Michael A. ThompsonFREDERIC W. COOK & CO.

July 19, 2000

2

Topics CoveredTopics Covered

• Old economy companies losing to new Old economy companies losing to new economy companieseconomy companies– May be changing, but not certainMay be changing, but not certain

• Retaining high performers harder than Retaining high performers harder than everever

• Investors pushing back on dilutionInvestors pushing back on dilution• Rescuing underwater options is difficult, Rescuing underwater options is difficult,

not impossiblenot impossible• Innovations and trends to watchInnovations and trends to watch

3

Stock MarketStock Market

“Bifurcated” Economy

4

Volatile Stock MarketVolatile Stock Market

• Nasdaq was down 1/3 but recoveringNasdaq was down 1/3 but recovering– Up 40% over past 12 monthsUp 40% over past 12 months

• Dow down slightly over past 12 mos.Dow down slightly over past 12 mos.• Many companies have lost 50% or more Many companies have lost 50% or more

of their valueof their value– XeroxXerox MattelMattel– ArmstrongArmstrong Bank OneBank One– Sara LeeSara Lee R.R. DonnelleyR.R. Donnelley– SearsSears Toys R UsToys R Us– E-ToysE-Toys Red HatRed Hat

“Bifurcated” Economy

5

Corporate TransactionsCorporate Transactions

• MergersMergers

• AcquisitionsAcquisitions

• Divestitures/ SalesDivestitures/ Sales

• IPOsIPOs

• Spin-offsSpin-offs

• Tracking StockTracking Stock

“Bifurcated” Economy

6

Rise of Venture CapitalRise of Venture Capital

• Corporate Venture Capital and Corporate Venture Capital and Private Equity FundsPrivate Equity Funds

• Creates significant pressure on Creates significant pressure on executive compensationexecutive compensation– Internal venture managersInternal venture managers

• Raises issues regarding “friends and Raises issues regarding “friends and family” shares on IPOfamily” shares on IPO

“Bifurcated” Economy

7

Corp. Venture CapitalCorp. Venture Capital

“Bifurcated” Economy

Corporate VC Compensation Practices

Carried Interest

Incentives

Mandatory Co-Invest

Voluntary Ad Hoc

Co-Invest

Voluntary Side-by-Side

Fund

Current Prevalence Future Prevalence

32%

68%

7% 11%

21% 18%

0%

32%

0%

25%

50%

75%

100%

8

Internet ImpactInternet Impact

• Changing the gameChanging the game– Focus on carried interest, not Black-Scholes Focus on carried interest, not Black-Scholes

valuevalue– Equity interest in E-commerce unitsEquity interest in E-commerce units

• Raises the ante for retentionRaises the ante for retention• Significant salary increases in some Significant salary increases in some

sectors, e.g., law firmssectors, e.g., law firms• Push to client equity pools in others, e.g., Push to client equity pools in others, e.g.,

consulting firmsconsulting firms

Oldcos vs. Newcos

9

Competing Pay ModelsCompeting Pay Models

Oldcos vs. Newcos

Relative ComparisonRelative Comparison

OldcosOldcos NewcosNewcos

Annual CashAnnual Cash HighHigh LowLow

BenefitsBenefits HighHigh LowLow

Stock OptionsStock Options Low Low HighHigh

10

Expensive RecruitingExpensive Recruiting

• In the money option values:In the money option values:– 18 internet companies18 internet companies

$0

$50

$100

$150

$200

$250

1999 2000

(est.)

1999 2000

(est.)

1999 2000

(est.)

1999 2000

(est.)

