Gap (GPS)

Fiscal 2009 Long-Term Incentives

During 2008 the Committee reviewed the long-term incentive structure for executives other than the CEO, including evaluation of a potential long-term plan with multiple year performance goals, with the objective of better promoting long-term value creation and in the case of division executives, to further tie executive incentives to business unit performance. In light of substantial uncertainty about economic conditions over the next year, the Committee determined not to proceed with such a long-term plan for 2009.

However, after considering the factors described under “Compensation Analysis Framework” above, the Committee made the following changes to long-term incentives to further the objective of tying incentives to business unit performance as well as to reduce reliance on stock price growth as a way to promote retention:

In January 2009 and again in March 2009, the Committee considered the value and vesting schedule of long-term incentives held by executives other than Mr. Murphy and assessed potential retention risk in light of the significant decline in our stock price and the associated decrease in the retention value of incentives that had not yet vested. Based on this review, the Committee determined it was in the Company’s interests to make special stock unit grants to certain executives to promote retention and further alignment with shareholder interests. In determining award amounts and recipients, the Committee considered the factors described above under “Compensation Analysis Framework” and used its judgment to identify the value required to help retain each executive, placing significant weight on Mr. Murphy’s recommendations. Ms. Hansen and Mr. Peck each received a special stock unit grant of 100,000 shares, and Ms. Simmons received a stock unit grant of 150,000 shares. Her stock unit grant was higher in order to position long-term incentive value appropriately relative to other executives. The grants were made in March 2009 and will vest 50% two years following the grant date to create a retention incentive for a shorter time horizon and 50% three years following the grant date to promote longer-term retention. The Committee determined that no further award was necessary for Mr. Wyatt.

Executives other than Mr. Murphy also received stock option grants in March 2009 under the annual program described above.

Fiscal 2007 Long-Term Incentives

We did not make further long-term incentive grants to executives in the first quarter of fiscal 2007 in light of the significant performance unit awards made to executives at the end of fiscal 2006, other than those earned by Ms. Hansen under the annual performance stock award program. To ensure competitiveness, appropriate balance of incentive vehicles, and to support the Company’s retention objectives, we have made the following changes to our long-term incentive program for executives for fiscal 2007:

For fiscal 2007, the annual performance stock award grant for Ms. Hansen will be based on the better of: 1) the value that would be earned based on Banana Republic financial results and assuming her salary prior to assumption of the role of President, Gap North America, or 2) the value earned based on Gap North America financial results and assuming her current salary as defined under the Executive MICAP. The Committee determined this treatment was appropriate for Ms. Hansen given the strategies she put in place at Banana Republic, which will continue to impact Banana Republic’s fiscal 2007 results, and the time necessary to fully impact results of Gap North America.

Long-Term Incentives

Stock-based long-term incentives create a direct link between executive rewards and shareholder returns by tying a significant portion of total compensation to the performance of the Company’s stock. The Company does not have a defined benefit pension plan covering executive officers and therefore we rely on long-term incentives to provide a significant percentage of each executive’s retirement portfolio. We have the authority to grant stock options, performance units and other awards under the Company’s 1996 Stock Option and Award Plan. On January 24, 2006, the Plan was amended, restated, and renamed the 2006 Long-Term Incentive Plan (the “Plan”), subject to shareholder approval at the Annual Meeting. A description of the Plan is located on page 18 of this Proxy Statement.

Stock Options

We believe that stock options focus executives on managing the Company from the long-term perspective of an owner with an equity stake in the business. Stock options are tied to the future performance of the Company’s stock and provide value to the recipient only if the price of the Company’s stock increases above the option exercise price. It has been our practice to grant stock options to executive officers on an annual basis, usually in the first quarter of each fiscal year. Options typically are scheduled to vest 25% per year beginning one year from the date of grant, and executives generally must be employed by the Company at the time of vesting in order to exercise the options. We determined that, in order to continue to motivate and retain key talent, it was in the best interests of the Company to grant stock options to executives in the first quarter of 2005. In order to determine the appropriate number of options to be granted to executive officers, we considered competitive practices, including the grant value of options in relation to the executive’s role, performance and potential, internal comparisons, and shareholder dilution. In addition, we considered such factors as awards previously granted to an individual, an individual’s outstanding awards, the vesting schedule of the individual’s outstanding awards, the aggregate total of all outstanding options and awards, and the relative value of awards offered by comparable companies to executives in comparable positions. Special additional stock options and other stock rights may be granted or approved from time to time to executive officers in connection with promotions, assumption of additional responsibilities and other factors.

