In the September issue of Executive Compensation Trends, our coverage examines the effect of FAS 123R on Employee Stock Purchase Plan design at Russell 3000 companies and on equity compensation practices at S&P 500 companies. Both feature articles use empirical data drawn from recently completed databases to highlight important shifts in compensation strategy during the past three years. For a preview of these articles, please see the summaries below.

Please feel free to contact our research team at 877.441.6090 or info@equilar.com if you have questions, comments, or if you would like a more specialized analysis of the data presented in this newsletter.

The implementation of FAS 123R has touched off much discussion about the future direction of Employee Stock Purchase Plans (ESPPs). Companies are now required to expense their ESPPs, along with other option-based award programs, unless their plans meet strict new safe-harbor provisions specified by the Federal Accounting Standards Board. The following article provides a glimpse of the early impacts of FAS 123R on ESPPs among Russell 3000 companies in 2005 and 2006 and presents a summary of several key findings from Equilar’s 2006 Employee Stock Purchase Plan Report and Database.

Methodology

Equilar reviewed the details of ESPPs disclosed by Russell 3000 companies in proxies containing additional share requests for new and amended plans during the first half of calendar years 2005 and 2006. From Jan. 1 to June 30, 2006, 103 Russell 3000 companies submitted additional share requests for new or amended ESPPs, compared to 110 Russell 3000 companies in the same six-moth period of 2005. The 2006 Employee Stock Purchase Plan Report and Database offer a comprehensive review of the components of these plans, based on information disclosed by each company.

Findings

• Safe Harbor: To qualify for an exemption from expensing an ESPP under FAS 123R, plans must meet safe-harbor provisions that prohibit look-back periods of any length and cap discount rates on share prices at 5 percent. These limits are more restrictive than the pre-FAS 123R safe-harbor provisions, which permitted look-back periods of up to 6 months and discount rates of up to 15 percent.
  
  In 2006, 41.5 percent of new plans and 8.1 percent of amended plans included zero look-back periods and capped discount rates at 5 percent. This brought the prevalence of all plans with new safe-harbor features to 21.4 percent. Although this represented an increase over 2005, it indicates that nearly four out of every five ESPPs placed before shareholders for approval do not meet the new FAS 123R safe-harbor provisions.
  
  The following chart illustrates the prevalence of ESPPs meeting the new safe-harbor provisions in the first half of calendar years 2005 and 2006.
  
  
  
  
• Qualified Plans: The overwhelming majority of companies, 98.1 percent in 2006, designed their ESPPs to qualify for tax benefits under Section 423 of the U.S. Internal Revenue Code (the tax code). As a result, nearly all plans included provisions that met the tax code criteria on such features as eligibility, shareholder approval, purchase limits and others.



• Purchase Periods: Though the preponderance of plans included purchase periods of 6 months or less in 2005 and 2006, there was some movement among newer plans to offer slightly longer purchase periods. In 2006, approximately 60 percent of all plans presented to shareholders were designed with a 6-month purchase period. During the same year, 12-month purchase periods were found in 15.8 percent of new plans, compared to only 4.9 percent of amended plans.



• Offering Periods: Longer offering periods were slightly more common among amended plans than they were among new plans in 2006. During this period, 32.7 percent of amended plans had an offering period greater than 6 months, compared to 17.1 percent of new plans.



• Plan Size: Shareholder concerns about stock dilution may be causing companies to design smaller plans. As shown in the following chart, from 2005 to 2006, the number of ESPP additional requests representing 2.0 percent or less of total shares outstanding increased from 61.8 percent to 71.6 percent. Moreover, the number of plans representing over 5 percent of total shares outstanding fell from 10.0 percent in 2005 to 3.9 percent in 2006.




• Interesting Plan Features: Matching contributions and evergreen provisions were rare features, offered in only 1.0 percent and 2.9 percent of plans, respectively, in 2006. Holding requirements beyond those specified under the tax code were prevalent in 8.7 percent of all plans in 2006 and 15.5 percent of all plans included a reset feature in 2006.



• Industry Comparisons:



• Among the major industry groups in 2006, 32.0 percent of all Healthcare company ESPPs met the new safe-harbor provisions on look-back periods and discount rates, compared to 18.2 percent of plans adopted by Technology and Industrial companies, and only 11.1 percent of Consumer Discretionary company plans.



• Among Consumer Discretionary companies, 77.9 percent of ESPPs submitted in 2006 included a look-back period of 3 or more months, compared to 72.7 percent of Industrial sector company plans, 69.7 percent of the Technology company plans, and 60.0 percent of the Healthcare company plans.



• The highest prevalence of 15 percent discount rates was found in Consumer Discretionary company plans. In 2006, 83.4 percent of this industry’s plans offered discount rates at the cap set by the old safe-harbor provisions, compared to 78.8 percent of Technology industry plans, 64.0 percent of Healthcare industry plans, and 63.7 percent of plans from the Industrial sector.



