Relative TSR Programs

Terry Adamson, SVP, National Practice Leader

Radford Valuation Services

June 25, 2009

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Agenda

> Overview of Current Equity Marketplace

> Relative Performance Metrics as a Solution

> Relative TSR - Description of a Plan Design

- Example #1

- Example #2

- Example #3

> Relative TSR – Value Delivery

> Relative TSR – Significant Plan Design Decisions

- Selection of a Peer Group

- Averaging Periods

- Threshold, Target, and Minimum Payouts

- Dividend Equivalents

- Treatment upon Separation / Termination

> Relative TSR – Hidden Plan Design “Gotchas”

> Relative TSR – FAS123R Valuation and Accounting

Source: www.RelativeTSR.com

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What do these companies have in common?

> Intel

> eBay

> Motorola

> Google

> Toll Brothers

> Cardinal Health

> Starbucks

> Genworth Financial

> AMD

And about 100 other public companies just in the last 12 months………..

All of these companies went through an Underwater Exchange or Repricing of traditional stock options for their employees

The fundamental problem of why all of these companies needed to go through these exchange programs are due to the binary and absolute nature of traditional stock options – you only get paid if the stock price goes up.

The solution is to create relative equity vehicles.

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Relative Performance Programs

>Normally designed with full value shares, since stock options are inherently a performance vehicle

- Using FAS123R terms, can either be defined as Performance Conditions or Market Conditions

- Performance Conditions (internal metrics)

> Typically based on internal metrics such as EBITDA, EPS, or revenue growth

- Market Conditions (market metrics)

> Typically based on a Total Shareholder Return (“TSR”) with dividends re-invested

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Relative Performance Conditions – Pros/Cons

Pros

- Arguably, the best alignment between Performance and Compensation

- Alignment between compensation delivered and FAS123R expense taken

Cons

- The challenge of picking the most appropriate metric

- Challenge of comparing relative internal metrics between companies

- Disconnects in fiscal reporting periods between companies

- Lag in public disclosure creates communication and financial reporting challenges (need to wait until Q’s or K’s are released)

- Creates volatile quarter over quarter compensation expense, as requires a probability assessment each quarter of the expected number of awards to vest, and a cumulative catch-up reflecting the change

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Relative Market Conditions – Pros/Cons

Pros

- Easily measurable and communicable at any point in time

- Directly aligned with shareholder returns

- Objective, auditable, and transparent metric

- Not required to reconcile FAS123R expense to actual awards paid out (if outperform levels are paid out, not required to take an additional charge - the glass is half-full argument)

- Very stable and fixed accounting as probability of all future possible payouts are considered in initial valuation

Cons

- Does TSR return accurately reflect performance?

- Not required to reconcile FAS123R expense to actual awards paid out (if no awards paid out, cannot reverse expense - the glass is half-empty argument)

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>Activist Investors becoming more involved in Executive Compensation decisions-Former Chairman of the SEC, Richard Breeden, wrote in a letter to Applebee’s Board of Directors on January 25, 2007

-link to Richard Breeden's letter

“I am writing to you in your capacity as Chairman of the Compensation Committee (the “Committee”) of Applebee’s International, Inc. on behalf of Breeden Partners, which owns 3.9 million Applebee’s shares, or just over 5% of the company’s outstanding shares. We wish to express our concerns with the bonus eligibility criteria adopted by the Committee, particularly the failure to utilize relative shareholder returns or other measures of competitiveness. In addition, we want to offer specific suggestions for improving the company’s compensation policies. “In determining the long-term incentive component of CEO compensation, the Executive Compensation Committee will consider, among other matters, the Company’s performance and relative shareholder return...” Given that the slide in the company’s operating performance has now entered its fourth year, it is long past time to start basing senior executive compensation in significant part on “relative shareholder return,” exactly as the Committee’s charter suggests. Unfortunately, the “performance criteria” recently adopted by the Committee under Applebee’s 1999 Management and Executive Incentive Plan and the 2001 Senior Executive Bonus Plan as disclosed in the company’s Form 8-K don’t appear to measure relative performance in any area. Unless there is detail that has not yet been disclosed, the Committee’s “performance criteria” seem vague and ineffectively targeted. The result is essentially a license to pay anything to anyone, irrespective of actual performance in the marketplace. While I understand that the Committee held back cash bonuses for 2005 on a discretionary basis, the Committee should revise its current criteria formally to put the “performance” back into “performance criteria.” At the same time, other compensation practices should also be changed to eliminate unnecessary expense and unhealthy practices.

