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FAS 123(R) (Now ASC 718) eliminated the adverse accounting consequences associated with net exercise that existed under APB 25, making it more feasible for companies to implement net exercise.

What exactly is a net exercise?

The concept of net exercise isn’t unfamiliar. Many companies already employ share withholding on restricted stock or even have a stock-settled SAR program. Like share withholding on restricted stock, a net exercise means that the employee tenders shares back to the company to cover his or her obligations from a transaction. Like a stock-settled SAR, the employee capitalizes on the appreciation in stock price without an output of cash for the exercise price and without a sale of shares.

In a net exercise, when a participant wants to exercise in-the-money shares, the company holds onto enough shares from the exercise to cover the exercise price and delivers the net amount remaining to the employee. For example, if an employee exercises 100 shares of an NQSO with an exercise price of $5.00 at a time when the current FMV is $10.00, then the company retains 50 shares and delivers 50 shares to the employee. Depending on the plan parameters, the shares tendered to the company may return to the stock plan or may be retired. Either way, the exercise does not result in a market sale. The company may also set up the net exercise program to include share withholding to cover the employee tax obligation.

When is net exercise a good fit?

There are many advantages to implementing a net exercise program. If those advantages are important to your company, then net exercise may be a good fit. If your company is concerned about dilution or wants to promote share ownership (especially if your executives are subject to holding or ownership requirements) then net exercise may be particularly appealing. For our top ten advantages of net exercise, check out the March-April 2008 issue of the Stock Plan Advisor.

One truly great aspect of net exercise is that it doesn’t require the company to grant new equity vehicles. Depending on how your company’s stock plan is structured, it may be possible to implement a net exercise program on existing option grants, in which case the company can realize the benefits of net exercise immediately. In fact, even if your plan doesn’t already include net exercises, it may even be possible to add net exercise without the need to obtain shareholder approval.

Net exercise is particularly useful with regards to your executives and Section 16 insiders. For one, because there isn’t a market sale of shares, no Form 144 needs to be filed for a net exercise (only on any subsequent sale). Additionally, the net exercise method provides Section 16 insiders a way to fund their exercise without risking short-swing profit recovery issues that must be considered with a came-day sale. Net exercise is also a particularly effective way to help your executives comply with company share holding or ownership requirements.

A really cool way to take advantage of net exercise is to implement a policy to process a net exercise on in-the-money options that are about to expire. This allows the company to obtain the tax deduction on options that have already been expense, prevents the participant from losing out on option shares they have earned, and doesn’t require brokers to impose a sale of shares that hasn’t been initiated by the account holder.

Issues to Consider

If you are contemplating whether net exercise is right for your company, there are several important issues to consider. Most importantly, take a good look at the goals of your equity compensation program and see if the benefits of net exercise facilitate those goals. If you really want to capitalize on the advantages of net exercise, you may decide to mandate net exercise for all or a portion of your employees.

Then, conduct a careful review of your plan document and grant agreements. In your plan document, check to see what exercise methods are permitted, any requirements around modifications to the plan, and if you have any pesky outdated language regarding the use of “immature” shares. You’ll also want to know if any of your grant agreements limit the methods of exercise that may be used.

The issue of incentive stock options and net exercise is murky. A conservative view is that the use of net exercise ISOs disqualifies the entire grant from preferential tax treatment; while the most aggressive argument is that the shares tendered in a net exercise were never issued, preserving the ISO status of both the delivered shares and the remaining unexercised shares. If you do not wish to exclude ISO grants from your net exercise program, then you’ll need to consult closely with your legal counsel and auditors to determine what your company’s position is.

Finally, your international employee population must also be considered. There may be jurisdictions in which net exercise is either prohibited or where the challenges outweigh the benefits. Before implementing net exercise outside the United States, consult with your advisors.

If you’re looking for more information on net exercise, refer to our practice alert on the benefits of net exercise, this handy net exercise comparison chart, or the session and materials from last year’s Conference session “The Roadmap: How–and Why–to Implement Net Exercises”. You can access the session on our 2009 Conference Materials page in the Plan Design and Redesign section (and don’t forget that you can purchase access if you weren’t able to attend last year).

NASPP Conference 2010

Speaking of our Conference, be sure to get your speaking proposals in for the NASPP Conference this year! You can submit your proposal HERE. If you are wondering how to put together a winning proposal, check out our Top Ten Tips For Creating A Successful Proposal.

-Rachel