six years?
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Behavior and Personal Perceptions
• Endowment Effect– People place a higher value on objects they own than objects
that they do not.
– For example, people demanded a higher price for a item that had been given to them but put a lower price on the same they did not yet own.
– An employee may continue to hold a large number of worthless underwater stock options rather than exchanging them for a smaller number of new at-the-money options.
– What would work better, an option exchange or a cas h exchange?
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Behavior and Personal Perceptions
• Loss Aversion– People have a tendency to strongly prefer avoiding losses to
acquiring gains
– This leads to risk aversion when people evaluate a possible gain; since people prefer avoiding losses to making gains
– For example, loss aversion has been implicated in the premium for stock returns over bond returns
– It may also explain why an employee who has experienced underwater stock options will exercise and sell an “in-the-money” option as soon as it vests, even though there is no indication that the option will not continue to appreciate.
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Behavior and Generational
Differences
• Generational differences manifest themselves in several ways, including how individuals view their compensation.
• There is variation in the nature of intrinsic rewards each generation considers important.
• The generations also relate to their organizations differently.
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Some generational differences are obvious
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US Generational Differences
Generation Baby Boomers
(1943-1960)Generation X
(1960-1981)
Generation Y
(1982-2001)
Company LoyaltyCommitted to their employers and
do not change jobs frequently
Change employers frequently and
will leave if their rate of career
growth or company culture is not to
their satisfaction
Change employers often and will
continually look for a workplace that
provides them with what they want.
Workplace
Environment
Focus on relationships, outcomes,
their rights and skills.
Flexible work schedule and location.
Telecommuting is very popular with
this generation and supports their
aim for a balanced work-life.
Casual and supportive environment
Very flexible working hours and
location.
What They Look
For in a Company
Stable employment, career
progression potentials
Company that promotes social
stimulus, including social events.
Company that is involved with their
community and encourages their
employees to give back.
Avoids bureaucratic companies and a
company that has a strong viable
social culture and code of ethics.
Management
Style
Comfortable with directive
command and control management
style and values feedback.
Need a mentor or supervisor to
encourage and facilitate their career
development
Requires instant gratification
constant encouragement through
rewards, entitlements and
promotions. Uncomfortable with
directive style of management.
Personality TypeResourceful, individualistic, self
reliant and skeptical of authority
Optimistic, confident, sociable, and
have strong morals and sense of civic
duty. They put great value on their
free time away from work
Have been taught the value of
individuality and independent
thinking.
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Global Generational Differences
1950 1960 1970 1980 1990 2000China Post-1950s Post 1960s Post 1970s Post 1980s Post 1 990s
Generation Generation Generation Generation Generation(1950-1959) (1960-1969) (1970-1979) (1980-1989) (1990-1999)
India "Traditional" Generation "Non-Traditional" Gen Y(1948-1968) Generation (1981-onward)
(1969-1980)South "475" Generation "386" Generation Gen X and Gen YKorea (1950-1959) (1960-1969) 1070 - onward
Japan 1st Baby Danso Shinjinrui 2nd Baby ShinjinruiBoomer Generation Generation Boomer Post Bubble Junior Yu tori
(1946-1950) (1951-1960) (1961-1970) (1971-1975) (1976-1987) (1986-1995) (1987-2002)Russia Baby Boomers Gen X Gen Y (Gen "Pu")
(1943-1964) (1965-1983) (1983-2000)
Bulgaria Post War Communist Gen YGeneration Generation (1980 - onward)(1945-1965) (1965-1980)
Czech Baby Boomers Gen X-"Husak"'s Children Gen YRepublic (1943-1970) (1965-1982) (1983-2000)
South Baby Boomers Gen X Gen YAfrica (1943-1970) (1970-1989) (1990-2001)
Brazil Baby Boomers Gen X Gen Y(1946-1964) (1965-1980) (1981-2001)
US Baby Boomers Gen X Gen Y(1943-1964) (1965-1980) (1981-2001)
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Implications on Perceived Equity Values
Baby Boomer:Optimistic + Involved + High Risk/High Rewards = Preference for highly leveraged grants like stock options
Generation X:Cautious + Conservative + Distrustful = Preference for low leverage grants like service-based restricted stock
Generation Y:Realistic + Confident + Career Focused = Preference for moderate leverage grants like performance shares
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Behavior and Global Culture
• Culture is the underlying value framework that guides an individual’s behavior
• Culture is reflected perceptions, social interactions and business interactions
• Culture guides the selection of appropriate responses in social and business situations
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Rapaille’s Archtypes
• The more global, the more local
• Collective cultural consciousness
• For example, quality is a key to success, but quality has different meanings in different countries
– US: It works
– Japan : Perfection
– Germany : Made to standards
– France : Quality = Luxury
– India : Quality = Reliability
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Hofstede’s Cultural Dimensions
• Power distance : degree to which members of society accept an unequal distribution of power in organizations and society
• Individualism : degree to which individuals perceive themselves to be separate from a group and to be free from group pressure to conform
• Masculinity : degree to which a society looks favorably on aggressive and materialistic behavior
• Uncertainty avoidance : degree to which members of society deal with the uncertainty and risk and prefer to work with long-term acquaintances and friends rather than with strangers
• Long-term orientation : degree to which members of a culture will defer present gratification to achieve long-term goals
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Hofstede’s Cultural Dimensions
0
10
20
30
40
50
60
70
PDI IDV MAS UAI LTO
World Average
0
10
20
30
40
50
60
70
80
90
100
PDI IDV MAS UAI LTO
United States
Source: Geert Hofstede™ Cultural Dimensions
One Company, One Plan
But One Plan for One World?