Postscript: Applebee’s introduced a Relative TSR plan in 2007

>With “Say-On-Pay”, expect more of this

Relative TSR – Governance Considerations

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• Data below provided by Equilar• For the second straight year, TSR and EPS are the most

commonly cited metrics for equity incentive plan awards.

Relative TSR – Prevalence of Relative TSR

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Example Design #1 – See Intel’s Plan, filed 3/23/2009

Awards EarnedSample Relative TSR Payout Schedule Upon Vesting

MAXIMUM: Comparator Group (CG) + 33.3% 200%

Comparator Group TSR + 1% 103%TARGET: Comparator Group TSR 100%Comparator Group TSR - 1% 98%

MINIMUM: Comparator Group TSR - 33.5% 33%

For every 1% in excess of Comparator Group,vesting payouts increase by 3%.

For every 1% less than Comparator Group, vestingpayouts decrease by 2%.

“Replacing Annual Stock Option and RSU Grants with Outperformance Stock Units - Beginning with the equity awards that will be granted in 2009, the committee will award outperformance stock units (OSUs) as their primary equity awards. OSUs are performance-based RSUs. The number of shares of Intel common stock that an employee receives will range from 33% to 200% of the target amount. The performance period is three years, and the performance metric to be used is total stockholder return (TSR). TSR is measured against the 15 technology companies included in our peer group for determining executive compensation averaged with the companies included in the S&P 100. If Intel underperforms the peer group, the number of units earned will be reduced from the 100% target amount at a rate of two to one (two-percentage-point reduction in units for each percentage point of underperformance), with a minimum of 33% of units earned. If Intel outperforms the peer group, the number of units earned will be increased from the 100% target amount at a rate of three to one (three-percentage-point increase in units for each percentage point of over-performance), with a maximum of 200% units earned.

This planned change to Intel’s equity incentive design serves a number of purposes. First and foremost, because OSUs deliver value in the form of Intel common stock, it focuses the leadership team on ensuring the long-term viability of the enterprise. Secondly, due to the relative performance metric, this design provides an incentive to outperform the composite index over the three-year performance cycle. By utilizing full shares, this program is typically less dilutive than stock options while providing alignment with stockholders. Finally, the payout range of 33% to 200% of target moderates unnecessary risk taking while still providing an incentive to outperform the composite index over a multi-year period.” Link to Intel's SEC filing here, filed 3/23/2009

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Example #2 – See BKNY Mellon’s Plan, filed 3/16/2009

“Performance Shares. The committee used performance shares to reward named executive officers based on the company’s total shareholder return, which we refer to as “TSR,” compared to the total shareholder return of the companies in our peer group and the S&P 500 Financials Index during a three-year period of 2008 through 2010. The S&P 500 Financials Index was used in addition to the peer group to assess the degree to which the company creates value relative to the broader market as well as versus peers. The actual number of shares of our common stock that a named executive officer may receive at the end of the three year performance period is based on the company’s actual TSR relative to our peer group and the S&P 500 Financials Index. TSR performance is weighted two-thirds relative to the peer companies and one-third relative to the S&P 500 Financials Index. The committee has negative discretion with respect to the determination of the final amounts of performance shares granted at the end of the three-year period, which means that the committee has the authority to reduce the size of the performance share awards otherwise payable to the named executive officers.

