After the Storm – High Tech Pay in a Post-Expensing World

1. After the Storm –High Tech Pay in a Post-Expensing World May 25, 2005

2. Today’s Speakers Carl Schmitt Director Human Resources & Investor Solutions 415-617-3914 schmitt.c@mellon.com Brett Harsen Senior Consultant Human Resources & Investor Solutions 312-846-3418 harsen.b@mellon.com

3. INTRODUCTION Today’s Session • Approximately one-hour presentation • Question and answer period to follow • Questions can be directed via e-mail to radowick.d@mellon.com(please note this email now – we encourage questions)

4. INTRODUCTION In today’s discussion, we will cover six topics Overview of recent accounting developments The latest on Mellon’s research into vesting acceleration practices Update on option valuation trends in High Tech Developments in High Tech equity compensation programs Expected future directions for High Tech equity compensation Issues to consider One Two Three Four Five Six

5. Section One – Overview of Recent AccountingDevelopments

6. ACCOUNTING DEVELOPMENTS Much has happened since our January 2005 webcast on the final FAS123R rules ? April • SEC delays FAS123R • IBM starts expensing (retrospectively) February • Options bill reintroduced in Congress March • SEC issues SAB107 May • Cisco intends to issue new security to value employee options Jan - May • Number of companies accelerating vesting grows from approx. 15 to over 100 • High Tech companies continue to assess alternative equity strategies, but have largely stuck to the wait-and-see mindset Just what is in store for the future is anyone’s guess right now…

7. ACCOUNTING DEVELOPMENTS SAB 107 is meant to expand upon and clarify FAS123R…

8. ACCOUNTING DEVELOPMENTS SAB 107 is meant to expand upon and clarify FAS123R…

9. Section Two – Vesting Acceleration

10. VESTING ACCELERATION A unique window of opportunity exists to shift option costs into footnotes prior to SFAS123(r) • While a modification, no variable accounting is triggered and no fixed charge is recognized if the options are underwater (recent auditor interpretations have also indicate that in-the-money options can be accelerated without incurring substantial costs) • Requires immediate recognition of remaining grant-date fair value in the SFAS123 footnotes • Does not require shareholder approval under the new NYSE and Nasdaq corporate governance rules • Shareholders may view this as a giveaway – especially if the options accelerated are not significantly underwater and/or are held by officers or outside directors • Eliminates any remaining employee retention value associated with the award • Will create spikes in option-related (footnote) expenses that may increase the difficulty of comparing period-over-period financials How it Works Implications

11. VESTING ACCELERATION The simplified mechanics of the strategy are as follow

12. VESTING ACCELERATION Forty percent of the 97 companies we studied were from high technology Including some large, well-known tech companies: • Tech Data • Flextronics • Sanmina • Solectron • Jabil Circuit • AMD • Micron Technology • International Rectifier • Monster Worldwide • InFocus Vesting Acceleration Industry Breakdown LifeSciences 10% High Technology 40% GeneralIndustry 50% n=97

13. VESTING ACCELERATION The number of companies continues to grow – even immediately after the SEC’s delay of mandatory implementation in March (As of 5/09) n=97

14. VESTING ACCELERATION While most only accelerate those underwater, a growing number have accelerated in-the-money options as well

15. VESTING ACCELERATION Additional program design findings include… • Roughly one-quarter of outstanding options were accelerated • Only 12% excluded board options and 6% excluded officers • Only 13% placed restrictions on the sale of stock acquired through early exercises

16. VESTING ACCELERATION … And from outward appearances, shareholders haven’t reacted negatively toward the stock

17. Section Three – Trends in Option Valuation

18. OPTION VALUATION Many High Tech companies are realizing that binomial is no silver bullet • The binomial model can theoretically be more accurate because it can incorporate a greater array of inputs • However, the output of the model is only as good as the quality of the inputs • Yes, the binomial model can accommodate volatility, risk-free rate and dividend yield assumptions that vary from period to period into the future based on predicted company or market events… • But, how many companies can reliably predict how future events will impact these variables? • In some cases, given the nature of binomial calculations, increased accuracy may even mean increased cost • Finally, it is still unclear exactly how auditors will respond to the more complex inputs required by robust binomial models as the large accounting firms are still developing their own internal guidance

19. OPTION VALUATION Binomial complexity can easily get out of control Our auditors give us a hard enough time on the six basic Black-Scholes inputs!

