CAPELLA EDUCATION COMPANY

225 South 6th Street, 9th Floor

Minneapolis, Minnesota 55402

(888) 227-3552

 

March 20, 2007

 

Dear Shareholder:

 

You are cordially invited to attend the annual meeting of shareholders of Capella Education Company to be held at the Pantages Theatre, 710 Hennepin Avenue, Minneapolis, Minnesota 55403, commencing at 1:00 p.m., central time, on Wednesday, May 9, 2007.

 

The Secretary’s notice of annual meeting and the proxy statement that follow describe the matters to come before the meeting. During the meeting, we also will review the activities of the past year and items of general interest about our company.

 

We hope that you will be able to attend the meeting in person and we look forward to seeing you. Please mark, date and sign the enclosed proxy and return it in the accompanying envelope, or vote the enclosed proxy by telephone or through the Internet in accordance with the voting instructions set forth on the enclosed proxy card, as quickly as possible, even if you plan to attend the annual meeting. You may revoke the proxy and vote in person at that time if you so desire.

 

Sincerely,

 

 

Stephen G. Shank
Chairman and Chief Executive Officer

 

VOTING METHODS

 

The accompanying proxy statement describes important issues affecting Capella Education Company. If you are a shareholder of record, you have the right to vote your shares through the Internet, by telephone or by mail. You also may revoke your proxy any time before the annual meeting. Please help us save time and administrative costs by voting through the Internet or by telephone. Each method is generally available 24 hours a day and will ensure that your vote is confirmed and posted immediately. To vote:

 

1. BY TELEPHONE

 

 

2. BY INTERNET

 

 

3. BY MAIL (if you vote by telephone or Internet, please do not mail your proxy card)

 

 

If your shares are held in the name of a bank, broker or other holder of record, you will receive instructions from the holder of record that you must follow in order for your shares to be voted.

 

Your vote is important. Thank you for voting.

 

CAPELLA EDUCATION COMPANY

 

 

Notice of Annual Meeting of Shareholders

to be held on May 9, 2007

 

 

The annual meeting of shareholders of Capella Education Company will be held at the Pantages Theatre, 710 Hennepin Avenue, Minneapolis, Minnesota 55403, commencing at 1:00 p.m., central time, on Wednesday, May 9, 2007 for the following purposes:

 

 

Our board of directors has fixed March 12, 2007 as the record date for the meeting, and only shareholders of record at the close of business on that date are entitled to receive notice of and vote at the meeting.

 

Your proxy is important to ensure a quorum at the meeting. Even if you own only a few shares, and whether or not you expect to be present, you are urgently requested to vote the enclosed proxy by telephone or through the Internet in accordance with the voting instructions set forth on the enclosed proxy card or to date, sign and mail the enclosed proxy in the postage-paid envelope that is provided. The proxy may be revoked by you at any time prior to being exercised, and voting your proxy by telephone or through the Internet or returning your proxy will not affect your right to vote in person if you attend the meeting and revoke the proxy.

 

By Order of the Board of Directors,

 

 

Gregory W. Thom
Secretary

 

Minneapolis, Minnesota

March 20, 2007

 

PROXY STATEMENT

 

 

GENERAL INFORMATION

 

The enclosed proxy is being solicited by our board of directors for use in connection with the annual meeting of shareholders to be held on Wednesday, May 9, 2007 at the Pantages Theatre, 710 Hennepin Avenue, Minneapolis, Minnesota 55403, commencing at 1:00 p.m., central time, and at any adjournments thereof. Our telephone number is (888) 227-3552. The mailing of this proxy statement and our board of directors’ form of proxy to shareholders will commence on or about March 20, 2007.

 

Record Date and Quorum

 

Only shareholders of record at the close of business on March 12, 2007 will be entitled to vote at the annual meeting or adjournment. At the close of business on the record date, we had 16,023,250 shares of our common stock outstanding and entitled to vote. A majority of the shares outstanding on the record date, present in person or represented by proxy, will constitute a quorum for the transaction of business at the meeting.

 

Voting of Proxies

 

Proxies voted by telephone or through the Internet in accordance with the voting instructions set forth on the enclosed proxy card, or in the accompanying form that are properly signed and duly returned to us, and not revoked, will be voted in the manner specified. A shareholder executing a proxy retains the right to revoke it at any time before it is exercised by notice to one of our officers in writing of termination of the proxy’s authority or a properly signed and duly returned proxy bearing a later date.

 

Shareholder Proposals

 

We must receive shareholder proposals intended to be presented at the 2008 annual meeting of shareholders that are requested to be included in the proxy statement for that meeting at our principal executive office no later than November 21, 2007. We must receive any other shareholder proposals intended to be presented at the 2008 annual meeting of shareholders at our principal executive office no later than February 9, 2008.

 

Quorum

 

The presence at the meeting, in person or by proxy, of the holders of a majority of the shares of common stock outstanding on the record date will constitute a quorum for the transaction of business at the meeting. Abstentions and broker non-votes will be counted as present for purposes of determining the existence of a quorum.

 

Vote Required

 

Election of Directors.  The affirmative vote of a plurality of the shares of common stock present in person or by proxy at the meeting and entitled to vote is required for the election to the board of directors of each of the nominees for director. Shareholders do not have the right to cumulate their votes in the election of directors. Votes that are withheld and broker non-votes will have no effect on the outcome of the election.

 

Other Proposals.  The affirmative vote of the holders of the greater of (1) a majority of the shares of common stock present in person or by proxy at the meeting and entitled to vote and (2) a majority of the minimum number of shares entitled to vote that would constitute a quorum for the transaction of business at the meeting is required for approval of each other proposal presented in this proxy statement. A shareholder who abstains with respect to a proposal will have the effect of casting a negative vote on that proposal. A shareholder who does not vote in person or by proxy on a proposal (including a broker non-vote) is not deemed to be present in person or by proxy for the purpose of determining whether a proposal has been approved.

 

Adjournment of Meeting

 

If a quorum is not present to transact business at the meeting or if we do not receive sufficient votes in favor of the proposals by the date of the meeting, the persons named as proxies may propose one or more adjournments of the meeting to permit solicitation of proxies. Any adjournment would require the affirmative vote of a majority of the shares present in person or represented by proxy at the meeting.

 

Expenses of Soliciting Proxies

 

We will pay the cost of soliciting proxies in the accompanying form. In addition to solicitation by the use of mail, certain directors, officers and regular employees may solicit proxies by telephone or personal interview, and may request brokerage firms and custodians, nominees and other record holders to forward soliciting materials to the beneficial owners of our stock and will reimburse them for their reasonable out-of-pocket expenses in forwarding these materials.

 

PROPOSAL NO. 1

 

ELECTION OF DIRECTORS

 

Composition of our Board of Directors

 

Our bylaws provide that our business will be managed by or under the direction of a board of directors. The number of directors constituting our board of directors is determined from time to time by our board of directors and currently consists of ten members. Each director will be elected at the annual meeting to hold office until the next annual shareholders meeting or the director’s resignation or removal. Upon the recommendation of the governance committee of the board of directors, the board has nominated the ten persons named below for election as directors. Proxies solicited by our board of directors will, unless otherwise directed, be voted to elect the ten nominees named below to constitute the entire board of directors.

 

Directors and Director Nominees

 

All of the nominees named below are current directors of our company. Each nominee has indicated a willingness to serve as a director for the ensuing year, but in case any nominee is not a candidate at the meeting for any reason, the proxies named in the enclosed proxy form may vote for a substitute nominee selected by the governance committee.

 

The following table sets forth certain information regarding each director nominee:

 

 

 

 

Stephen G. Shank founded our company in 1991 and has been serving as our Chairman and Chief Executive Officer since that time. Mr. Shank also has been serving as Chancellor of Capella University since 2001, and as emeritus (non-voting) director of Capella University from 2003 to 2006. Mr. Shank is currently a voting director of Capella University. Mr. Shank served as a member of the board of directors of Capella University from 1993 through 2003. From 1979 to 1991, Mr. Shank was Chairman and Chief Executive Officer of Tonka Corporation, an NYSE-listed manufacturer of toys and games. Mr. Shank is a member of the board of directors of Tennant Company, an NYSE-listed manufacturer of cleaning solutions. Mr. Shank earned a B.A. from the University of Iowa, an M.A. from the Fletcher School, a joint program of Tufts and Harvard Universities, and a J.D. from Harvard Law School.

 

Gordon A. Holmes has served as a director of our company since 2000. Since 2005, Mr. Holmes has been a Managing Principal with Quadrangle Group LLC, an investment firm. Mr. Holmes has been a General Partner of several limited partnerships affiliated with Forstmann Little & Co., an investment firm. From 1998 to 2001, Mr. Holmes was an Associate at Forstmann Little & Co. Mr. Holmes earned a B.C.L. degree from University College, Dublin and an M.B.A. from the Stanford University Graduate School of Business.

