Share-based compensation

The Company has granted stock options on its common shares and rights to receive common shares in the future (restricted share rights) to members of the Board of Management and other members of the Group Management Committee, Philips executives and certain selected employees. The purpose of the share-based compensation plans is to align the interests of management with those of shareholders by providing incentives to improve the Company’s performance on a long-term basis, thereby increasing shareholder value. Under the Company’s plans, options are granted at fair market value on the date of grant.

The Company issues restricted share rights that vest in equal annual installments over a three-year period, starting one year after the date of grant. If the grantee still holds the shares after three years from the delivery date, Philips will grant 20% additional (premium) shares, provided the grantee is still with the Company on the respective delivery dates.

The Company grants stock options that expire after 10 years. Generally, the options vest after 3 years; however, a limited number of options granted to certain employees of acquired businesses may contain accelerated vesting. Of the total stock options that are outstanding as of December 31, 2009, 2,720,000 options contain performance conditions.

In contrast to the year 2001 and certain prior years, when variable (performance) stock options were issued, the share-based compensation grants as from 2002 consider the performance of the Company versus a peer group of multinationals.

USD-denominated stock options and restricted share rights are granted to employees in the United States only.

Under the terms of employee stock purchase plans established by the Company in various countries, substantially all employees in those countries are eligible to purchase a limited number of shares of Philips stock at discounted prices through payroll withholdings, of which the maximum ranges from 8.5% to 10% of total salary. Generally, the discount provided to the employees is in the range of 10% to 20%. A total of 2,185,647 shares were sold in 2009 under the plan at an average price of EUR 13.30 (2008: 1,051,206 shares at EUR 21.82, 2007: 707,717 shares at EUR 29.99).

In the Netherlands, Philips issued personnel debentures with a 2-year right of conversion into common shares of Royal Philips Electronics starting three years after the date of issuance, with a conversion price equal to the share price on that date. The last issuance of this particular plan was in December 2008. From 2009 onwards employees in the Netherlands are able to join an employee stock purchase plan as described in the previous paragraph. The fair value of the conversion option of EUR 2.13 in 2008, and EUR 4.01 in 2007, is recorded as compensation expense over the period of vesting. In 2009, 183,330 shares were issued in conjunction with conversions at an average price of EUR 19.56 (2008: 485,331 shares at an average price of EUR 19.13, 2007: 2,019,788 shares at an average price of EUR 18.94).

Share-based compensation expense was EUR 94 million (EUR 86 million, net of tax), EUR 78 million (EUR 106 million, net of tax) and EUR 111 million (EUR 84 million, net of tax) in 2009, 2008 and 2007, respectively.

The fair value of the Company’s 2009, 2008 and 2007 option grants was estimated using a Black-Scholes option valuation model and the following weighted average assumptions:

The assumptions were used for these calculations only and do not necessarily represent an indication of Management’s expectations of future developments.

The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of subjective assumptions, including the expected price volatility.

The Company has based its volatility assumptions on historical experience for a period equal to the expected life of the options. The expected life of the options is also based upon historical experience.

The Company’s employee stock options have characteristics significantly different from those of traded options, and changes in the assumptions can materially affect the fair value estimate.

The following tables summarize information about Philips stock options as of December 31, 2009 and changes during the year:

The exercise prices range from EUR 12.63 to 53.75. The weighted average remaining contractual term for options outstanding and options exercisable at December 31, 2009, was 4.8 years and 3.0 years, respectively. The aggregate intrinsic value of the options outstanding and options exercisable at December 31, 2009, was EUR 36 million and EUR 10 million, respectively.

The weighted average grant-date fair value of options granted during 2009, 2008, and 2007 was EUR 2.78, EUR 5.69 and EUR 8.72, respectively. The total intrinsic value of options exercised during 2009, 2008, and 2007 was approximately EUR 0 million, EUR 1 million and EUR 16 million, respectively.

The exercise prices range from USD 16.41 to 49.71. The weighted average remaining contractual term for options outstanding and options exercisable at December 31, 2009, was 5.4 years and 3.2 years, respectively. The aggregate intrinsic value of the options outstanding and options exercisable at December 31, 2009, was USD 55 million and USD 24 million, respectively.

The weighted average grant-date fair value of options granted during 2009, 2008 and 2007 was USD 3.83, USD 7.97 and USD 11.99, respectively. The total intrinsic value of options exercised during 2009, 2008 and 2007 was USD 1 million, USD 13 million and USD 64 million, respectively.

The outstanding options are categorized in exercise price ranges as follows:

The aggregate intrinsic value in the tables and text above represents the total pretax intrinsic value (the difference between the Company’s closing stock price on the last trading day of 2009 and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders if the options had been exercised on December 31, 2009. At December 31, 2009, a total of EUR 38 million of unrecognized compensation cost related to non-vested stock options. This cost is expected to be recognized over a weighted-average period of 1.4 years. Cash received from option exercises under the Company’s option plans amounted to EUR 4 million, EUR 24 million and EUR 140 million in 2009, 2008, and 2007, respectively. The actual tax deductions realized as a result of stock option exercises totaled approximately EUR 0 million, EUR 3 million and EUR 36 million, in 2009, 2008, and 2007, respectively.

A summary of the status of the Company’s restricted share plans as of December 31, 2009 and changes during the year are presented below:

At December 31, 2009, a total of EUR 35 million of unrecognized compensation cost related to non-vested restricted share rights. This cost is expected to be recognized over a weighted-average period of 2.0 years.

In December 2006, the Company offered to exchange outstanding Lumileds Depository Receipts and options for cash and shared-based instruments settled in cash. The amount to be paid to settle the obligation, with respect to share-based instruments, will fluctuate based upon changes in the fair value of Lumileds. Substantially all of the holders of the options and the depository receipts accepted the Company offer. The amount of the share-based payment liability, which is denominated in US dollars, recorded at December 31, 2008 was EUR 10.4 million. During 2009, the Company paid EUR 5.9 million as a part of the settlement of the liability. Additionally, an increase of EUR 27.1 million was recognized to reflect an adjustment to the value of the liability. The balance at December 31, 2009 amounted to EUR 31.6 million which will be settled between 2010 and 2012.