20. OPTION VALUATION Before investing in expensive binomial technology or outsourcing, three low effort/high-impact steps should be explored FIRST – Scrutinize your volatility assumption(s) within the context of the new guidance (lower volatility = lower cost) Greater flexibility now exists for building cases to excluded historic periods of extraordinary volatility… If your company has market traded options that can be referenced, SAB 107 tells us implied volatility is a strong benchmark… Use multiple approaches to support your case for what you expect the company’s volatility to be in the future – but be prepared for increased disclosure

21. OPTION VALUATION Before investing in expensive binomial technology or outsourcing, three low effort/high-impact steps should be explored (continued) SECOND – Use existing data from your option administration software or outsourcer to scrutinize historic exercise periods (shorter holding period = shorter cost) • Don’t rely on solely standard reports from your option software or outside administrator to provide accurate employee holding period data (some systems use subjective calculations, most systems will aggregate holding periods on grants with different vest schedules) • Look for different exercise patterns among employee groupings, but only use these differences if the patterns are sustainable and do not make valuation overly-complicated Calculate the period of time employees hold options after they become exercisable so that data on grants with different vest schedules can be properly compared

22. OPTION VALUATION Before investing in expensive binomial technology or outsourcing, three low effort/high-impact steps should be explored (continued) THIRD – Value each tranche of a ratably vested award as a different grant to recognize early exercisability • Assumptions • Stock options are granted with a four-year total vest period, vesting in tranches of 25% per year • From historic experience, employees are shown to exercise 12 months after vest • This single grant is broken into 4 tranches based on vesting…

23. OPTION VALUATION Before investing in expensive binomial technology or outsourcing, three low effort/high-impact steps should be explored (continued) THIRD – Value each tranche of a ratably vested award as a different grant to recognize early exercisability (continued) • … this tranche-based approach virtually eliminates the differences between Black-Scholes and binomial (assuming all other assumptions remain equal) Substantially Similar

24. OPTION VALUATION In summary, when binomial is used to increase option valuation complexity… Some things are certain… = Complexity Administrative Burden = Audit Scrutiny/Burden = Transparency But some things are NOT… ? = Accuracy Complexity ? = Expense Complexity

25. Section Four – Developments in Equity CompensationPrograms

26. HIGH-TECH TRENDS Option accounting is not the only issue driving equity compensation decisions Major Drivers Secondary Drivers Option ExpensingFAS123R SEC (Disclosure Requirements) Equity Compensation ShareholderPressure NYSE/NASDAQ(Approval Requirements) Taxation &Deferred Compensation(AJCA) Congress(Pending Legislation)

27. HIGH-TECH TRENDS High Tech companies have been (slowly) modifying their equity compensation programs in anticipation of option expensing • The primary changes have been evolutionary… • Stock options are still the dominant form of equity compensation • However, a notable portion of companies have introduced alternative equity vehicles, primarily restricted stock (units) and performance shares Reduce overall share usage (burn rate) Reduce participation and/or eliminate eligibility Reduce individual grant levels Implement/refine international differentials

28. HIGH-TECH TRENDS Overall share usage has been the primary focus • Reducing the burn rate for equity addresses both expensing and investor dilution concerns • High Tech companies are targeting 3.0% gross burn rate for 2005 • Lower burn rate of 2.0% for largest tech companies • Small and rapidly growing companies will struggle to get below 4.0% • These target burn rates represent a significant decline in share usage over the past few years • Burn rates have been declining 20%-30% year over year for most companies

29. HIGH-TECH TRENDS To reduce usage, companies have been making tough decisions around eligibility and participation • Our Summer 2004 flash survey found that companies expected to reduce participation primarily for lower level employees • To date, this prediction has proven to be true

30. HIGH-TECH TRENDS High Tech companies still believe in broad equity grants, but are raising the bar on performance • Grants to new hires are still nearly universal • The majority of companies still grant options to nearly all (~100%) new hires • Ongoing grant programs have seen the biggest cutbacks in participation • Below the director level, universal participation is becoming rare • Companies generally set a target portion (15%-75%) of employees expected to receive a grant in any year • “Annual” grants are now “performance” grants • International grant levels and participation are receiving greater scrutiny • “One size fits all” is an unaffordable luxury

31. HIGH-TECH TRENDS High Tech companies are increasing usage of stock option alternatives • Stock options are still the dominant form of equity compensation! • And will be for the foreseeable future • Among the alternatives, full-value grant programs (restricted stock, performance shares) are getting the most attention • Other option alternatives like stock-based SARs (Stock Appreciation Rights) are becoming more common • Some potential successors to options have lost favor because of tax, accounting, or investor issues • A number of High Tech companies have implemented full value grant programs in the past year despite APB25 expense • Expect the trend to increase as companies get closer to FAS123R implementation • Companies have taken widely divergent approaches with full value grants • Carve-out vs. wholesale replacement of options • Executives only vs. all employees vs. only lower levels