 

S. Joshua Lewis has served as a director of our company since 2000. Since 2001, Mr. Lewis has been Managing Member and a Principal of Salmon River Capital LLC, a private equity/venture capital firm he founded. During 2000, he was a General Partner of Forstmann Little & Co., an investment firm. From 1997 to 1999, Mr. Lewis was a Managing Director of Warburg Pincus, a private equity/venture capital firm with which he was associated for over a decade. Mr. Lewis serves on several corporate, non-profit and advisory boards of directors. Mr. Lewis earned an A.B. from Princeton University and a D.Phil. from Oxford University.

 

Jody G. Miller has served as a director of our company since 2003. Ms. Miller serves as CEO and President of the Business Talent Group, a company matching independent business executives with interim and project-based assignments, which she founded in 2005. Ms. Miller is also a venture partner with Maveron LLC, a Seattle-based venture capital firm, a position which she has held since 2000. From 1995 to 1999, Ms. Miller held various positions at Americast, a digital video and interactive services partnership, including as Acting President and Chief Operating Officer, Executive Vice President, Senior Vice President for Operations and Consultant. From 1993 to 1995, Ms. Miller served in the White House as Special Assistant to the President with the Clinton Administration. Ms. Miller is a member of the board of directors of the National Campaign to Prevent Teenage Pregnancy, a not-for-profit program devoted to reducing teen pregnancy, and since May 2005 has been serving as a member of the board of directors of TRW Automotive Holdings Corp., an NYSE-listed global supplier of automotive components. From 2000 to 2004, Ms. Miller also served as member of the board of directors of Exide Technologies, an NYSE listed battery manufacturing company. Ms. Miller earned a B.A. from the University of Michigan and a J.D. from the University of Virginia.

 

James A. Mitchell has served as a director of our company since 1999. From 1993 to 1999, when he retired, Mr. Mitchell served as Executive Vice President of Marketing and Products of American Express Company, a diversified global financial services company. From 1984 to 1993, he served as Chairman, President and CEO of IDS Life, a life insurance company and a wholly owned subsidiary of American Express. From 1982 to 1984, he served as President of the reinsurance division at CIGNA Corp., an insurance company. Mr. Mitchell is Executive Fellow — Leadership at the Center for Ethical Business Cultures, a non-profit organization assisting business leaders in creating ethical and profitable cultures, and serves as a member of the board of directors of Great Plains Energy Incorporated, an NYSE-listed diversified public utility holding company. He earned a B.A. from Princeton University.

 

Jon Q. Reynolds, Jr. has served as a director of our company since 2005. Since 1999, Mr. Reynolds has been a General Partner at Technology Crossover Ventures, a private equity and venture capital firm, which he joined in 1997. Mr. Reynolds earned an A.B. degree from Dartmouth College and an M.B.A. from Columbia Business School.

 

David W. Smith has served as a director of our company since 1998 and is currently our lead director. From 2000 to 2003, when he retired, Mr. Smith was the Chief Executive Officer of NCS Pearson, Inc. Mr. Smith is a member of the boards of directors of Plato Learning, Inc. and Scientific Learning Corporation, both of which are

Nasdaq listed companies. Mr. Smith earned a B.A. and an M.A. from Southern Illinois University, as well as an M.B.A. from the University of Iowa.

 

Jeffrey W. Taylor has served as a director of our company since 2002. Since 2003, Mr. Taylor has been the President of Pearson, Inc., the U.S. holding company of Pearson plc. From 2000 to 2003, Mr. Taylor served as Vice President of Government Relations for Pearson, Inc. From 1994 to 2000, he served as Vice President and Chief Financial Officer of National Computer Systems, an education testing and software company. Mr. Taylor earned a B.S. from Indiana State University.

 

Sandra E. Taylor has served as a director of our company since 2006. Ms. Taylor serves as Senior Vice President, Corporate Social Responsibility of Starbucks Corporation, where she has been employed since 2003. Prior to joining Starbucks, Ms. Taylor served as Vice President and Director of Public Affairs for Eastman Kodak Company from 1996 until 2003. She has also held senior leadership positions with a number of other organizations, including ICI Americas Inc. and the European American Chamber of Commerce in the United States. In addition, Ms. Taylor sits on the board of several non-profit organizations, including the Center for International Private Enterprise, the Seattle Public Library Foundation, the Public Affairs Council, the National Center for Asia-Pacific Economic Cooperation, and the Women’s Leadership Board of the Kennedy School of Government at Harvard University. Ms. Taylor received a B.A. from Colorado Women’s College, and a J.D. from Boston University School of Law.

 

Darrell R. Tukua has served as a director of our company since 2004. From 1988 to 2003, when he retired, Mr. Tukua was a Partner with KPMG LLP, a public accounting firm he joined in 1976. Mr. Tukua is a member of the audit and budget committee of The MMIC Group, an insurance company, where he also served as a board observer from May 2004 to August 2005 and was elected to serve on the board of directors in August 2005. In addition, in 2004 Mr. Tukua was elected an advisory board member of Gate City Bank, a retail and commercial bank, and in 2005 he became a member of the board of directors and audit and compensation committees of Gate City Bank. Mr. Tukua earned a B.S. from the University of South Dakota.

 

None of the above nominees is related to each other or to any of our executive officers.

 

Under a third amended and restated co-sale and board representation agreement, dated January 22, 2003, between the company and certain of our shareholders, Forstmann Little & Co. Equity Partnership-VI, L.P. (Forstmann VI) currently has the right to designate one person for election to our board, and the company and certain shareholders party to the agreement have agreed to take all steps necessary to cause the nomination and election to our board of such designee. Forstmann VI has designated Mr. Holmes to be nominated to the board.

 

Board of Directors Meetings and Attendance

 

Our board of directors held six meetings and took action by written consent four times during fiscal year 2006. During fiscal year 2006, each director attended at least 75% of the aggregate number of the meetings of our board of directors and of the board committees on which such director serves. In the past, we have not had a policy regarding attendance of our directors at annual meetings of our shareholders, but going forward we will encourage each of our directors to attend annual meetings of our shareholders. One director attended the 2006 annual meeting of our shareholders.

 

Director Independence

 

Our board of directors reviews at least annually the independence of each director. During these reviews, our board of directors considers transactions and relationships between each director (and his or her immediate family and affiliates) and our company and its management to determine whether any such transactions or relationships are inconsistent with a determination that the director was independent. In August 2006, our board of directors conducted its annual review of director independence and determined that no transactions or relationships existed that would disqualify any of the individuals who then served as a director under the rules of The Nasdaq Stock Market, Inc., or require disclosure under Securities and Exchange Commission rules, with the exception of Mr. Shank, who is also our Chairman and Chief Executive Officer. Based on a review of information provided by the directors and other information we reviewed, our board of directors concluded that none of our non-employee

directors have or had any relationship with our company other than as a director or shareholder of our company. Based upon that finding, our board of directors determined that Messrs. Holmes, Lewis, Mitchell, Reynolds, Smith, Taylor and Tukua, and Ms. Miller and Ms. Taylor, are “independent.” In addition, our board of directors determined that Tony J. Christianson, who served as our director until his resignation following our initial public offering in November 2006, was “independent.”

 

Committees of Our Board of Directors

 

Our board of directors has an audit committee, a compensation committee, a governance committee and an executive committee. The charters for our audit committee, compensation committee, governance committee and executive committee are available in the Corporate Governance section of the Investor Relations page on our website at www.capellaeducation.com.

 

Audit Committee.  Our audit committee consists of Messrs. Tukua (chair), Holmes, Lewis and Taylor. Our audit committee is directly responsible for, among other things, the appointment, compensation, retention and oversight of our independent registered public accounting firm. The oversight includes reviewing the plans and results of the audit engagement with the firm, approving any additional professional services provided by the firm and reviewing the independence of the firm. Commencing with our first report on internal controls over financial reporting, the committee will be responsible for discussing the effectiveness of the internal controls over financial reporting with the firm and relevant financial management. The purpose and responsibilities of our audit committee are more fully described in the committee’s charter, a copy of which as mentioned in the immediately preceding paragraph is available on our website. Our audit committee held seven meetings in fiscal year 2006. Our board of directors has determined that each member of our audit committee is “independent,” as defined under and required by the rules of The Nasdaq Stock Market, Inc. and the federal securities laws. The board of directors has determined that each of Messrs. Tukua and Taylor qualifies as an “audit committee financial expert,” as defined under the rules of the federal securities laws.

 

Compensation Committee.  Our compensation committee consists of Messrs. Mitchell (chair), Holmes, Lewis, Reynolds and Smith. Our compensation committee is responsible for, among other things, recommending the compensation level of our Chief Executive Officer to the executive committee, determining the compensation levels and compensation types (including base salary, stock options, perquisites and severance) of the other members of our senior executive team and administering our stock option plans and other compensation programs. The compensation committee also recommends compensation levels for board members and approves new hire offer packages for our senior executive management. The purpose and responsibilities of our compensation committee are more fully described in the committee’s charter. Our compensation committee held ten meetings in fiscal year 2006.

