Gap (GPS)

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options and preserve as closely as practicable the economic characteristics that were contemplated when the grants were originally made.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Code and proposed regulations thereunder, neither of which were in effect or anticipated at the time the grants were originally made, the discounted options would have constituted deferred compensation which would likely have resulted in income recognition prior to exercise, an additional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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