Vested Unvested

Option Gains ($000,000)

CEO COO CFO Top Sales

Oldcos vs. Newcos

11

Different Pay PackagesDifferent Pay Packages

• Joseph Galli example:Joseph Galli example:From To

Company Black & Decker Amazon

Position Head of Power ToolBusiness

President & COO

Compensation (Latest year) $1.1Mannual cash + $460KLTI + 75K options +rich pension/SERP

$200K salary +3.9M options with$20M guarantee +$5M cash signingbonus

Oldcos vs. Newcos

12

Generic ComparisonsGeneric Comparisons

$0

$500

$1,000

$1,500

$2,000

$2,500

Salary Bonus Long-Term

CEO CFO Top Sales General Counsel

GI

GIGI

GI

Internet

Internet

Internet

Internet

($000)

Oldcos vs. Newcos

13

Pre- vs. Post-IPOPre- vs. Post-IPO

Pre-IPOPre-IPO Post-IPOPost-IPO

Median RevenuesMedian Revenues $3 MM$3 MM $6 MM$6 MM

Median Market Median Market ValuationValuation

$38 MM$38 MM $362 MM$362 MM

Median Number of Median Number of EmployeesEmployees

4040 158158

Source: SCA ePay Study, April 2000-- Over 30 pre-IPO companies and 50 post-IPO companies-- Traditional company assumed to be $400MM revenue and $275 Market Cap

Oldcos vs. Newcos

14

Company PracticesCompany Practices

$118$153

$175

$20

$30

$80

13%

13%22%

87%65%

$0

$50

$100

$150

$200

$250

$300

Pre-IPO Post-IPO Traditional Post-IPO Traditional

Dol

lars

(00

0)

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

% o

f sh

ares

out

stan

ding

Investors

Founders

Employees

Source: SCA ePay Study, April 2000

Vice President Cash Compensation Median Company Ownership

Salary

Bonus

Oldcos vs. Newcos

15

Company PracticesCompany Practices

$145

$250

$140

8.0%

5.0%

0.9%

$0

$50

$100

$150

$200

$250

$300

CEO-Founder CEO-Nonfounder

Vice President CEO-Founder CEO-Nonfounder

Vice President

Dol

lars

(00

0)

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

% o

f sha

res

outs

tand

ing

Median Cash Compensation Median Equity Owned

Source: SCA ePay Study, April 2000

Oldcos vs. Newcos

16

Run Rate ComparisonsRun Rate Comparisons

1.1%

5.0% - 7.0%

2.1%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

Old Economy New Economy

1989 1999

An

nu

al G

ran

ts a

s a

% o

f O

uts

tan

din

g S

har

es

91% Growth

Oldcos vs. Newcos

17

Dilution ComparisonsDilution Comparisons

6.9%

13.7%

20.0% - 25.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

Old Economy New Economy

1989 1999

Pot

enti

al D

ilu

tion

as

a %

of

Ou

tsta

nd

ing

Sh

ares

99% Growth

Oldcos vs. Newcos

18

Candidates’ ResponseCandidates’ Response

• More risk averseMore risk averse• Want additional cashWant additional cash• Will trade-off options for Will trade-off options for

– restricted stock, restricted stock, – SERPs, SERPs, – deferred annuities, deferred annuities, – forgivable loans, forgivable loans, – etc.etc.

Oldcos vs. Newcos

19

Recent InitiativesRecent Initiatives

• Tracking stockTracking stock– Disney, DLJ, Quantum, Staples, ATTDisney, DLJ, Quantum, Staples, ATT

• Spinoffs/IPOsSpinoffs/IPOs– ATT, GM, HP, LucentATT, GM, HP, Lucent

• Subsidiary OptionsSubsidiary Options• Venture Capital IncentivesVenture Capital Incentives

– Merrill Lynch, ?Merrill Lynch, ?