 

Governance Committee.  Our governance committee consists of Ms. Miller (chair), Messrs. Reynolds, Smith and Taylor, and Ms. Taylor. Our governance committee is responsible for, among other things, assisting the board of directors in selecting new directors and committee members, evaluating the overall effectiveness of the board of directors, and reviewing developments in corporate governance compliance. The purpose and responsibilities of our governance committee are more fully described in the committee’s charter. Our governance committee held one meeting in fiscal year 2006.

 

Executive Committee.  Our executive committee consists of all non-management members of our board of directors, or all of our directors except Mr. Shank, and is chaired by Mr. Smith, who is our lead director. Our executive committee is responsible for, among other things, evaluating and determining the compensation of our Chief Executive Officer, setting the agenda for meetings of our board of directors, establishing procedures for our shareholders to communicate with our board of directors and reviewing and approving our management succession plan. The purpose and responsibilities of our executive committee are more fully described in the committee’s charter. Our executive committee held three meetings in fiscal year 2006.

 

Corporate Governance Principles

 

Our board of directors has adopted Corporate Governance Principles. These guidelines are available on the Corporate Governance section of the Investor Relations page on our website at www.capellaeducation.com.

 

Code of Business Conduct

 

We have adopted the Capella Education Company Code of Business Conduct, which applies to all of our employees, directors, agents, consultants and other representatives. The Code of Business Conduct includes particular provisions applicable to our senior financial management, which includes our chief executive officer, chief financial officer, principal accounting officer and other employees performing similar functions. A copy of our Code of Business Conduct is available on the Corporate Governance section of the Investor Relations page on our website at www.capellaeducation.com. We intend to post on our website any amendment to, or waiver from, a provision of our Code of Business Conduct that applies to any director or officer, including our chief executive officer, chief financial officer, principal accounting officer and other persons performing similar functions, promptly following the date of such amendment or waiver.

 

Corporate Governance Documents Available on Our Website

 

Copies of our key corporate governance documents are available on the Investor Relations page of our website at www.capellaeducation.com. The charters for our audit committee, compensation committee, governance committee and executive committee, as well as copies of our Corporate Governance Guidelines and our Code of Business Conduct, are available on our website. In addition, any shareholder that wishes to obtain a hard copy of any of these corporate governance documents may do so without charge by writing to Investor Relations, Capella Education Company, 225 South 6th Street, 9th Floor, Minneapolis, MN 55402.

 

Director Qualifications

 

Candidates for director nominees are reviewed in the context of the current composition of our board of directors, our operating requirements and the long-term interests of our shareholders. The governance committee will consider, at a minimum, the following factors in recommending to our board of directors potential new members, or the continued service of existing members, in addition to other factors it deems appropriate based on the current needs and desires of our board of directors:

 

 

Director Nomination Process

 

Our governance committee selects nominees for directors pursuant to the following process:

 

 

 

Our governance committee will reassess the qualifications of a director, including the director’s performance on our board to date, the director’s current employment, the director’s service on other boards and the director’s independence, prior to recommending a director for reelection to another term.

 

Shareholders who wish to recommend individuals for consideration by our governance committee to become nominees for election to our board of directors may do so by submitting a written recommendation to our governance committee, c/o General Counsel, Capella Education Company, 225 South 6th Street, 9th Floor, Minneapolis, Minnesota 55402. Submissions must include a written recommendation and the reason for the recommendation, biographical information concerning the recommended individual, including age, a description of the recommended individual’s past five years of employment history and any past and current board memberships. The submission must be accompanied by a written consent of the individual to stand for election if nominated by our governance committee and to serve if elected by our board of directors or our shareholders, as applicable. Alternatively, shareholders may directly nominate a person for election to our board of directors by complying with the procedures set forth in our bylaws, any applicable rules and regulations of the Securities and Exchange Commission and any applicable laws.

 

Compensation Committee Interlocks and Insider Participation

 

During 2006, Messrs. Holmes, Lewis, Mitchell and Smith served as the members of our compensation committee. No executive officer serves, or in the past has served, as a member of the board of directors or compensation committee of any entity that has any of its executive officers serving as a member of our board of directors or compensation committee.

 

Communication with our Board of Directors

 

Interested parties may communicate directly with Mr. Smith, our lead director, or the non-management members of our board of directors as a group by mail addressed to the attention of Mr. Smith as lead director, or the non-management members of our board of directors as a group, c/o General Counsel, Capella Education Company, 225 South 6th Street, 9th Floor, Minneapolis, MN 55402. If our General Counsel in consultation with Mr. Smith determines that such communication to non-management members as a group is relevant to and consistent with our operations and practices, our General Counsel will then forward the communication to the appropriate director or directors on a periodic basis.

 

Our board of directors recommends that the shareholders vote for the election of each of the ten nominees listed above to constitute our board of directors.

 

PROPOSAL NO. 2

 

RATIFICATION OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

The firm of Ernst & Young LLP (“Ernst & Young”) has been our independent registered public accounting firm since 1999. Our audit committee has selected Ernst & Young to serve as our independent registered public accounting firm for the fiscal year ending December 31, 2007, subject to ratification by our shareholders. While it is not required to do so, our audit committee is submitting the selection of that firm for ratification in order to ascertain the view of our shareholders. If the selection is not ratified, our audit committee will reconsider its selection, and

based on that reconsideration, may or may not select Ernst & Young. Proxies solicited by our board of directors will, unless otherwise directed, be voted to ratify the appointment of Ernst & Young as our independent registered public accounting firm for the fiscal year ending December 31, 2007.

 

A representative of Ernst & Young will be present at the meeting and will be afforded an opportunity to make a statement if the representative so desires and will be available to respond to appropriate questions during the meeting.

 

Fees

 

For the years ended December, 2006 and 2005, Ernst & Young billed us the amounts set forth below for professional services rendered in connection with audit, audit-related, tax and other professional services.

 

 

 

 

Approval of Independent Registered Public Accounting Firm Services and Fees

 

The audit committee has adopted a policy regarding pre-approval of audit and non-audit services performed by the company’s independent registered public accounting firm. The audit committee is responsible for pre-approving all engagements of the company’s independent registered public accounting firm. The policy also highlights services the audit committee will and will not approve for audit and non-audit services. The policy requires written documentation be provided by the independent registered accounting firm to the audit committee for all tax services. In addition, all required discussions are held between the independent registered accounting firm and the audit committee.

 

The audit committee may, annually or from time to time, set fee levels for certain non-audit services, as defined in the policy, that may be paid for all non-audit services. Any engagements that exceed those fee levels must receive specific pre-approval from the audit committee. The audit committee may delegate to the audit committee chair authority to grant pre-approvals of permissible audit and non-audit services, provided that any pre-approvals by the chair must be reported to the full audit committee at the next scheduled meeting.

 

On a regular basis, management provides written updates to the audit committee consisting of the amount of audit and non-audit service fees incurred to date. All of the services described above were pre-approved by the company’s audit committee.

 

Our board of directors recommends that the shareholders vote for the ratification of the appointment of Ernst & Young LLP as our independent registered public accounting firm for the fiscal year ending December 31, 2007.

 

AUDIT COMMITTEE REPORT

 

The role of our audit committee, which is composed of four independent non-employee directors, is one of oversight of our company’s management and independent registered public accounting firm in regard to our company’s financial reporting and internal controls respecting accounting and risk of material loss. In performing our oversight function, we relied upon advice and information received in our discussions with management and the independent registered public accounting firm.

 

We have (a) reviewed and discussed our company’s audited consolidated financial statements for the fiscal year ended December 31, 2006 with management; (b) discussed with our company’s independent registered public accounting firm the matters required to be discussed by Statement on Auditing Standards No. 61, as amended, regarding communication with audit committees (Codification of Statements on Auditing Standards, AU § 380); and (c) received the written disclosures from our company’s independent registered public accounting firm required by Independence Standards Board Standard No. 1 (Independence Discussions with Audit Committees), and discussed with our company’s independent registered public accounting firm their independence.

 

Based on the review and discussions with management and our company’s independent registered public accounting firm referred to above, we recommended to our company’s board of directors that the audited consolidated financial statements be included in our company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2006 for filing with the Securities and Exchange Commission.

 

Audit Committee:

 

Darrell R. Tukua, Chair
Gordon A. Holmes
S. Joshua Lewis
Jeffrey W. Taylor

 

EXECUTIVE COMPENSATION

 

Compensation Discussion and Analysis

 

Overview

 

The compensation committee of the board of directors (the “Committee,” for purposes of this Compensation Discussion and Analysis) has responsibility for establishing and overseeing our compensation program as it applies to our executive officers. The Committee is responsible for ensuring that our compensation program positions us to compete successfully for skilled executive talent in our dynamic business environment.

