W.W. Grainger (GWW)

Long Term Incentives

        The Company annually provides long-term incentives to NEOs and other key managers in order to:

•

Strengthen management alignment with shareholders in value creation;



•

Achieve specific business goals (including balancing growth, profitability and asset management);



•

Attract qualified executives to join the Company; and



•

Retain management through business cycles.

25

        The Company's long-term incentives are stock-based. The target number of shares covered by long-term incentive awards is designed to provide an economic value that is generally at the median of the compensation comparator group for comparable jobs; the target can be adjusted up or down to reflect individual performance. The Committee established the target number of shares at its February 2006 meeting using a projected price and approved the awards at its April 2006 meeting for all participants, including the NEOs. In connection with their long-term incentive awards, recipients are required to sign an agreement containing confidentiality and non-competition provisions designed to protect the Company's confidential and proprietary information and to preserve the Company's competitive advantages.

        The Company's long-term incentives consist of stock options, performance shares, and restricted stock units (RSUs) and are provided under the 2005 Incentive Plan. In 2006, the Company increased the performance component of the long-term incentive program by adding performance shares as a part of its annual long-term incentive program for the NEOs and other officers. The performance shares can be earned only if the Company achieves certain objectives described below. The Company seeks to structure awards such that stock options represent approximately 40% of the total value of long-term incentive compensation, RSUs represent approximately 30% of the total value, and performance shares represent approximately 30% of the total value. This mix was chosen to achieve the program objectives, which as noted above are to strengthen management alignment with shareholders in value creation; achieve specific business goals (including balancing growth, profitability and asset management); attract qualified executives to join the Company; and retain management through business cycles.

•

40% Stock Options.    The Company's stock options provide the right to purchase Company stock at a specified price over a ten-year term and vest 100% on the third anniversary of grant. They are intended to directly link management and shareholders' interests by tying a substantial portion of their long-term incentives to stock price appreciation. The ten-year term is designed to focus executives on long-term value creation. Three-year cliff vesting encourages retention and requires a meaningful amount of future effort before the executives can realize the value they helped to create. In all cases, stock options are awarded at an exercise price equal to the closing price of the Company's common stock reported for the business day before the grant. Stock option repricing is not permitted under the 2005 Incentive Plan.



•

30% RSUs.    The Company's RSUs are settled with the specified number of Company shares if the executive is still employed with the Company on the fourth anniversary of the grant. RSUs are intended to increase the retentive qualities of the compensation program through the four-year cliff vesting provision of the awards, to help build stock ownership and to help meet stock ownership guidelines. Dividend equivalents are paid during the vesting period in order to simulate share ownership.



•

30% Performance Shares.    Performance shares are intended to further align compensation with the Company's business strategy and the long-term creation of shareholder value. The Company's performance shares provide the executive with a range of potential share payouts in three years only if specified performance criteria are met. The actual number of earned shares can range from 0% to 200% of the target number of shares depending on one-year sales growth and continued ROIC achievement over three years.

        The three-year performance cycle for the performance shares begins on January 1 of each year. The number of shares that could have been earned for the 2006 grant of performance shares ranged

26

from 0% to 200% of the target award depending on the Company's year-over-year growth in sales. The sales growth portion of the 2006 performance shares was structured as follows:

(1)

Amounts are interpolated, as necessary.

(2)

Vesting is contingent upon the achievement of a 3-year average ROIC threshold.

        If during 2006, the Company achieved less than five percent sales growth, 0% of the target award would be paid, five percent growth would have yielded 50% of the target award, nine percent growth would have yielded 100%, and 12% growth would have yielded 200%. Given actual sales growth performance of 6.5%, the number of shares determined for the NEOs for 2006 was 69% of target. These shares will vest at the end of fiscal year 2008 only if the average ROIC performance over the three-year period from 2006 through 2008 is greater than or equal to 18%. The Committee selected these measures as they balance sales growth with profitability, expense management, and asset management and are consistent with the short-term objectives established in the annual incentive program. The Committee may use different sales growth and ROIC objectives and target share numbers from year to year to maximize alignment with then-current business objectives. Performance shares pay dividend equivalents after the end of the first year in order to simulate share ownership.

        The annual options, RSUs and performance shares vest upon death, disability or retirement from the Company. The definition of retirement eligibility is the same for all U.S. employees for the long-term incentive program, as well as the profit sharing program. Under this definition, an employee is retirement-eligible upon attaining any of the following:

•

Age 60;



•

Age 55 and 20 years of service; or



•

25 years of service.

Messrs. Keyser, Loux and Ryan are currently retirement-eligible.

        The use of options and performance shares satisfies the requirements for qualified performance-based compensation under Section 162(m) of the Internal Revenue Code. The use of RSUs and performance shares also helps reduce share dilution, as compared with stock options. The Company historically makes stock option and RSU awards to current officers and employees each year on the date of the annual meeting of shareholders, and performance share awards no later than February in order to qualify those awards as performance-based compensation under Section 162(m) of the Internal Revenue Code. The Company has not timed the grant of long-term incentive awards in

27

respect of the release of material, non-public information nor for the purpose of affecting the value of executive compensation.

        Based on the amounts of total compensation listed in the Summary Compensation Table, long-term variable compensation represented from 39% to 57% of total compensation for the NEOs in fiscal year 2006, which is consistent with the compensation comparator group practice as well as the Committee's overall compensation objectives.