Oldcos vs. Newcos

20

Reason for the ProblemReason for the Problem

• High demandHigh demand• High mobility and High mobility and

accessible infoaccessible info• Recruiting premiums Recruiting premiums

and buyout packagesand buyout packages• ““Star” systemStar” system

• Longest bull marketLongest bull market• Options and other Options and other

equity compequity comp• Stock price is major Stock price is major

determinant of comp determinant of comp valuevalue

Retention

Labor Market Stock Market

21

Carly Fiorina ExampleCarly Fiorina Example

Retention

FromFrom ToTo

CompanyCompany LucentLucent Hewlett-PackardHewlett-Packard

PositionPosition Group President, Group President, Global Service Global Service

Provider BusinessProvider Business

Chief Executive Chief Executive OfficerOfficer

CompensationCompensation $70MM of unvested $70MM of unvested options forfeited at options forfeited at

terminationtermination

$100MM signing $100MM signing packagepackage

22

Design ProvisionsDesign Provisions

Beyond the traditional . . .Beyond the traditional . . .• Option Clawbacks (Cigna, Delta, Goodyear, Option Clawbacks (Cigna, Delta, Goodyear,

IBM)IBM)• Tandem option guarantees (Amazon)Tandem option guarantees (Amazon)• Stock purchase loans (eBay, Excite@Home, Stock purchase loans (eBay, Excite@Home,

Kodak) Kodak) • Career Restricted Stock (Coca-Cola, GE, 3M)Career Restricted Stock (Coca-Cola, GE, 3M)• Forfeitable Deferral Premiums (Alcoa, Dell, Forfeitable Deferral Premiums (Alcoa, Dell,

GM)GM)

Retention

23

Design ProvisionsDesign Provisions

• Restricted stockRestricted stock– 3/5 year vesting or career3/5 year vesting or career

• VC investment fundsVC investment funds• Shared participation in e-commerce Shared participation in e-commerce

subsidiariessubsidiaries• Voluntary cash/stock deferrals, with Voluntary cash/stock deferrals, with

forfeitable sweetenerforfeitable sweetener• Supplemental retirement plans with “bad Supplemental retirement plans with “bad

boy” clausesboy” clauses

Retention

24

• Higher “burn rates” and “overhang”Higher “burn rates” and “overhang”

• More scrutiny from institutional investorsMore scrutiny from institutional investors

Upward TrendUpward Trend

% Outstanding SharesTop-200 (P. Meyer Survey)

1989 1999

Annual Grants 1.1% 2.1%

Potential Dilution 6.9% 13.7%

Dilution

25

2000 Voting--ISS2000 Voting--ISS

• Opposed majority of plans (55%)Opposed majority of plans (55%)– Limited impact, but still a concernLimited impact, but still a concern

• Continued flaws in modelContinued flaws in model– Overvalues grants at high performers and Overvalues grants at high performers and

vice-versavice-versa– Penalizes omnibus plans without limits on Penalizes omnibus plans without limits on

full-value grantsfull-value grants– Discourages breakout from low utilization Discourages breakout from low utilization

industries (defense, utilities)industries (defense, utilities)

Dilution

26

2000 Voting--Others2000 Voting--Others

• Focused mostly on dilution, not wealth Focused mostly on dilution, not wealth transfertransfer

• Fidelity opposed to RS without Fidelity opposed to RS without minimum 2-3 years restrictionsminimum 2-3 years restrictions

Dilution

Large Cap Small Cap

> 15% > 20%

10-15% 15-20%

<10% <15%

27

Changes in PracticesChanges in Practices

• Smaller more Smaller more frequent share frequent share authorizationsauthorizations

• Shares counted on Shares counted on net, as issued basis, net, as issued basis, not gross, as granted not gross, as granted basisbasis

• Add back shares re-Add back shares re-purchased with option purchased with option proceedsproceeds

• Board approved plans Board approved plans for non-officersfor non-officers

• Best voting outcome Best voting outcome because of dilution because of dilution teststests

• Add back shares to Add back shares to pool from stock-swap pool from stock-swap exercises, etc.exercises, etc.