 

In this Compensation Discussion and Analysis, the individuals in the Summary Compensation Table set forth after this Compensation Discussion and Analysis are referred to as the “named executive officers.” Generally, the types of compensation and benefits provided to the named executive officers are similar to those provided to our other executive officers.

 

Our compensation design is influenced by the incentive compensation rules promulgated by the U.S. Department of Education. Under these rules, we may not provide any commission, bonus or other incentive payment to any person or entity engaged in any student recruitment, admissions or financial aid awarding activity, based directly or indirectly on success in securing enrollments or awarding financial aid.

 

Our Philosophy

 

We have established our executive compensation programs to attract, motivate and retain top quality executives and managers who are able to help us achieve superior short- and long-term performance objectives.

 

Our compensation philosophy is based on the following principles:

 

 

 

Compensation Determination

 

We benchmark our executive compensation against the for-profit education sector, along with the services industry, and the general market for all of industry. We recognize that a blended approach is necessary due to the fact that it is not possible to compare all our executive positions to comparables from one industry segment. For example, our University President position requires that we employ a highly experienced, highly educated executive with a strong academic leadership background. Therefore we are able to benchmark against the for-profit sector for that position. Other positions do not require the same industry-specific background, and we are therefore better served by benchmarking against broader information sources. Our past approach has been to use input from consulting firms to supplement information obtained and developed by members of our human resources staff.

 

For purposes of comparison to companies in the for-profit education sector in 2006, we reviewed the compensation practices of Apollo, Blackboard, Career Education Company, Corinthian Colleges, DeVry, eCollege, Education Management, EVCI, ITT Educational Services, Laureate, Lincoln Education Services, Strayer and Universal Technical Institute. The list of comparable companies in the for-profit education sector may change over time. For purposes of comparison to companies in the services industry and general industry, we utilize well- established executive compensation survey sources that include a representative sample of organizations with approximately $300 million in annual revenue.

 

In 2006, with assistance from the consulting firm Towers Perrin, the Committee benchmarked our compensation against surveys that included a specific set of companies in the for-profit education sector, service companies and companies in general industry. The Committee’s benchmarking of executive compensation included the following elements: base salary; total cash compensation, which is comprised of base salary and short-term incentive compensation; and total direct compensation, which is comprised of total cash compensation plus the value of long-term incentive compensation. This information was used by the Committee to set compensation levels for 2007.

 

In establishing specific executive compensation plans, levels and amounts, several of our senior executives play a role. Our Chairman and Chief Executive Officer recommends to the Committee compensation levels for all other executive officers. The Vice President of Human Resources, under the direction of the Committee and the Chairman and Chief Executive Officer, gathers information and makes recommendations to the Committee on executive compensation generally, including recommendations as to specific plans and programs. Our Senior Vice President and Chief Financial Officer provides information and recommendations to the Committee on important accounting, tax and financial matters. In the future, we intend to utilize the services of a compensation consulting firm as the primary source for gathering executive compensation information and making recommendations to the Committee.

 

Compensation consultants working on our executive compensation matters are selected and engaged by the Committee, based on input from senior management. Consultants providing input, information and recommendations on executive compensation matters report directly to the Committee.

 

In 2006, in addition to the engagement mentioned above, Towers Perrin was retained by the Committee to consult in our hiring of a President and Chief Operating Officer.

 

Compensation Elements

 

From time to time, we have entered into certain employment agreements addressing specific compensation arrangements when hiring senior executives. These are individually developed based on relevant considerations at the time of hiring. We have selectively offered signing bonuses and/or guaranteed incentive compensation for the first year of employment. Employment agreement terms have also included severance and change in control provisions. In those instances when we entered into employment agreements with senior executives, the Committee’s judgment was that such agreements were appropriate and necessary.

 

Our current executive compensation mix includes the following elements: base salary; short-term incentive opportunity, generally in the form of annual cash bonuses; long-term incentive opportunity in the form of stock options; and perquisites and other benefits. In contrasting between the various compensation elements, the short-term incentive opportunity is focused on annual results, and the long-term incentive opportunity is focused on periods beyond one year.

 

Base Salary

 

Base salary reflects the experience, knowledge, skills and performance record the executive brings to the position, and is influenced by market factors.

 

The Committee reviews executive salaries annually based on market survey data. In 2006, the Committee reviewed the salaries of our four highest paid senior executives and the General Counsel, and in 2007, the Committee reviewed the salaries of all of our officers that are subject to Section 16 of the Securities Act of 1933, except the Principal Accounting Officer. In some cases, market competitive information may be difficult to obtain due to unique duties and responsibilities of a particular position. In those instances, we consider qualitative criteria, such as education and experience requirements, skills, complexity and scope/impact of the position compared to other executive positions internally.

 

Individual executive base salaries are reviewed annually and may be adjusted based on individual performance, company performance and placement relative to market-adjusted ranges. The performance assessment for each executive includes an evaluation of performance against objectives established at the beginning of the year and demonstration of leadership competencies. In evaluating executive performance for purposes of merit pay adjustments, the Committee also considers overall company performance, and the performance of the functional area(s) under an executive’s scope of responsibility.

 

Short-Term Incentive Opportunity

 

The short-term incentive opportunity is provided through our cash-based management incentive plan. This is a group incentive plan and is based on the company’s overall financial performance. The level of participation for each executive in the annual incentive plan is based upon the degree to which his or her position impacts overall financial performance of the company, and also on market competitive factors. Target award opportunities are established as a percentage of the executive’s base salary, and currently range between 40% to 60% of base salary. The management incentive plan is based on targets that reward strong company financial performance and growth, year over year, and is administered to comply with Department of Education guidelines described above in this Compensation Discussion and Analysis under “Overview.”

 

At the beginning of each year, the Committee approves a matrix that reflects payout opportunities based on the company’s achievement of certain financial objectives. Upon completion of the fiscal year, executives receive bonus payments, if any, pursuant to the terms of the management incentive plan and the matrix approved at the beginning of the year.

 

In 2006, our management incentive plan provided participants an opportunity to earn between 0 and 200% of targeted incentive opportunity, depending on the degree to which the company achieved its annual performance objectives for revenue and income before income taxes, excluding the impact of stock-based compensation expense under FAS 123(R). We based 70% of the target incentive opportunity on achieving the full-year targets for revenue and income before income taxes, and 30% of the opportunity on achieving the revenue and income before income tax targets for the second half of the year. By virtue of this design, we emphasized a strong finish to the year and

momentum going into 2007. The minimum thresholds for incentive payouts in 2006 were set at 93% and 85% of revenue and income before income tax objectives, respectively. Participants had the opportunity to earn a maximum payout of 200% of their targeted incentive opportunity if the company achieved 103% and 115% or more of its revenue and income before income tax objectives, respectively. Performance between the minimum and maximum levels results in prorated payments to plan participants. Our 2006 targets reflected target revenue growth over the prior year of approximately 25% and target income before income tax growth over the prior year of approximately 56%.

 

Income before income taxes, excluding the impact of stock-based compensation expense under FAS 123(R), is a non-GAAP financial measure. We used this measure in our 2006 management incentive plan because we believe it was the most useful measure with which to evaluate performance of our business in 2006. Stock-based compensation expense was excluded to achieve comparability with prior years, where it had similarly not been included.

 

In 2006, we provided to several key executives a special one-time grant of performance-based stock options in lieu of cash payouts under the management incentive plan. This design was adopted by the Committee to more closely align key management and investor interests at a critical time as we prepared to become a public company. The decision to provide this one-time stock option grant also reinforced among those executives the concept of stock ownership. In 2007, we have returned to providing an entirely cash-based management incentive plan for all participants.

 

Based on the Company’s performance against full year 2006 and second half 2006 revenue and income before income tax targets as described above, participants in the management incentive plan earned 74.5% of the targeted incentive opportunity in 2006.

 

In 2007, our financial metrics for full-year revenue and operating income, including the impact of stock-based compensation expense under FAS 123(R) (as opposed to the income before income tax metric used in 2006) will comprise 90% of the targeted incentive opportunity, and a learner satisfaction component will comprise 10% of the targeted opportunity. The revenue and operating income metrics are weighted equally in 2007, so each metric comprises a total of 50% of the financial metric component of the targeted opportunity; however, if performance exceeds target, then revenue will comprise 75% and operating income will comprise 25% of the financial metric component. We believe that focusing operating management on operating income (rather than income before income taxes) ensures better alignment between company performance and our objective to create shareholder value by focusing management’s attention on metrics that management is better able to control. The new learner satisfaction component is measured using a survey instrument that measures learner satisfaction over the course of the year against a pre-established baseline.

 

For participants to earn a payout under the 2007 plan, the company must achieve a minimum of 93% of its revenue objective and a minimum of 95% of its operating income objective. A maximum payout can be achieved if the company achieves at least 101.4% of its revenue and operating income objectives. Performance between minimum and maximum levels results in prorated payments to plan participants. Payouts under the 2007 management incentive plan will range between 0% and 190% of target incentive. A plan participant achieves a 190% maximum payout if the company performs at that 200% level for both financial metrics, and the company performs at the 100% level on the learner satisfaction metric (90% * 2 + 10% = 190%).