Long Term Incentives

        Long term incentives provided under a shareholder-approved stock plan are an important means of aligning the financial interests of executive officers and other key employees to the longer term financial interests of the shareholders. In 2004, the Company started using a combination of stock options and RSUs as a part of its annual long term incentive program for top management. To keep the target grant value of long term incentives consistent with Company pay objectives and median market practice, the target annual stock option awards were significantly lowered from the 2003 levels,

23

reflecting the use of RSUs. Including RSUs as a component of the long term incentive program lessens the primary reliance on stock options, increases the retentive qualities of the awards (given four-year cliff vesting provisions for RSUs compared to three-year cliff vesting provisions for stock options), and reduces annual share usage. The number of shares covered by stock options and RSUs is designed to provide an economic value that is generally competitive with awards made by other companies to their employees in comparable jobs. Recipients are required to sign an agreement containing confidentiality and non-competition provisions.

        Beginning in 2006, the Company will use performance shares as a part of its annual long term incentive program for officers. The Committee approved the long term program under which performance shares will represent approximately 30% of the total value of long term compensation, while stock options and RSUs will represent approximately 40% and 30% of the total value, respectively. Including performance shares as a component of the long term incentive program is intended to further align management compensation with the Company's business strategy and the creation of shareholder value. In addition, the use of performance shares satisfies the requirements for qualified performance-based compensation under Internal Revenue Code Section 162(m).

        The number of shares that can be earned for the 2006 grant of performance shares will range from 0% to 200% of the target award and will be determined based on the Company's growth in revenue in 2006 over 2005. These shares will then vest at the end of three years only if the Company meets an ROIC hurdle. These measures were selected as they balance revenue growth with profitability, expense management and asset management, and are consistent with the short term objectives established in the annual incentive program for key managers.

        In April 2005, approximately 800 employees received stock options covering 1,138,150 shares through the long term incentive program. This number includes approximately 171,000 stock options awarded to seven executive officers. In addition, approximately 170 employees received RSUs covering 173,150 shares through this program. This number includes approximately 57,150 RSUs awarded to seven executive officers.

        Beginning in 2001, the Company also has periodically issued options to its employees under a broad-based stock option program. Under this program, employees who do not participate in any other option program are awarded stock options covering 100 shares upon reaching five-year service-level milestones. In February 2006, 1,906 employees received options covering 190,600 shares under this broad-based program. The option terms are generally similar to those of the annual stock option program.

        In all cases, stock options are awarded at an exercise price equal to the closing price of the Company's common stock reported for the business day before the grant. Stock option repricing is not permitted under the plan.

        The Company also from time to time has granted restricted stock (generally subject to forfeiture if employment terminates before the end of the restricted period) to executive and other officers of the Company, in each case subject to the execution of a confidentiality and non-competition agreement with the Company. When these grants have been made, the objectives of the grants and related confidentiality and non-competition agreements are to align more closely the interests of executives with those of shareholders, to protect proprietary Company information, to preserve the Company's competitive advantages, to provide a strong executive retention incentive, and to provide for executive continuity. There were no such awards to executive officers in 2005.

24

Long Term Incentives

        Long term incentives provided under a shareholder-approved stock plan are considered an important means of aligning the financial interests of executive officers and other key employees to the longer term financial interests of the shareholders. In 2004, the Company started using a combination of stock options and restricted stock units as a part of its annual long term incentive program for top management. To keep the target grant value of long term incentives consistent with Company pay objectives and median market practice, the target annual stock option awards were significantly lowered from the 2003 levels, reflecting the accompanying award of restricted stock units. Including restricted stock units as a component of the long-term incentive program is intended to reduce annual share usage, increase the retentive qualities (given four-year cliff vesting provisions for RSUs and three-year cliff vesting provisions for stock options), and lessen the primary reliance on stock options. The number of shares covered by stock options and RSUs is designed to provide an economic value that is generally competitive with awards made by other companies to their employees in comparable jobs. Recipients are required to sign an agreement containing confidentiality and non-competition provisions.

22

        In April 2004, approximately 675 employees received stock options covering 990,000 shares through this program. This number includes approximately 161,000 stock options awarded to seven executive officers. In addition, approximately 150 employees received restricted stock units covering 161,000 shares through this program. This number includes approximately 54,000 restricted stock units awarded to seven executive officers.

        The Company also periodically issues options to its employees under the broad-based stock option program. Under this program, employees who do not participate in any other option program are awarded stock options covering 100 shares upon reaching five-year service-level milestones. Under this broad-based program, 2,380 employees received options covering 238,000 shares. The general option terms are similar to those of the annual stock option program.

        In all cases, stock options are awarded at an exercise price equal to the closing price of the Company's common stock reported for the business day before the grant. Stock option repricing is not permitted under the plan.

        The Company also has granted restricted stock (generally subject to forfeiture if employment terminates before the end of the restriction) to executive and other officers of the Company, in each case subject to the execution of a confidentiality and non-competition agreement with the Company. The objectives of the grants and related confidentiality and non-competition agreements are to align more closely the interests of executives with those of shareholders, to protect proprietary Company information, to preserve the Company's competitive advantages, to provide a strong executive retention incentive, and to provide for executive continuity.