• Particularly with Particularly with prevalent buy-back prevalent buy-back programsprograms

• Possible under stock Possible under stock exchange rulesexchange rules

Dilution

28

Looking AheadLooking Ahead

• NYSE may limit broad-based exemptionNYSE may limit broad-based exemption• Efforts needed to encourage improved Efforts needed to encourage improved

investor voting rulesinvestor voting rules– Especially ISSEspecially ISS

• % of salary grant guidelines no longer % of salary grant guidelines no longer usefuluseful– Start with competitive % share usage, using Start with competitive % share usage, using

surveys for surveys for allocationallocation

Dilution

29

Underwater Options

If shares availableIf shares available

• Front-load future option grantsFront-load future option grants• Next 2-3 yearsNext 2-3 years• Incentive for price recovery and Incentive for price recovery and

retentionretention• No additional “competitive” No additional “competitive”

compensation valuecompensation value

30

If shares not availableIf shares not available

New option grants could be made New option grants could be made after 6 months with no variable after 6 months with no variable accounting expenseaccounting expense

• Executives voluntarily cancelExecutives voluntarily cancel• Company buys back for restricted Company buys back for restricted

stock or cashstock or cash– At fair value (Black-Scholes)At fair value (Black-Scholes)– Discount from fair valueDiscount from fair value

Underwater Options

31

More Drastic HedgesMore Drastic Hedges

• Options with dividend equivalentsOptions with dividend equivalents• Replace u/w options with restricted Replace u/w options with restricted

stockstock• Price-recovery restricted stockPrice-recovery restricted stock• Cash-appreciation bonusesCash-appreciation bonuses• Subsidiary optionsSubsidiary options• Relative performance sharesRelative performance shares• Combination option/rs grantsCombination option/rs grants

Underwater Options

32

Innovations/Trends

Option-RelatedOption-Related

• Opportunistic grant timingOpportunistic grant timing• More frequent grants More frequent grants • Shorter option termsShorter option terms• Offset guaranteesOffset guarantees• ReloadsReloads• Auto-acceleration at terminationAuto-acceleration at termination

– Except cause or voluntary quitExcept cause or voluntary quit

• Price thresholds for exercisePrice thresholds for exercise

33

OtherOther

• Double-trigger change-in-control Double-trigger change-in-control stock vestingstock vesting– No vesting if stock awards replacedNo vesting if stock awards replaced

• Personal loansPersonal loans– Forgivable and non-forgivableForgivable and non-forgivable

• Flexible DeferralsFlexible Deferrals

Innovations/Trends

34

Likely ResponseLikely Response

• Increased share usage/dilutionIncreased share usage/dilution– Human capital value addedHuman capital value added

• Greater dispersion and selectivity of Greater dispersion and selectivity of rewards by individualsrewards by individuals– Four critical factorsFour critical factors

• Focus on line-of-sight incentivesFocus on line-of-sight incentives– Less focus on wholeLess focus on whole– More potential for inequitiesMore potential for inequities

Innovations/Trends

35

Frederic W. Cook & Co., Inc. provides management compensation consulting services to business clients.Formed in 1973, our firm has served over 1,000 corporations in a wide variety of industries from our offices in NewYork, Chicago, and Los Angeles. Our primary focus is on performance-based compensation programs which helpcompanies attract and retain key employees, motivate and reward them for improved performance, and align theirinterests with shareholders. Our range of consulting services encompasses the following areas:

Total Compensation Reviews Incentive Grant Guidelines Performance Measurement Strategic Incentives Executive Ownership Programs Globalization Specific Plan Reviews All-Employee Plans Privatization Restructuring Services Directors’ Compensation Compensation Committee Advisor Competitive Comparisons Equity Instruments Stock Option Enhancements

Our offices are located:

New York Chicago Los Angeles90 Park Avenue35th floor

19 South LaSalle StreetSuite 400

2029 Century Park EastSuite 1130

New York, New York 10016 Chicago, Illinois 60603 Los Angeles, California 90067212-986-6330 phone 312-332-0910 phone 310-277-5070 phone212-986-3836 fax 312-332-0647 fax 310-277-5068 fax

Web site address:www.fredericwcook.com