The NASPP Blog

January 20, 2009

Options for Nothing

Things are bad out there.  I’m not talking about the freezing temperatures and snow that much of the country is experiencing (that’s bad, but weather is a topic for someone else’s blog); I’m talking about underwater stock options.  The market is so depressed that some companies have options so far underwater that they think their employees might be willing to voluntarily give them up for nothing in return–no cash, no new stock option, no stock or units–zip, nil, nada, a big fat $0.  I’ve had enough people ask me about this that I’ve decided to make it the topic of today’s blog. 

You Aren’t Doing Your P&L Statement Any Favors

From an accounting standpoint, this strategy doesn’t do anything for you.  If the options are fully vested, you’ve already fully expensed them and you don’t reverse any of that expense.  If the options aren’t fully vested, then the transaction is viewed as akin to an acceleration of vesting and all remaining unamortized expense is recognized immediately. Don’t believe me–check out paragraph 57 in SFAS No. 123(R). 

In this scenario, the company would be ahead if the employees kept their options. Some of the employees are surely going to terminate before their options vest, forfeiting their unvested options; when that occurs, no further expense is recognized for the forfeited options.  By having employees voluntarily surrender their options, the company loses the opportunity to reduce the expense for future forfeitures upon termination.

Some members have wondered if the company would have to be careful about making future grants, lest they be combined with the voluntary surrender of the underwater options and the whole thing treated as a repricing.  I’m not terribly concerned about this, at least from an accounting standpoint, because the company would come out ahead if the surrender and new grants were treated as a repricing. 

Let’s say that an employee holds a option granted a year ago to purchase 1,000 shares at a price of $50 per share and the stock is currently trading at $5 per share.  The option is 25% vested, with the remaining shares vesting over the next three years.  The grant date fair value of the option is about $28, resulting in an aggregate expense of $28,000.  The company has recognized 25% of this, or $7,000, with remaining unamortized expense of $21,000. 

If the employee surrenders the option for no compensation, the company immediately recognizes the remaining $21,000 of unamortized expense and that’s the end of the story.  If the employee then terminates a month later, this event has no impact on the expense recognized for the employee’s option.

If the employee tenders the option for a new grant, however, that’s a completely different story.  Let’s assume the new grant is for 500 shares at the current FMV of $5 per share, and is subject to a new four-year vesting schedule.  First off, if the employee terminates a month later, the company doesn’t recognize any expense for the new grant or any of the remaining expense on the original underwater grant (since the employee won’t have fulfilled the new grant’s vesting requirements or the remaining vesting requirements on the old grant).  If the employee terminates any time during the next three years (before the original grant would have vested), the company benefits by not recognizing expense for the portion of the original grant that would have been forfeited (and also doesn’t recognize expense for the unvested portion of the new grant). 

And there’s more.  The grant date fair value of the new option is about $3 per share.  If granted on a standalone basis, that’s a total expense of $1,500.  But if granted in exchange for the underwater option, that expense is reduced by the current fair value of the cancelled option, which is about $.50 per share or $500 in total. This reduces the expense for the new grant by a third. 

* For those of you doing the math on your own, for purposes of computing the fair values in this example, I used the Black-Scholes model and assumed a volatility of 60%, historical interest rate of 5%, current interest rate of 1.5%, and no dividend yield. I also assumed an expected life of 5 years for all valuations, which is probably not reasonable.  And I rounded, quite liberally, so the numbers would come out even. 

Other Considerations

My understanding is that there’s no black and white definition of a tender offer, but I’ve got to believe the SEC would view this as one if more than just a handful of employees are asked to surrender their options. It’s clearly an investment decision.  I also think that the SEC might be concerned that companies were trying to use this strategy to circumvent the tender offer requirements that would apply to an exchange for consideration.

The cynic in me is concerned that this is just a tactic to get more shares into the hands of executives. Senior managements’ options are underwater and the plan is running out of shares, so they figure they can replenish the share reserve by convincing employees to give up their “worthless” options. 

And there’s the obvious obstacle of getting employees to agree to surrender their options. Companies that implement programs in which employees do actually receive something of value in exchange for their options put in a lot of effort encouraging employees to participate and rarely have 100% participation. I imagine it would be even harder to get employees to participate when they won’t get anything out of it.  As a recent article in Finance and Commerce demonstrates, savvy employees know that even underwater options have value (“Stock Options Boost Income–For Those Who Know the Rules,” Mark Anderson, January 15, 2009). 

For more information on underwater options, check out the NASPP’s Underwater Options Portal.  The following articles in the portal discuss the treatment of options that are surrendered for no compensation:

And don’t miss our January 29 webcast: The Dark Side of Option Exchanges. 

Reason #9 to Renew Your NASPP Membership:  Sample Employee Communications in Year-End Procedures Portal

The NASPP’s Year-End Procedures Portal includes sample memos, statements, disqualifying disposition surveys, and other materials that you send to employees at the end of the year.  Save time by using our samples as a starting point for your own employee communications. 

New NASPP Online Course on Stock Compensation and M&A

The NASPP is pleased to introduce our newest online educational program, Tackling Equity Compensation Issues Related to Mergers & Acquisitions. At only $495, this course is a true bargain–and members that register by February 6th can qualify for yet another $100 off this price. Stock plan professionals involved in any aspect of the M&A process won’t want to miss this valuable program. 

NASPP “To Do” List

We have so much going on here at the NASPP that it can be hard to keep track of it all, so I keep an ongoing “to do” list for you here in my blogs. 

– Barbara