Apple (AAPL)

3. The Crucial Role of Long-Term Equity Awards

Overview. The Compensation Committee believes that long-term equity awards are the most effective way to attract and retain a superlative executive team. Accordingly, executive compensation is heavily weighted toward long-term equity awards rather than cash compensation, and the awards have long vesting intervals to maximize their retention value. This approach is reflected in the following:

In designing long-term equity awards, the Compensation Committee seeks to maximize their effectiveness in accomplishing the Company’s compensation objectives while recognizing the Board’s duty to the Company’s shareholders to limit equity dilution. The Compensation Committee believes this balance has been achieved as follows:

Restricted Stock Units Minimize Dilution and Support Long-Term Focus. Since fiscal year 2004, all equity awards to the named executive officers have been RSUs rather than stock options. A grant of RSUs gives an officer the right to receive a specified number of shares of the Company’s common stock, at no cost to the officer, if the officer remains employed at the Company until the RSUs vest. RSUs granted in 2004 also provide for accelerated vesting if the named executive officer is terminated without cause or on a change of control, RSUs granted before 2007 provide for accelerated vesting on a change of control, and all RSUs provide for accelerated vesting upon the death of the officer. The compensation value of an RSU does not depend solely on future stock price increases; at grant, its value is equal to the Company’s stock price. Although its value may increase or decrease with changes in the stock price during the period before vesting, an RSU will have value in the long term, encouraging retention. By contrast, the entire compensation value of a stock option depends on future stock price appreciation. Accordingly, RSUs can deliver significantly greater share-for-share compensation value at grant than stock options, and the Company can offer comparable grant date compensation value with fewer shares and less dilution for its shareholders.

Long Vesting Intervals to Maximize Retention. All vesting of RSUs is generally subject to continued employment. Except for occasional new hire grants, vesting occurs at intervals of no less than two years after the grant date. This ensures that a meaningful portion of a named executive officer’s awards will vest every two years—a strong incentive to continue employment with the Company. The following table shows the grant and vesting patterns for ongoing RSU grants for the named executive officers since fiscal year 2004 (excluding those who were not named executive officers at the time of grant).

16

Vesting Conditions. As noted above, the vesting of all RSUs is generally contingent on the named executive officer’s continued employment with the Company, rather than on performance with regard to specific business objectives. From time to time, the Compensation Committee has considered various forms of performance-based vesting. After careful evaluation, the Compensation Committee has concluded that performance-based vesting would not serve the Company’s current objectives as effectively as the program described above. The Compensation Committee generally grants RSUs with two to four year vesting periods to maximize the award’s retention value. This retention value would be undermined if a named executive officer’s equity awards (which represent approximately 85% of the officer’s compensation) were at risk based on performance measures that were determined two or even four years prior to the vesting date. Given the intensely dynamic business environment in which the Company operates, it would be extremely difficult to craft meaningful objectives with such a long horizon. The Company imposes no requirement that the named executive officers hold their common stock for any period after vesting.

Annual Burn Rate Averages Less Than 2.5%. In fiscal year 2005, the Company committed to an annual “burn rate” (the total number of all equity award shares granted during the fiscal year divided by the total shares outstanding at the end of the fiscal year) of 2.5% from fiscal year 2005 through fiscal year 2007. This commitment represented a significant reduction from an average burn rate of 4.8% from fiscal year 2002 through fiscal year 2004. In fact, the Company’s average annual burn rate from fiscal year 2005 through fiscal year 2007 was approximately 1.6%.

Overhang from Equity Plans at 12.9%. Overhang (granted and outstanding equity awards plus shares reserved for future awards, divided by the sum of total shares outstanding, granted and outstanding equity awards, and shares reserved for future awards) is another measure of equity dilution. The efficient use of equity awards, combined with the substantial exercise of employee stock options due to the significant increase in the Company’s stock price over the past few years, has caused the Company’s overhang to decline from approximately 14.5% at the end of fiscal year 2005 to approximately 12.9% at the end of fiscal year 2007.

Frequency and Size of Equity Awards. The named executive officers typically receive equity awards every two years, rather than every year. This practice is consistent with the long time horizon and lengthy vesting periods of the awards. By making awards less frequently, the Compensation Committee can provide larger grants, which in turn promotes greater retention.

To determine the size of RSU grants, the Compensation Committee first establishes a target compensation value that it wants to deliver to the named executive officers through long-term equity awards. In doing so, the Compensation Committee considers various factors, including the following:

Once the target value has been established, the Compensation Committee determines the number of shares by reference to the current value of the Company’s common stock.

17