 

Shown below is a summary of the 2007 management incentive plan matrix.

 

 

 

 

The Committee believes this 2007 plan design will result in the alignment of incentive opportunity with shareholder value creation. We set our 2007 plan objectives such that they represent revenue growth of 18% to 22%, and operating income growth of 25% to 30%, in both cases above industry averages as projected by for-profit, post-secondary industry research analysts over the three- to five-year time horizon. The Committee believes that the revenue and operating income targets upon which the 2007 plan are built are aggressive but achievable. Over the last three years ending in 2006, our payout level has been between 60% and 80% of target.

 

In making its annual determination of minimum, target and maximum payout levels under the management incentive plan, the Committee may consider any specific and unusual circumstances facing us during the upcoming year. Generally, the Committee sets the minimum, target and maximum levels within the ranges described above such that the relative difficulty of achieving target level performance is consistent from year to year.

 

In hiring key executives, it has been in the past and may be in the future necessary to guarantee payout under the management incentive plan at a specified level in the first year of employment. This is situational, at the discretion of the Committee, and is not intended to be ongoing in nature.

 

Long-Term Incentive Opportunity

 

The long-term incentive opportunity for executives is provided through the use of stock options. Options have historically been granted with a four-year vesting schedule. We have on occasion granted options with shorter vesting schedules, including grants to our Chairman and Chief Executive Officer in 2006 and 2005, when we used two-year and three-year vesting schedules, respectively. We used those vesting schedules in order to afford our Chief Executive Officer additional flexibility, in recognition of our publicly disclosed succession planning objectives.

 

Options are granted to executives at the time of hire, and are typically granted annually thereafter once the executive has completed two years of service. The Committee relies on market survey information to help determine the size of new hire and annual stock option awards. Additionally, the Committee utilizes a formula that takes into account base compensation, position level and the fair market value of the company’s common stock (applying the Black-Scholes model) to determine the size of the award. The Committee has discretion as to actual award size based on individual performance factors.

 

By way of example, if an executive’s base salary was $200,000 and target incentive percentage based on her position level was 60%, her target annual long-term opportunity would be $120,000. We would then divide $120,000 by the Black-Scholes value of the stock option based on the fair market value of the company’s stock at the time of grant (using a Black-Scholes value of $12.00, for purposes of this example), resulting in an award of 10,000 stock options.

 

At this time, stock options are the only form of long-term incentive compensation used by the company. Target awards are 65% for the Chairman and Chief Executive Officer and 60% for the other named executive officers.

 

The Committee is considering alternative forms of long-term incentive compensation, primarily equity-based, for future long-term incentive awards. Our 2005 Stock Incentive Plan provides the Committee flexibility in that regard, allowing for various award types, including restricted stock, stock appreciation rights and performance shares.

 

Perquisites and Other Compensation

 

Employee benefits offered to key executives are designed to meet current and future health and security needs for the executives and their families. Executive benefits are the same as those offered to all employees, except that medical insurance premiums are paid in full by the company for the named executive officers enrolled in our medical benefit plan. The employee benefits offered to all eligible employees include medical, dental and life insurance benefits, short-term disability pay, long-term disability insurance, flexible spending accounts for medical expense reimbursements, a 401K retirement savings plan that includes a partial company match, and an Employee Stock Ownership Plan (ESOP). In addition, named executive officers are eligible to participate in our Senior Executive Severance Plan, and all executives receive certain retirement benefits.

 

The 401K retirement savings plan is a defined contribution plan under Section 401(a) of the Internal Revenue Code. Employees may make pre-tax contributions into the plan, expressed as a percentage of compensation, up to prescribed IRS annual limits. We provide an employer matching contribution. Through June 30, 2006, we matched 50% of the first 4% of employee pay contributed. As of July 1, 2006, we increased our matching contribution to 100% on the first 2% of employee pay contributed, and 50% on the next 4% of employee pay contributed.

 

Employee compensation for 2006 included company-funded ESOP contributions of approximately 1% of eligible employee compensation, which for 2006 was compensation earned during the period January 1, 2006 through June 30, 2006. Our ESOP retirement plan is a defined contribution plan, under which we may make a discretionary contribution of between 0% and 3% of eligible employee compensation per plan year. To receive a contribution in a given year, an employee must meet service requirements as to hours worked and dates of active employment. In addition, the plan includes a three-year vesting schedule. The ESOP holds shares of our common stock in an employee’s account through a retirement plan trust.

 

In 2006, following a review of external sources by our human resources organization, the Committee adopted a Senior Executive Severance Plan, which applies to our named executive officers and certain other senior executive officers. The plan provides severance benefits upon the occurrence of certain triggering events. The Committee believes that such a plan is necessary to attract and retain key executives in the company’s competitive employment market. Our Senior Executive Severance Plan pays additional benefits to most executives covered thereunder in the event of a change in control followed by an involuntary termination or termination for good reason. The Committee chose this “double trigger” design because it believed such design to be most consistent with current industry practice.

 

Upon retirement, each executive officer is entitled to medical, dental and life insurance plan continuation for 18 months under the federal and state COBRA provisions at his or her election. In addition, the executive is entitled to elect to receive distributions from our ESOP and the 401K retirement plans, under the terms of those plans. Under our 1993 and 1999 Stock Option Plans, any vested but unexercised stock options may be exercised for a period of 60 days and three months, respectively, after retirement. Under our 2005 Stock Incentive Plan, vested but unexercised stock options may be exercised for up to one year after retirement.

 

Policies And Practices

 

Grants of Equity Awards.  Prior to our initial public offering in 2006, we adopted a policy related to all grants of equity awards to ensure the most appropriate method, timing and delivery of equity awards. Under this policy, no grants shall occur on a date when our insider trading window is closed, which includes the period beginning the first day of the third month of a quarter, and continuing through the second trading day after a release of earnings, in addition to other times throughout the year when we may be aware of material, non-public information. Grants may be approved by the Committee during closed window periods; however, the grant date will be the first trading day after the trading window opens. This policy helps ensure that option grants are made at a time when any material

information that may affect our stock price has been provided to the market and, therefore, the exercise price or value of the award reflects the fair value of our stock based on all relevant information.

 

Promotional and other discretionary grants may occur at regularly scheduled Committee meetings throughout the year. The full board of directors must approve all equity awards to non-employee directors. The Committee has delegated authority to the Chief Executive Officer to award equity grants to employees who are not executive officers in connection with their commencement of employment, subject to guidelines established by the Committee as to position level and award size, and subject to a quarterly maximum number of shares.

 

We set the exercise price of the option award based on the closing price of our common stock on the date of grant.

 

Equity Terms and Conditions.  In 2006, we determined that the term of our stock options should not exceed seven years, which was shorter than the ten-year term used for prior option grants. This decision was based on a review of common practices among public companies in our industry. In 2006, we also adopted a practice of issuing only non-qualified stock options. This decision also considered common practice in the public company market. Vesting schedules for option awards are generally four years, at 25% per year. We believe this schedule reinforces performance over the long term, which will ultimately be reflected in the stock price.

 

Stock Ownership Guidelines.  During 2006, there were no stock ownership guidelines applicable to our executive officers. In February 2007, our board of directors adopted the following stock ownership guidelines for our officers:

 

 

 

 

The stock ownership guidelines can be met through holding shares (including ESOP shares), in-the-money vested stock options, or a combination of the two. In addition, the stock ownership guidelines also set guidelines for the amount of stock that may be sold in any one quarter by any persons with the title “vice president” or higher — these guidelines, as a percent of vested stock holdings are as follows: 15% for the chief executive officer, chief operating officer and chief financial officer; 20% for senior vice presidents (other than the chief financial officer); and 50% for vice presidents. Lastly, our insider trading policy prohibits executives from engaging in margin loans or otherwise pledging their shares.

 

Accounting and Tax Impact of Executive Compensation Programs.  We will consider Internal Revenue Code Section 162(m) as we establish compensation plans in the future. For 2006, the stock options granted to our named executive officers in connection with our 2006 management incentive plan were structured as “performance-based compensation” in a manner similar to that which would be required to satisfy the conditions of Section 162(m); however, for 2006, we intend to rely on an exemption from Section 162(m) for a plan adopted prior to the time a company becomes a public company. This transition exemption for our equity compensation plans will no longer be available to us after the date of our annual meeting that occurs after the third calendar year following the year of our initial public offering, or if we materially modify the plan earlier. We will continue to consider the implication of the limits on deductibility of compensation in excess of $1 million as we design our compensation programs. As previously explained, we modified other terms of our stock options in 2006 by reducing the term of awards to seven years and granting non-qualified stock options. Both of these modifications provided positive tax and accounting impacts.