The following chart illustrates what payouts would be at the various percentile ranks for company TSR performance compared to the peer group and the S&P 500 Financials Index. Payouts for performance between listed percentiles are interpolated.” , Link to Bank of New York Mellon's SEC Filing here , filed on 3/16/2009

Relative TSR PayoutPercentile Rank (% of Target)

Superior 75th and > 200%

70th 180%65th 160%60th 140%

55th 120%Target 50th 100%

45th 75%40th 50%

Threshold 35th 25%

< 35th 0

2008-2010 Performance SharePayout Schedule

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Example #3 – See Gilead Sciences, filed 2/5/2008

- Has both an internal Performance Metric (Revenue) combined with TSR

-A recommended payment schedule is provided below based on: (i) measuring TSR performance and revenue growth relative to the AMEX BioPharma Index, and (ii) a 200% maximum performance award opportunity

-Described in 8K filing of 2/5/2008, link to Gilead Sciences SEC Filing

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Relative Market Conditions – Value Delivery

$0

$10,000

$20,000

$30,000

$40,000

$50,000

$60,000

$70,000

$80,000

$90,000

$100,000

$1 $4 $7 $10 $13 $16 $19 $22 $25 $28 $31 $34 $37 $40 $43 $46 $49

Future Stock Price

Pay

ou

t at

Fu

ture

Sto

ck P

rice

3,000 Options 1,000 Shares 1,000 Relative TSR Awards

>All 3 alternatives are FAS123R equivalent

>Assumes a grant price of $10, and normal comparator TSR returns

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Relative TSR Award Value Delivery Compared To…

Relative TSR Award Value Delivery Compared To…

Stock Options Restricted Stock

UpMarket

Similar Greater

Stable Market Similar to Greater Similar to Greater

Down Market Greater Similar to Less

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Relative TSR – Expect it to go Broad-Based

>Relative TSR design concepts can be applied to broad-based equity programs to mimic strengths and minimize flaws of traditional options and restricted stock

- Maintain upside potential

- Minimize dilution

- Provide downside retention

- Collars possible windfall gains

- Improve FAS123(R) cost efficiencies

- Eliminates “rising tide lifts all boats” or “falling tide sinks all boats” effects

- Can maintain historic payout/vesting schedules (e.g., can be designed to vest 25% annually over four years)

- It’s simple to understand and payouts can be readily communicated daily

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Relative TSR – Specific Design Considerations

>In US, plan design is still evolving

>Abroad however, there is much more maturity

- Association of British Insurers (ABI) have issued guidelines on the design of Relative TSR plans, link to ABI Guidelines

>Key considerations

- Selection of an appropriate peer group

- Averaging period

- Threshold, Target, and Minimum payouts

- Dividend equivalents during performance period (2nd class of stock consideration)

- Treatment upon termination / separation (162M considerations)

- Summaries of this research can be found at www.RelativeTSR.com

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Relative TSR – Peer Group Considerations

>Peer Group Considerations

- Selection of an Index (Intel) or Percentile of an Index (BK)

- Number of comparators

> We recommend 20 or greater, and generally expect attrition of 10% per year

> Treatment upon disappearing companies (bankruptcies, acquisitions, dispositions, spin-offs)

- Look for comparators as closely correlated in stock price movement as possible (lowers the FAS123R valuation)

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Relative TSR – Averaging Period

>Averaging Period

Note: Not all industries contain a substantial amount of data, which may lead to statistically insignificant conclusions

Stock Price Averaging Period by Industry

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1

76

33

44

8

41

28

60

50

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30

60

90

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Copyright 2009 Radford

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Relative TSR – Threshold, Target, and Minimum

>Threshold, Target, and Minimum

Average Max Payout and Median Payout by Peer Group Type

73%

161%179%

89%

0%

40%

80%

120%

160%

200%

Max Payout Median Payout

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Custom Peer Group

Actual Indexn=105

Copyright 2009 Radford

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Relative TSR – Dividend Equivalents

>Dividend Equivalents

Note: Not all methods contain a substantial amount of data, which may lead to statistically insignificant conclusions

Breakdown of Methods of Paying Out Dividend Equivalents

62%

9%29%

0%

20%

40%

60%

80%

Payout at FutureMultiplier

Payout at Target No Payout

Per

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Copyright 2009 Radford

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• Be cautious of some “gotchas” with plan design

• Pay attention to payout bendpoints

– Very broadly speaking - a payout equal to 150% at the 75 th Percentile, 75% at the 55th Percentile, and 50% at the 40th percentile will approximate an instrument equal to 100% of the current FMV