• Among Technology companies, 75.3 percent of plans represented 2 percent or less of shares outstanding in 2006, compared to 72.0 percent of Healthcare Industry plans, 58.8 percent of Consumer Discretionary plans, and only 45.5 percent of Industrial plans.

To learn more about Equilar’s full suite of custom research capabilities, please contact Equilar by phone (877.441.6090) or via e-mail (info@equilar.com).

Given that stock option expensing under FAS 123R has now been in effect for over one year, it seems appropriate to investigate its effect on equity compensation practices. Using S&P 500 companies as a measure of the general impact of FAS 123R in the two years leading up to, and the one year after its adoption, it is apparent that several important trends have emerged. From 2003 to 2005, run rates, overhang rates and the prevalence of CEO stock option awards fell, and conversely, the prevalence of CEO restricted stock awards – the primary alternative to stock options – have increased.

Methodology

For this analysis, Equilar reviewed equity compensation practices at 472 companies in the S&P 500 index with three consecutive years of executive and equity compensation data and with their most recent fiscal year ending between June 2005 and May 2006.

Option Overhang

Option overhang, calculated as options outstanding divided by total shares outstanding, is a common measure for the potential dilutive effect of outstanding stock option awards. From 2003 to 2005, the median option overhang rate at S&P 500 companies fell from 8.7 percent to 7.5 percent– indicating a slow down in the replacement of exercised stock options. Most interestingly, the rate of change over this three-year period accelerated. From 2003 to 2004, overhang rates declined by 40 basis points, but from 2004 to 2005, the rate of change doubled, as overhang rates declined by 80 basis points.

The following chart illustrates three-year overhang trends at S&P 500 companies:

Run Rate

Run rate, or burn rate, is defined as the sum of options granted and options assumed divided by total shares outstanding. Run rate is a measure of the potential dilutive effect of new stock option grants. Similar to option overhang rates, median run rates at S&P 500 companies also declined from 2003 to 2005. Over this three-year period, run rates fell from a median of 1.5 percent to a median of 1.0 percent. Additionally, from 2003 to 2004, median run rates declined by 20 basis points, while from 2004 to 2005, run rates declined by 30 basis points.

The following chart illustrates three-year run rate trends at S&P 500 companies:

CEO Stock Option Awards

After growing in value by 13.3 percent from 2003 to 2004, the median value of stock option awards for CEOs of S&P 500 companies dropped by 7.9 percent from 2004 to 2005. This uneven road resulted in an annual growth rate of only 2.2 percent over the entire three-year period and led to an overall increase in the median value of stock option awards from approximately $3.5 million in 2003 to $3.7 million in 2005.

During this same period, the prevalence of CEO stock option awards declined from 81.8 percent in 2003 to 77.3 percent in 2005. The following chart illustrates both the median value of S&P 500 CEO stock option awards and their prevalence for fiscal years 2003 through 2005.

CEO Restricted Stock Awards

From 2003 to 2005, the median value of restricted stock awards for CEOs at S&P 500 companies grew by 8.9 percent annually. As opposed to the prevalence of CEO stock option awards, the frequency of restricted stock awards rose significantly. By 2005, 52.5 percent of S&P 500 CEOs received a restricted stock award, and these awards had a median value of approximately $2.4 million (approximately 64.8 percent of the median value of CEO stock option awards).

The following chart illustrates both the median value of S&P 500 CEO restricted stock awards and their prevalence for fiscal years 2003 through 2005.

Stock Options and Restricted Stock

Given the data presented above, it seems easy to conclude that stock options are becoming less relevant after the adoption of FAS 123R. However, while the prevalence of stock option awards for S&P 500 CEOs has declined since the end of 2003, an increase in the prevalence of CEOs receiving both stock option and restricted stock awards indicates that stock options will remain an important part of an increasingly diverse equity compensation pie. From 2003 to 2005, the prevalence of S&P 500 CEOs receiving both stock options and restricted stock awards increased from 33.5 percent to 42.2 percent. Furthermore, the number of CEOs receiving a mix of equity vehicles increased more rapidly than the number of CEOs receiving solely restricted stock awards.

The following chart illustrates the prevalence of various equity compensation practices at S&P 500 companies for fiscal years 2003 to 2005.

For more details on stock option design features described above or to learn about Equilar’s full suite of custom research capabilities, please contact Equilar by phone at 877.441.6090 or e-mail at info@equilar.com.

Equilar research appeared in several news articles published in September. Click the links below to view these articles. For a complete list of articles featuring Equilar research, please visit our online Knowledge Center.

• Top CFOs are playing catch-up on compensation
  Globe and Mail
  September 18, 2006
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• Firms tweaking ways of awarding options
  San Jose Mercury News
  September 10, 2006