 

Compensation Committee Report

 

The Compensation Committee has discussed and reviewed the Compensation Discussion and Analysis with management. Based upon this review and discussion, the Compensation Committee recommended to the board of directors that the Compensation Discussion and Analysis be included in this proxy statement.

 

Compensation Committee:

 

James A. Mitchell, Chair
Gordon A. Holmes
S. Joshua Lewis
Jon Q. Reynolds, Jr.
David W. Smith

 

Summary Compensation Table

 

The following table shows, for our Chief Executive Officer, our Chief Financial Officer and the three other most highly compensated executive officers of our company, together referred to as our named executive officers, information concerning compensation earned for services in all capacities during the fiscal year ended December 31, 2006.

 

 

 

 

 

 

Grants of Plan-Based Awards in 2006

 

The following table sets forth certain information concerning plan-based awards granted to the named executive officers during the fiscal year ended December 31, 2006.

 

 

 

 

Determination of Fair Market Value for Option Awards of Common Stock

 

In determining the exercise price for stock option grant awards, under our 2005 Stock Incentive Plan, options must be granted at an exercise price not less than the fair market value of our common stock at the close of business on the grant date. Prior to our initial public offering in November 2006, the valuation used to determine the fair market value of our common stock at each grant date was performed internally and contemporaneously with the issuance of the options. The options expire on the date determined by the board of directors but may not extend more than ten years from the grant date for options granted prior to August 2, 2006. On August 2, 2006, the board of directors approved a change to our stock option policy to shorten the contractual term from ten years to seven years for future grants. The options generally become exercisable over a four-year period. Canceled options become available for re-issuance under the 2005 Plan. We have also issued stock options under two discontinued plans (the 1993 and 1999 Plans). Stock options issued pursuant to the 1993 and 1999 Plans are still outstanding, however, unexercised options that are canceled upon termination of employment are not available for re-issuance.

 

Explanation of Option Award Corrective Actions for Mr. Shank

 

The Option Awards column in the Summary Compensation Table includes the incremental fair market value for two corrective actions approved by our board of directors, related to options previously issued to Mr. Shank. On two different dates, October 24, 2000, and August 26, 2002, we issued an option to purchase 28,070 and 17,078 shares of our common stock, respectively, to Mr. Shank. The term of the October 24, 2000 option award,

and the vesting schedule of the August 26, 2002 option award were communicated to Mr. Shank in two forms which were found to be in conflict. This had the result of modifying the agreements. As a result, the board of directors approved an extension on March 22, 2006, to the term of the October 24, 2000 option to ten years from original grant date, and approved a corrected vesting schedule for the August 26, 2002 award. We recognized the incremental compensation expense associated with these corrections in 2006.

 

Employment Agreement Provisions

 

The following provisions for individual employment agreements are applicable to understanding the tables. On February 27, 2006, we entered into a letter agreement with Kenneth J. Sobaski, pursuant to which Mr. Sobaski agreed to serve as President and Chief Operating Officer. Pursuant to the terms of the letter agreement, Mr. Sobaski received, among other things, (1) a signing bonus of $60,000, payable in 2006, (2) an initial annual base salary of $400,000, (3) an annual incentive compensation award targeted at 50% of his base salary (which is guaranteed for his first year of employment, and the amount shown in the bonus column of the Summary Compensation Table reflects the guaranteed 50% level, as applied to his actual base salary earnings in 2006), and (4) options to purchase 165,000 shares of our common stock at an exercise price of $20.00 per share, 41,250 of which will vest on each of February 27, 2007, 2008, 2009 and 2010, subject to acceleration in certain situations.

 

On October 25, 2004 we entered into a letter agreement with Lois M. Martin, pursuant to which Ms. Martin agreed to serve as our Senior Vice President and Chief Financial Officer. Pursuant to the terms of the letter agreement, Ms. Martin received, among other things, (1) an annual incentive compensation award targeted at 40% of her annual base salary, and (2) an option to purchase 100,000 shares of our common stock at an exercise price of $20.00 per share, of which 50,000 have vested and 25,000 of which will vest on each of November 15, 2007 and 2008, subject to acceleration in certain situations.

 

On March 9, 2001, we entered into a letter agreement with Paul A. Schroeder, pursuant to which Mr. Schroeder agreed to serve as our Senior Vice President and Chief Financial Officer. On May 30, 2006, Mr. Schroeder’s agreement was amended. Under the terms of the amended agreement, as further amended in August, 2006, Mr. Schroeder served as Senior Vice President of both Capella Education Company and Capella University. Effective March 1, 2007, Mr. Schroeder’s title changed to Senior Vice President of Operations and Business Transformation for Capella Education Company, and he no longer serves as Senior Vice President for Capella University. He continues to receive his current base salary of $274,000, and continues his eligibility in our annual incentive compensation plan at a target bonus level of 40% of his annual base salary.

 

On April 17, 2001, we entered into a letter agreement with Michael Offerman, pursuant to which Dr. Offerman agreed to serve as our Senior Vice President, and President and Chief Executive Officer of Capella University. The agreement was amended on November 10, 2003, and again on May 30, 2006. Pursuant to the terms of the amended agreements, as further amended in August, 2006, Dr. Offerman now serves as our Senior Vice President and President of Capella University. On March 1, 2007, we announced that Dr. Offerman’s will become the Vice Chairman — External University Initiatives for Capella Education Company and University President Emeritus for Capella University. He continues to receive his annual base salary of $274,000, and continues his eligibility in our annual incentive compensation plan at a target bonus level of 40% of his annual base salary.

 

Outstanding Equity Awards at 2006 Fiscal Year-End

 

The following table sets forth certain information concerning equity awards outstanding to the named executive officers at December 31, 2006.

 

 

 

 

 

Potential Payments Upon Termination or Change-in-Control

 

On September 11, 2006, we established the Capella Education Company Senior Executive Severance Plan, referred to as the Senior Executive Severance Plan, to provide severance pay and other benefits to certain eligible employees. To be eligible for the Senior Executive Severance Plan, the employee must: (1) be designated as a participant in writing by our Chief Executive Officer, (2) be in a select group of management or highly compensated employees within the meaning of the Employee Retirement Income Security Act of 1974, (3) have completed 90 days of service with us from the most recent date of hire, (4) have their employment terminated under certain circumstances, (5) not be a participant in the Executive Severance Plan and (6) execute a release. The release contains non-competition and non-solicitation provisions that apply for a period of twelve months post-termination of employment, and confidentiality provisions that apply indefinitely following termination of employment. Currently, the participants in the Senior Executive Severance Plan include our Chief Executive Officer and Chairman of the Board of Directors, senior vice president level employees and vice president level employees, including all of the named executive officers in the Summary Compensation Table.

 

Under the Senior Executive Severance Plan, a qualifying severance event occurs if, unrelated to a change-in-control, there is an involuntary termination other than for cause. A qualifying event also occurs in the event there is a change-in-control, and there is a voluntary termination of employment for good reason or an involuntary termination other than for cause, within 24 months following the change-in-control. Participants who experience a qualifying severance event will be eligible to receive severance benefits, based on their termination event, including severance pay ranging from twelve to 24 months, outplacement assistance, and continuation coverage under certain employee benefit plans for up to 18 months (subject to adjustment, alternative or previous severance benefits). For employee benefit plan continuation, the departed employee must pay the employee portion of applicable premiums during the continuation period, just as he/she would have paid during his/her employment. Severance payments are made bi-weekly in accordance with our standard payroll practices. In change-in-control situations involving a qualifying termination within twenty-four months of the change-in-control event, a participant (except the Chief Executive Officer) may also be eligible to receive payment of 200% of any targeted bonus for the year of termination; the Chief Executive Officer may be eligible to receive payment of 80% of any targeted bonus for the year of termination. We have also provided specific severance benefits to certain of our executives under such executives’ employment agreements, which are described below. The Senior Executive Severance Plan provides that any employment agreement that specifically provides for the payment of severance benefits will remain in full force and effect and that any payments due under the Senior Executive Severance Plan will be reduced or offset by any similar amounts payable due to termination under an employment agreement.

 

Our board of directors, Chief Executive Officer, or any other individual or committee to whom such authority has been delegated may amend or terminate the Senior Executive Severance Plan (the “Plan”). The Plan cannot be amended to reduce benefits or alter Plan terms, except as may be required by law, for a period of 24 months following a change-in-control, as defined in the Plan. In addition, the Plan provides that any amendment to the Plan, or termination of the Plan, adopted within six months prior to a change in control will become null and void upon the change-in-control event. The Senior Executive Severance Plan will terminate immediately upon our filing for relief in bankruptcy or on such date as an order for relief in bankruptcy is entered against us.

