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, 2008, approximately 3 million 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 1,051,206 shares were sold in 2008 under the plan at an average price of EUR 21.82 (2007: 707,717 shares at EUR 29.99, 2006: 1,016,421 shares at EUR 24.70).

In the Netherlands, Philips issues 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 fair value of the conversion option of EUR 2.13 in 2008 (EUR 4.01 in 2007 and EUR 6.41 in 2006) is recorded as compensation expense over the period of vesting. In 2008, 485,331 shares were issued in conjunction with conversions at an average price of EUR 19.13 (2007: 2,019,788 shares at an average price of 18.94, 2006: 1,570,785 shares at an average price of EUR 16.94).

Share-based compensation expense was EUR 78 million, EUR 111 million and EUR 107 million, in 2008, 2007, and 2006, respectively.

The fair value of the Company’s 2008, 2007 and 2006 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 that approximates 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, 2008 and changes during the year:

The exercise prices range from EUR 15.28 to 53.75

The weighted average grant-date fair value of options granted during 2008, 2007, and 2006 was EUR 5.69, EUR 8.72 and EUR 9.76, respectively. The total intrinsic value of options exercised during 2008, 2007, and 2006 was EUR 1 million, EUR 16 million and EUR 8 million, respectively.

The exercise prices range from USD 16.41 to 49.71

The weighted average grant-date fair value of options granted during 2008, 2007 and 2006 was USD 7.97, USD 11.99 and USD 12.31, respectively. The total intrinsic value of options exercised during 2008, 2007 and 2006 was USD 13 million, USD 64 million and USD 46 million, respectively.

The aggregate intrinsic value in the tables above represents the total pretax intrinsic value (the difference between the Company’s closing stock price on the last trading day of 2008 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, 2008. At December 31, 2008, a total of EUR 68 million of unrecognized compensation cost related to non-vested stock options. This cost is expected to be recognized over a weighted-average period of 1.8 years. Cash received from option exercises under the Company’s option plans amounted to EUR 24 million, EUR 140 million and EUR 120 million in 2008, 2007, and 2006, respectively. The actual tax deductions realized as a result of stock option exercises totaled EUR 3 million, EUR 36 million and EUR 16 million, in 2008, 2007, and 2006, respectively.

A summary of the status of the Company's restricted share plans as of December 31, 2008 and changes during the year is presented below:

At December 31, 2008, a total of EUR 63 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 2.3 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, 2007 was EUR 49 million. During 2008, the Company paid EUR 11 million as a part of the settlement of the liability. Additionally, a release of EUR 27.6 million was recognized to reflect an adjustment to the value of the liability. The balance at December 31, 2008 amounted to EUR 10.4 million which will be settled between 2009 and 2012.