• Disconnects between the Grant Date and the Performance Period

– For example many companies have issued awards in March based on a January 1 performance period. The 2-month+ disconnect must be considered in the initial grant date valuation

– Analogous to a “headstart” or “starting from behind” in a head-to-head race

– Can create very volatile and unpredictable valuation results than compared to if all companies are on a level playing field

• Long Averaging Periods

– Also can create a disconnect between Grant Date from the TSR performance during the averaging period

• Treatment of Dividend Equivalents during vesting period (None, guaranteed at target, or paid out at future payout multiplier)

– Can create a separate instrument and special valuation

Relative TSR – Design “Gotchas”

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Relative TSR Plans – FAS123(R) Valuation

> Monte Carlo Simulation

• Generally based in a Risk Neutral framework (similar financial principles as Black-Scholes or binomial modeling)

• Simulates stock prices for company and each relative peer company, including the underlying correlation of stock prices in the projection

• Simulated stock prices are used for determination of expected awards to vest as well as the discounting of future cash flows

• Requires knowledge of all information known on Date of Grant

• Assumptions Required: Risk-Free Rate, Term of Performance Period, Expected Volatility and Correlation Coefficient (for each entity), and Expected Dividend Yield

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Relative TSR Plans – Monte Carlo Simulation

> Principles of Monte Carlo simulation can be borrowed from the game, Plinko, of The Price Is Right

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Relative TSR Plans – Monte Carlo Simulation

• The Price Is Right!!!

The Grant Date

The end of the Performance Period, at which time the number of awards paid out are calculated, and the future simulated fair value is discounted to a present value. If done enough times, a statistically normal distribution of future payouts is created

During every measurement period of the simulation, either the stock price can go up or go down, drifting with the risk free rate of return ± volatility

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> Much more can be learned at Relative TSR plans at www.RelativeTSR.com

– Further examples of Plan Provisions

– Summary of Companies who have disclosed their Relative TSR plan

– Links to SEC filings of disclosed companies

– Examples of Employee Communications

– Radford’s recent white paper on Relative TSR at www.Radford.com/RelativeTSR-whitepaper

• Contact us at:

• Terry Adamson – 215.255.1802 – tadamson@radford.com

Summary

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Terry Adamson Bio

Terry Adamson is a Senior Vice President at Aon. He has over fifteen years of benefit and compensation consulting experience. Terry is involved with all phases of equity compensation valuations, including design of executive packages, valuation of compensatory arrangements for purposes of a change in control under IRC 280G, SERP design and valuation, and employee stock option valuations and employee stock purchase plans under FAS 123 and FAS 148. Additionally, Terry consults with clients on issues involving all aspects of a company’s benefit and equity programs in mergers, acquisitions and divestitures.

As national practice leader for Aon’s national employee stock option valuation practice and the lead project manager, Terry manages a team of valuation experts and is responsible for the completion of quarterly FAS 123R accounting valuations in addition to being the primary client contact. Terry also leads Aon’s practice in valuing sabbatical liabilities under FAS43/EITF 06-2.

He has recently co-authored articles in the Tax Management Compensation Planning Journal entitled “Golden Parachutes – New Planning Opportunities” and “Executive Compensation Audits – Planning Now to Avoid Trouble Later”, Benefits Quarterly “Employee Stock Options – New Valuation Responsibilities and Planning Opportunities”, Journal of Employee Ownership Law and Finance, “A Technical Roadmap to Expense Allocation under FAS 123(R)”, and Compensation and Benefits Review, “No Vacation on Sabbatical Accounting”. Terry is a frequent speaker regarding stock option valuation at various conferences and seminars, more recently at The Conference Board in New York, the NASPP Conference, E-Trade’s Directions2009, and with the Joint Board of Enrolled Actuaries. Terry was also on the FASB Round Table on Employee Share Options. Terry is the chair of the Society of Actuaries research project on stock option valuation.

Prior to joining Aon, Terry was employed as an Actuary at The Hay Group in New York City. Terry graduated from Georgetown University where he obtained a Bachelor of Science degree in Mathematics.