 

For purposes of the Senior Executive Severance Plan, certain terms are defined as follows:

 

 

 

(1) Any person or entity acquires or becomes a beneficial owner, directly or indirectly, of securities of Capella representing 35% or more of the combined voting power of our then outstanding voting securities, subject to certain exceptions;

 

(2) A majority of the members of our board of directors shall not be continuing directors, for which purpose continuing directors are generally those directors who were members of our board at the time we adopted the Plan and those directors for whose election our board of directors solicited proxies or who were elected or appointed by our board of directors to fill vacancies caused by death or resignation or to fill newly-created directorships;

 

(3) Approval by our shareholders of a reorganization, merger or consolidation or a statutory exchange of our outstanding voting securities unless, immediately following such reorganization, merger, consolidation or exchange, all or substantially all of the persons who were the beneficial owners, respectively, of our voting securities and shares immediately prior to such reorganization, merger, consolidation or exchange beneficially own, directly or indirectly, more than 65% of, respectively, the combined voting power of the then outstanding voting securities entitled to vote generally in the election of directors and the then outstanding shares of common stock, as the case may be, of the corporation resulting from such reorganization, merger, consolidation or exchange in substantially the same proportions as their ownership, immediately prior to such reorganization, merger, consolidation or exchange, of our voting securities and shares, as the case may be; or

 

(4) Approval by the shareholders of (x) a complete liquidation or dissolution of our company or (y) the sale or other disposition of all or substantially all of our assets (in one or a series of transactions), other than to a corporation with respect to which, immediately following such sale or other disposition, more than 65% of, respectively, the combined voting power of the then outstanding voting securities of such corporation entitled to vote generally in the election of directors and the then outstanding shares of common stock of such corporation is then beneficially owned, directly or indirectly, by all or substantially all of the persons who were the beneficial owners, respectively, of our voting securities and shares immediately prior to such sale or other disposition in substantially the same proportions as their ownership, immediately prior to such sale or other disposition, of our voting securities and shares, as the case may be.

 

Kenneth J. Sobaski Employment Agreement.  Under our letter agreement with Mr. Sobaski, in the event that Mr. Sobaski’s employment terminates, he is entitled to receive the greater of the severance benefits provided to him under our Senior Executive Severance Plan, or the severance benefits provided for in his letter agreement. Mr. Sobaski’s letter agreement provides that, in the event that Mr. Sobaski’s employment is terminated without cause (as defined below) or he voluntarily terminates his employment for good reason (as defined below), Mr. Sobaski will be entitled to the following severance benefits: (1) twelve months total compensation (base salary plus target bonus) and (2) senior executive outplacement services for twelve months and provision of certain office support equipment during that period. In the event any such termination follows a change-in-control, Mr. Sobaski’s letter agreement entitles him to receive two times the severance package described above. As defined in his letter agreement, “cause” means (i) commission of a crime or other act that could materially damage our reputation, (ii) theft, misappropriation or embezzlement of company property, (iii) falsification of company records, (iv) failure to substantially comply with our written policies and procedures, or (v) misconduct directed toward learners, employees or adjunct faculty. “Good reason” as defined in his letter agreement means (i) a change in his position to one with a lower pay grade or lesser responsibilities, (ii) a decrease in fixed compensation by more than 10% in any 12 month period, (iii) relocation more than 50 miles from his current work location, or (iv) Mr. Shank is no longer Chief Executive Officer and Mr. Sobaski has not been assigned to that position. Our obligation to make the

severance payments described above will terminate if Mr. Sobaski breaches any provision the non-competition or confidentiality provisions of the release agreement.

 

Lois M. Martin Employment Agreement.  Under the terms of our letter agreement with Ms. Martin, in the event Ms. Martin’s employment terminates, she is entitled to receive the greater of the severance benefits provided to her under our Senior Executive Severance Plan or the severance benefits provided for in her letter agreement. Ms. Martin’s letter agreement provides that, if Ms. Martin voluntarily terminates her employment for good reason (as defined below), or if her employment is terminated by Capella for a reason other than cause or within two years of a change-in-control, she will be entitled to receive severance pay in an amount equal to up to twelve months base salary, outplacement assistance for up to twelve months, a benefits package at the regular employee rate, and eighty percent of her targeted bonus amount for the year of termination (prorated to the date of termination). As defined in her letter agreement, “good reason” includes (i) a change in her position to one with a lower pay grade or less responsibilities, (ii) a decrease in fixed compensation by more than 10% in any 12 month period, (iii) relocation more than 50 miles from her current work location, or (iv) being temporarily laid off and not reinstated within 90 days. Finally, Ms. Martin’s letter agreement provides that she will be entitled to the highest level of severance benefits available to any other employee under the Senior Executive Severance Plan. Our obligation to make the severance payments described above will terminate if Ms. Martin breaches any provision the non-competition or confidentiality provisions of the release agreement.

 

Michael J. Offerman, Ed.D. Employment Agreement.  Under the terms of our letter agreement with Dr. Offerman, Dr. Offerman is also eligible to participate in our Senior Executive Severance Plan, subject to the following modifications. If Dr. Offerman should voluntarily terminate his employment at any time for good reason, he shall be entitled to receive benefits under our Senior Executive Severance Plan as if his employment had been terminated without cause. As defined in his letter agreement, “good reason” includes (i) a change in his position to one with a lower pay grade or lesser responsibilities, (ii) a decrease in his fixed compensation or (iii) a material change to his reporting relationship to the Capella University Board. Dr. Offerman is also subject to a confidentiality, non-competition and inventions agreement. In the event that he leaves the company for any reason other than termination for cause, and is unable to find suitable employment, as a direct result of the restrictions imposed by his non-competition agreement, he will be entitled to the greater of twelve months base salary or his severance entitlements, if any, pursuant to the Senior Executive Severance Plan. Our obligation to make the severance payments described above will terminate if Dr. Offerman breaches any provision the non-competition or confidentiality provisions of the release agreement. In the event that Dr. Offerman remains an employee of the company on June 1, 2007, the letter agreement terminates.

 

For purposes of the following tables, certain terms, such as “cause,” “good reason,” and “change-in-control” are defined in the Senior Executive Severance Plan as described above, or, if the definition is more favorable to the executive, as such term is defined in any letter agreement between us and the executive, which are also described above.

 

In the event that an involuntary termination of the employment of a named executive officer other than for cause (assuming a change-in-control had not occurred) on December 31, 2006, the following amounts would have been paid to each named executive officer:

 

 

 

 

In the event of a change-in-control, if within 24 months of the change in control a voluntary termination of the employment of a named executive officer for good reason, or an involuntary termination other than for cause, had occurred on December 31, 2006, the following amounts would have been paid to each named executive officer:

 

 

 

 

 

 

Summary of Other Provisions — Termination of Employment

 

Disability Termination.  Executive officers whose employment terminates due to disability have the following provisions specific to the termination event:

 

 

Retirement.  Senior executive officers (which currently includes all executives at or above the vice president level, including each of the named executive officers) whose employment terminates due to retirement have the following provisions specific to the termination event:

 

 

Death.

 

 

Director Compensation

 

The following table shows, for the fiscal year ended December 31, 2006, all compensation that our company paid to our directors. We did not pay any director compensation in 2006 to Messrs. Shank, Holmes, Lewis and Reynolds, each of whom was either our employee or had represented an entity that had a financial interest in our company.

 

 

 

 

 

 

 

During 2006, the directors who were our employees or who had represented an entity that had a financial interest in us did not receive any compensation. The directors who were not our employees and who did not represent an entity that had a financial interest in us received an option to purchase 2,500 shares of our common

stock under our 2005 Stock Incentive Plan, with the exception of Sandra Taylor, who joined the Board in May of 2006. Ms. Taylor received an option to purchase 10,000 shares of our common stock upon her election to the board.

 

We also paid our committee chairpersons an annualized cash retainer for serving in that role. Mr. Mitchell and Mr. Smith received $5,000 in 2006, paid quarterly. Mr. Tukua received $7,500 in 2006, paid quarterly. All directors were eligible for reimbursement of reasonable expenses incurred to attend board and committee meetings.

 

In 2007, we implemented our previously disclosed public company board compensation package. This includes payment of an annual cash retainer of $32,500, paid quarterly, to non-employee directors, for fees associated with board and committee service. Chairs of the governance and compensation committees, and our lead director, will receive an additional cash retainer of $5,000, paid quarterly, and the chair of the audit committee will receive $7,500, paid quarterly. Each non-employee director (except Mr. Holmes, who declined) will also receive an annual stock option grant valued at $32,500 which is vested in full immediately upon grant. Also, any non-employee director who wishes to receive stock options in lieu of cash compensation may elect this form of payment. The number of shares subject to such stock options is determined by dividing the cash retainer by the Black-Scholes value based on the closing price of our common stock on the grant date. These options are also vested in full immediately upon grant. New non-employee directors who join the board will receive an option to purchase 10,000 shares of our common stock, with a four year vesting schedule, granted upon election. All stock options issued to directors have an exercise price equal to the closing price of our common stock on the date of grant, and a term of seven years. We will reimburse all directors for reasonable expenses incurred to attend our board and board committee meetings.