32. Section Five – Future Directions

33. FUTURE DIRECTIONS Due to the staggered implementation of FAS123R, equity practices will continue to evolve at a measured pace Winter ’05/’06 • Calendar YE companies begin expensing Summer ‘05 • June 30 FYE companies begin expensing Fall ‘05 • First required Q1 releases under FAS123R (for 6/30/06 FYE) Spring ‘06 • Remaining public companies begin expensing Accounting Equity Compensation • Option acceleration increases in lead-up to fiscal year ends • Wider use of full-value shares and stock-based SARs in lieu of options • Continued reduction in equity burn rates and grant levels • Revival of exchange programs for underwater options (repricing)

34. FUTURE DIRECTIONS Now: Acceleration of underwater optionsFuture: Exchange of underwater options • We expect the pace of vesting accelerations to increase as companies approach their fiscal year ends • After adoption of FAS123R, acceleration is considered “non substantive” and has no accounting benefit • We expect to see increasing acceleration of vesting on in-the-money options • Under APB25/FIN44, recognition of expense for in-the-money value is contingent upon an event that would have otherwise caused forfeiture • As year end approaches, potential APB 25 cost of acceleration is minimized

35. FUTURE DIRECTIONS Now: Acceleration of underwater optionsFuture: Exchange of underwater options • After adoption of FAS123R, we expect option exchanges (repricing) to experience a resurgence • No longer any need for the “6 month and a day” (6+1) maneuver • Exchanges can occur immediately after close of tender offer • Under FAS123R, the exchange only increases accounting cost if incremental value is delivered • Most exchanges will be done on a value-neutral basis, so there will be no incremental expense • For most companies, shareholder approval is required for option exchanges • Need for shareholder approval may constrain frequency and variation in practices

36. FUTURE DIRECTIONS The “level playing field” will give full value shares closer parity with option programs • Once companies have to recognize an expense for all equity grants, the full-value grants will be a viable alternative • We expect an increasing portion of companies to incorporate full value grants into their equity programs • Options will likely remain the most common form of equity • In High Tech companies, the accounting cost of options is starting to become an issue for budgeting and planning purposes • Planning for future grants and impact on earnings guidance • Internal budgeting for equity costs by department/function • The net result will be increasing downward pressure on equity grant levels • “What gets measured, gets managed”

37. FUTURE DIRECTIONS The “level playing field” will give full value shares closer parity with option programs • A key issue for the options vs. full value shares is trade-off ratio • As companies reduce their option valuations, the implied trade-ratio becomes higher in order to remain expense neutral • At higher trade-off ratios, it takes only minimal stock price increases for options to achieve higher gains • The following table illustrates the gain required and years to achieve under various stock price growth scenarios

38. Section Six – Closing:Issues to Consider

39. LONGER-TERM STRATEGIES How much do all your programs cost?Who benefits from each program? Benefits (no pension) $60 MM • Company has more than $1.5 B in revenues • Company has more than $200 MM in profits • Bonuses are 30% of profits • Options are 35% of profits • ESPP is 2% of profits ESPP $4 MM Salaries $300 MM Options $70 MM Bonuses $60 MM Everything must be taken in context

40. LONGER-TERM STRATEGIES To support the total rewards philosophy, the design of LTI programs requires balancing several factors • SHAREHOLDERCONCERNS • Manage dilution COMPETITIVE NORMS ORGANIZATION STRATEGY • What are competitive opportunities at similar companies? Do we have to match the opportunities? • How deep do these opportunities extend and what forms do they take? • What is our business strategy? • What goals do we need to achieve over the next Year? Two Years? Three years? PLAN DESIGN ORGANIZATION SITUATION • Does our pay philosophy support: • Pay for performance • Risk/reward tradeoffs • What is the culture we want to reinforce and how far do we have to go to achieve it? Do you want to be a "first mover“ (“market leader”), "market follower", or in the middle?

41. LONGER-TERM STRATEGIES In conclusion… • High Tech is changing its equity practices at an evolutionary rate • There are specific accounting related actions that can (and should) be taken before implementing FAS123R • Over time, grant levels will likely continue to decrease and become more focused on top performers • In considering changes to equity programs, look at equity and its cost in the context of total rewards and the business strategy … The times, they are changing

42. Thank You Questions? (email now to: radowick.d@mellon.com) Carl Schmitt 415-617-3914 schmitt.c@mellon.com Brett Harsen 312-846-3418 harsen.b@mellon.com

43. APPENDIX For some companies, full-value grant programs can be a better match for their situation and needs