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Hofstede’s Cultural Dimensions
0
10
20
30
40
50
60
70
PDI IDV MAS UAI
European Countries
0
10
20
30
40
50
60
70
80
90
100
PDI IDV MAS UAI LTO
United States
0
10
20
30
40
50
60
70
80
PDI IDV M AS UAI
Latin American Countries
0
10
20
30
40
50
60
70
80
90
PDI IDV MAS UAI LTO
Asian Countries
Source: Geert Hofstede™ Cultural Dimensions
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Hofstede’s Cultural Dimensions
0
10
20
30
40
50
60
70
80
PDI IDV MAS UAI LTO
India
0
10
20
30
40
50
60
70
80
PDI IDV MAS UAI LTO
Singapore
0
20
40
60
80
100
120
PDI IDV MAS UAI LTO
China
0
10
20
30
40
50
60
70
80
90
100
PDI IDV MAS UAI LTO
Japan
Source: Geert Hofstede™ Cultural Dimensions
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So, Do We Recognize These Differences?
• Senior management roles are likely to receive an equity grant regardless of global location
• The differences in global participation start at the Managerial level and more apparent at the Individual Contributor level
Equity Plan Participation Rates by Country & Level
96%100% 100% 100% 100% 100%
94%94%
100%
93%
100%
92%
72%
57%
76%81%
75%
50%
17%11%10%
25%
33%34%
0%
20%
40%
60%
80%
100%
120%
United States Uni ted
Kingdom
Germany India China Austra l ia% o
f E
mp
loye
e P
op
ula
tio
n P
art
icip
ati
ng
in
Eq
uit
y P
lan
VP/GM
Director/Sr Mgr
Manager/Supv
Ind Contr
* Buck Consultants Global Long-Term Incentive Practices Survey
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Do We Recognize These Differences?
Percentage of Companies with Grant Type
VP Level95% 94%
84% 82%
73%
63% 61%
9%
26%
48%
67%64%
58%62%
2% 3%9%
13%18%
27% 26%
0
0.2
0.4
0.6
0.8
1
2004 2005 2006 2007 2008 2009 2010
SO
RSU
PRS
•The shift from stock options toward full value shares slows
•Full value shares have edged ahead of options for the first time
•Performance-based shares have become a major practice
* Buck Consultants Global Long-Term Incentive Practices Survey
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Do We Recognize These Differences?
Average Value Allocation by Equity Type 2009
VP Level
42% 45% 43% 45%36%
42%31%
38%40% 41%
26%34%
42%
36%
16%14% 15%
28%24%
14%
30%
6%
3% 1% 1% 2%
0%
20%
40%
60%
80%
100%
United States United
Kingdom
Germany India China Japan Austra l ia
Cash
PRS
TBRS
SO
Average Value Allocation by Equity Type 2010
VP Level
43%52% 49% 50% 52% 50%
45%
41%
41% 41% 41% 34% 44%49%
12%6% 9% 9%
9%4% 4%5%
3%2%1%3%
0%
20%
40%
60%
80%
100%
Uni ted States Uni ted
Kingdom
Germany India Chi na Japan Austra l ia
Cash
PRS
SO
TBRS
* Buck Consultants Global Long-Term Incentive Practices Survey
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Achieving Equity Effectiveness
• If this is what an understanding of global employee behavior tells us, then how do we act today?
• By left-brain– Accounting
– Tax
– Compliance
• Not by right-brain:– Perceptions
– Behaviors
– Culture
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What does this knowledge tell us
about plan design going forward?
One Company, One Plan?
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Looking Ahead…
One Company, One Plan?
0%
50%
100%
150%
200%
250%
300%
70% 80% 90% 100% 110% 120% 130%
% of Goal Achieved
% o
f Tar
get P
aym
ent R
ecei
ved
Performance Share Plans provide the
flexibility to adapt to global differences
Leverage can also be adjusted to respond to
difference in risk profiles
Performance metrics can be set to create global
alignment and/or maximize line-of-sight
Awards can be paid in stock, cash or a
combination to maximize perceived value
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Parting thoughts
• Technical aspects of equity compensation are important, but not enough
• To understand perceived value, a better understanding of the global workforce is needed
• Value is perceived, not calculated
• Classical rational decision-making is not the model for actual employee decision-making
• Triangulate to get answers rather than focusing on the single best base of information
• Design simplicity should be an imperative
• More intuition, less conventional wisdom
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Questions
Jim SilleryPrincipal+1 (1) 312 846 [email protected]
Ben WellsSenior Consultant+44 (0) 207 429 [email protected]