 

The Committee believes that a balance of equity and cash compensation for non-employee directors is the most appropriate way to compensate them for board service. Providing the non-employee director the ability to elect equity in lieu of any or all cash compensation also offers some flexibility to the individual members. Equity compensation also aligns the board member’s interests with the shareholders.

 

SECURITIES OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

 

The following table sets forth information with respect to the beneficial ownership of our common stock as of December 31, 2006 by:

 

 

Beneficial ownership is determined in accordance with the SEC’s rules. In computing percentage ownership of each person, shares of common stock subject to options held by that person that are currently exercisable, or exercisable within 60 days of December 31, 2006, are deemed to be outstanding and beneficially owned by that person. These shares, however, are not deemed outstanding for the purpose of computing the percentage ownership of any other person.

 

Except as indicated in the notes to this table and pursuant to applicable community property laws, each shareholder named in the table has sole voting and investment power with respect to the shares set forth opposite such shareholder’s name. Percentage of ownership is based on 16,002,371 shares of our common stock outstanding on December 31, 2006. All fractional common share amounts have been rounded to the nearest whole number. The address for each executive officer and director is Capella Education Company, 225 South 6th Street, 9th Floor, Minneapolis, MN 55402.

 

 

 

 

CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS

 

Related Person Transaction Approval Policy

 

In March 2007, our board of directors adopted a written related person transaction approval policy, which sets forth our company’s policies and procedures for the review, approval or ratification of any transaction required to be reported in the Company’s filings with the Securities and Exchange Commission. Our policy applies to any transaction, arrangement or relationship or any series of similar transactions, arrangements or relationships in which our company (including any subsidiaries) is or will be a participant and in which a related person has a direct or indirect interest, but exempts the following:

 

 

The audit committee of our board of directors is to approve any related person transaction subject to this policy before commencement of the related person transaction. If such a transaction is not identified until after it has commenced, it must then be brought to the audit committee, which will consider all options, including approval, ratification, amendment, denial, termination or, if the transaction is completed, rescission. The audit committee will

analyze the following factors, in addition to any other factors the committee deems appropriate, in determining whether to approve or ratify a related person transaction:

 

 

The audit committee may, in its sole discretion, approve or deny any related person transaction. Approval of a related person transaction may be conditioned upon our company and the related person taking any actions that the audit committee deems appropriate. The audit committee has delegated to its chairperson authority to approve or take any other action with respect to a related person transaction that the committee itself would be authorized to take pursuant to this policy.

 

Related Person Transaction Summary

 

Capella was a party to the transactions with related persons described below in the year ended December 31, 2006. All such transactions were entered into prior to the adoption of our related person transaction approval policy.

 

Special Distribution.  In November 2006, we paid a special distribution promptly after the completion of our initial public offering to our shareholders of record as of October 3, 2006. The aggregate amount of the special distribution was $72.6 million, or $6.19 per common share on an as if converted basis. The amount of the special distribution was equal to the gross proceeds from the sale of common stock by us in the initial public offering, excluding the proceeds received by us from the underwriters’ exercise of their over-allotment option. A special committee, comprised of Mr. Taylor, Ms. Taylor and Mr. Tukua, was appointed by our board of directors for the purpose of considering whether and on what terms a distribution to our shareholders should be paid in connection with our initial public offering. The board declared the special distribution upon the recommendation of the special committee, and on the same terms recommended by the special committee.

 

The following table sets forth the amount of cash paid as a result of the special distribution in respect of shares of our capital stock as to which each of our more than 5% shareholders, directors and executive officers was deemed to have sole or shared voting or investment power as of October 3, 2006.

 

 

 

 

Purchase of Shares in our Initial Public Offering.  The entities affiliated with Technology Crossover Ventures collectively beneficially own approximately 12.2% of our common shares, and Jon Q. Reynolds, Jr., one of our

directors, is a General Partner of Technology Crossover Ventures. The Salmon River and Insight entities collectively beneficially own approximately 8.5% of our common shares, and S. Joshua Lewis, one of our directors, is a principal of Salmon River Capital LLC and a special partner of Insight Venture Partners. In our November 2006 initial public offering, the entities affiliated with Technology Crossover Ventures purchased an aggregate of 100,000 shares of our common stock from the underwriters for $2 million, and the Salmon River and Insight entities purchased an aggregate of 100,000 shares of our common stock from the underwriters for $2 million (in each case, at the initial public offering price of $20.00 per share).

 

Other than the transactions set forth above, our company had no other transactions during fiscal 2006 which would have required review, approval or ratification under our related party transaction approval policy or where the policies and procedures under the related party transaction approval policy were not followed.

 

EQUITY COMPENSATION PLAN INFORMATION

 

The following table provides information as of December 31, 2006, with respect to shares of our common stock that may be issued under our existing equity compensation plans:

 

 

 

 

SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE

 

Section 16(a) of the 1934 Act requires that our company’s directors and executive officers file initial reports of ownership and reports of changes in ownership with the SEC. Directors and executive officers are required to furnish our company with copies of all Section 16(a) forms they file. Based solely on a review of the copies of such forms furnished to our company and written representations from our company’s directors and executive officers, all Section 16(a) filing requirements were met for the fiscal year ended December 31, 2006, except that one report filed for Dr. Offerman during 2006 failed to disclose 1,504 shares owned by his wife, which mistake was corrected on a subsequent filing.

 

ADDITIONAL INFORMATION

 

Our 2006 Annual Report and our Annual Report on Form 10-K for fiscal year 2006, including financial statements, are being mailed with this proxy statement.

 

As of the date of this proxy statement, management knows of no matters that will be presented for determination at the meeting other than those referred to herein. If any other matters properly come before the

meeting calling for a vote of shareholders, it is intended that the persons named in the proxies solicited by our board of directors, in accordance with their best judgment, will vote the shares represented by these proxies.

 

Shareholders who wish to obtain an additional copy of our Annual Report on Form 10-K, to be filed with the Securities and Exchange Commission for the fiscal year ended December 31, 2006, may do so without charge by writing to Investor Relations, Capella Education Company, 225 South 6th Street, 9th Floor, Minneapolis, Minnesota 55402.

 

By Order of the Board of Directors,

 

 

Gregory W. Thom
Secretary

 

Dated: March 20, 2007

Capella Education Company
225 South Sixth Street, 9th Floor
Minneapolis, MN 55402		proxy

THIS PROXY IS SOLICITED ON BEHALF OF THE BOARD OF DIRECTORS OF THE COMPANY

The undersigned, revoking all prior proxies, appoints Stephen G. Shank and Gregory W. Thom, or either of them acting alone, as proxies, with full power of substitution, to represent the undersigned and to vote, as indicated on the reverse side and otherwise in their discretion upon such other matters as may properly come before the meeting, all shares of the common stock of Capella Education Company that the undersigned is entitled to vote at the Annual Meeting of Shareholders of the Company to be held at Pantages Theatre, 710 Hennepin Avenue, Minneapolis, Minnesota 55403 on Wednesday May 9, 2007 at 1:00 p.m. and at any adjournment thereof. The undersigned hereby acknowledges receipt of the Proxy Statement of the Annual Meeting.

See reverse for voting instructions.

			COMPANY #

There are three ways to vote your Proxy

Your telephone or Internet vote authorizes the Named Proxies to vote your shares in the same manner as if you marked, signed and returned your proxy card.

VOTE BY PHONE — TOLL FREE — 1-800-560-1965 — QUICK ««« EASY ««« IMMEDIATE

•		Use any touch-tone telephone to vote your proxy 24 hours a day, 7 days a week, through 11:59 p.m. (CT) on Tuesday, May 8, 2007.
•		Please have your proxy card and the last four digits of your Social Security Number or Tax Payer Identification Number available. Follow the simple instructions the voice provides you.

VOTE BY INTERNET — http://www.eproxy.com/cpla/ — QUICK ««« EASY ««« IMMEDIATE

•		Use the Internet to vote your proxy 24 hours a day, 7 days a week, through 11:59 p.m. (CT) on Tuesday, May 8, 2007.
•		Please have your proxy card and the last four digits of your Social Security Number or Tax Payer Identification Number available. Follow the simple instructions to obtain your records and create an electronic ballot.

VOTE BY MAIL

Mark, sign and date your proxy card and return it in the postage-paid envelope we’ve provided or return it to Capella Education Company, c/o Shareowner Services^SM, P.O. Box 64873, St. Paul, MN 55164-0873.

 

 

If you vote by Phone or Internet, please do not mail your Proxy Card
ò Please detach here ò

The Board of Directors Recommends a Vote FOR Items 1 and 2.

THIS PROXY WHEN PROPERLY EXECUTED WILL BE VOTED AS DIRECTED OR, IF NO DIRECTION IS GIVEN, WILL BE VOTED FOR ITEMS 1 AND 2.