Performance Units

Executive officers are eligible under Executive MICAP to earn performance units payable in shares of our stock each year based on achievement of specific performance goals. Specific measurements that can be used by the Committee (in its sole discretion) each period are detailed in the Executive MICAP. We approve threshold, target, and maximum performance goals and potential awards at the beginning of each annual performance period. Actual awards are calculated pursuant to a predetermined formula that incorporates the extent to which performance goals are achieved and the award target for each executive officer. Awards are made only if threshold performance levels are met. We certify the attainment level of all goals and approve specific grants to executive officers. We also review the performance of each executive officer and, in our sole discretion, may reduce (but not increase) actual awards. Following grant, awards are subject to a vesting period based on continued service with the Company.

For fiscal 2005, awards were based on performance against Earnings Per Share (EPS) growth goals set for the Company. The target annual award was equal to 30% of the executive officer’s base salary, except for the CEO, whose target award was 50%. Awards could have ranged from 50% to 200% of the target amount unless the threshold EPS growth goal was not met, in which case no award is made. We determined that the Company’s performance in fiscal 2005 did not meet the threshold EPS growth goal and therefore no awards were granted to executive officers, including the CEO.

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Tender Offer to Certain Stock Option Holders

On November 23, 2005, the Company made a tender offer to employees, including certain executive officers, holding stock options that had an exercise price that was less than the fair market value on the date of grant and that were not vested as of December 31, 2004 (“discounted options”). The offer was completed on December 22, 2005. We approved this offer in order to help eligible employees avoid unintended and unfavorable tax consequences related to their discounted options and preserve as closely as practicable the economic characteristics that were contemplated when the grants were originally made. Under Section 409A of the Internal Revenue Code and proposed regulations thereunder, neither of which were in effect or anticipated at the time the grants were originally made, the discounted options would have constituted deferred compensation which would likely have resulted in income recognition prior to exercise, an additional 20% tax, and potential interest charges if they had remained outstanding. The offer provided a voluntary opportunity for eligible employees to exchange outstanding, discounted options for new options and, if applicable, cash payments on either the offer expiration date or in the future (for those options that were not yet vested) to compensate for the lost discount. The offer was designed in a way that was specifically contemplated by the Treasury Department and the Internal Revenue Service in the proposed Internal Revenue Code Section 409A regulations. As permitted by these proposed regulations, some of the new options granted as part of the offer have per share exercise prices equal to the original grant date fair market value of the Company’s shares, while others have per share exercise prices equal to the fair market value of the Company’s shares on December 22, 2005.

The discounted options were originally granted to executive officers in order to attract and/or retain them as part of their overall compensation package. For example, upon the initial employment of Paul Pressler, our CEO, we approved the award of a combination of discounted options (such as those that were subject to this offer), options with an exercise price at the then current fair market value of the Company’s shares, and premium-priced options (with an exercise price greater than the then current fair market value of the Company’s shares). Efforts by the Company to design appropriate long-term incentive awards such as Mr. Pressler’s have been recognized outside the Company. For example, in a November 19, 2002 column in “Bloomberg News,” entitled “Gap Breaks the Mold With CEO Pay,” Graef Crystal, a nationally recognized compensation consultant, cited favorably the Company’s innovative stock option package granted to Mr. Pressler, saying that “Gap’s inventive approach comes close to reconciling the ultimately irreconcilable desires of both shareholders and the new CEO.”

Our Committee’s independent executive compensation consultant, George Paulin of Frederic W. Cook & Co., endorsed the offer. Mr. Paulin believes that the offer was reasonable and appropriately reflected the objectives which guided us, which was to treat employees fairly by preserving as closely as practicable the economic characteristics that were contemplated when the grants were originally made. Mr. Paulin believes that the offer appropriately aligns with the spirit and requirements of the new tax regulations for amending past practices to comply while maintaining the employment retention and employee ownership characteristics of the original grants.

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Long-Term Incentives

Stock-based long-term incentives create a direct link between executive rewards and shareholder returns by tying a significant portion of total compensation to the performance of the Company’s stock. We believe that stock options focus executive attention on managing the Company from the long-term perspective of an owner with an equity stake in the business. Stock options are tied to the future performance of the Company’s stock and provide value to the recipient only if the price of the Company’s stock increases above the option exercise price.

We have the authority to grant stock options and other awards under the Company’s 1996 Stock Option and Award Plan. It has been our practice to grant stock options to executive officers on an annual basis, usually in the first quarter of each fiscal year. Options typically vest 25% per year beginning one year from the date of grant, and executives generally must be employed by the Company at the time of vesting in order to exercise the options. We have discretion to grant discounted and premium stock options and have done so when appropriate to attract and/or retain key executives. The Committee determined that it was in the best interests of the Company to grant stock option awards to executives in the first quarter of 2004. In order to determine the appropriate number of options to be granted to executive officers, we considered competitive practices, including the grant value of options (number of shares times the exercise price) in relation to the executive’s individual performance and potential, and shareholder dilution. The Company does not have a defined benefit pension plan covering executive officers and therefore we rely on long-term incentives to provide a significant percentage of each executive’s retirement portfolio.

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