The NASPP Blog

June 2, 2009

Dilution, Overhang, and Repricings

Option Exchange Programs Reduce Overhang and Dilution–Not So Fast!
I often hear reducing overhang and stock plan dilution cited as a reason for option exchange programs; I’ve even seen companies state this in their Schedule TO filing. But, in my opinion, this isn’t the case; exchange programs don’t reduce overhang or dilution.

Overhang Remains the Same

While there’s no legally defined formula for computing overhang, the typical computation is:

( options/awards outstanding + shares available for grant ) / common stock outstanding = overhang

This is essentially the computation we used in the 2007 Domestic Stock Plan Design and Administration Survey and it’s the computation I see most often in other industry surveys and resources.

In a one-for-one exchange program (e.g., Google), the transaction has no impact whatsoever on overhang. All of the cancelled options are immediately regranted, so that the total options outstanding and the total shares available for grant remain the same. And the transaction clearly has no impact on the denominator, so stock plan overhang doesn’t change.

Even in the more typical less than one-for-one exchange, there often is no impact on overhang. With a few rare exceptions (e.g., Intel and eBay), in most of the option exchange programs I see, the shares underlying the cancelled options return to the plan and are again available for grant. Even though the company has reduced its options outstanding, the shares available for grant have increased by the same amount, keeping the numerator the same. So once again, stock plan overhang remains unchanged.

Only when the cancelled shares are not added back to the plan (which we recommend) does the option exchange program truly reduce overhang.

Dilution Increased, Not Decreased

In the case of dilution, not only is it not reduced, it could actually increase as a result of the option exchange. Dilution is the impact a company’s stock plans have on earnings-per-share. This is computed using the Treasury Stock Method, which is a little more complicated than we have time to discuss today (see Chapter 10 of “Accounting for Equity Compensation Under FAS 123(R)” in the NASPP’s Stock Plan Expensing Portal for an explanation of the Treasury Stock Method).

Under the Treasury Stock Method, options that are underwater are excluded from the calculation altogether. But, once the options are regranted with a lower price, they are likely to be in-the-money quite a bit sooner and once again diluting EPS. If the options are replaced with full value awards, they are likely to be immediately dilutive to EPS. And, in both cases, there will be fewer exercise proceeds available to repurchase shares to offset that dilutive impact. Thus, even in an exchange at a less than one-for-one ratio, the options/awards are likely to be more dilutive afterwards than they were before the exchange.

The only way to be 100% sure that an option exchange program will reduce plan dilution is if the options are exchanged for cash (e.g., Nvidia)–a rarity in this cash-strapped economy.

The Long-Term View

You might argue that by reducing the exercise price (or eliminating it altogether in the case of exchanges for full value awards), the likelihood that the shares will be issued is increased. This would, in fact reduce overhang–once the shares underlying the options or awards are issued, they move from the numerator of the overhang formula to the denominator. But I’m not sure this is quite what your shareholders had in mind in terms of reducing plan overhang. And it doesn’t help at all with dilution; unless the company has a repurchase program in place (for which it will have fewer funds available thanks to the reduced option price), issued shares are even more dilutive than shares underlying stock awards.

Reason #27 to Renew Your NASPP Membership: Our Section 409A Portal
The NASPP’s Section 409A Portal includes everything you need to know about how Section 409A impacts your stock compensation arrangements.  We’ve just reorganized the portal to make it easier to navigate–you’ll find numerous articles and memos along with the text of relevant IRS regulations, notices, and other pronouncements.  The portal also clarifies which pronouncements supersede which, so you know which rules are currently in effect. 

“Last-Chance Early-Bird Savings” on the NASPP Annual Conference
The 2009 NASPP Annual Conference will be held in San Francisco from November 9-12. NASPP members that register by June 26 save $100 and then receive half-off all subsequent registrations from the same company/location. We haven’t offered the Conference at this price for a long time and it will be a long time before we offer a price like this again, so make this the year you attend!

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 blog. 

– Barbara