The treatment of equity compensation in a change-in-control is complicated and perhaps the most complicated of all is the spin-off. We recently posted an article by Michael Gorski of Semler Brossy that looks at various ways outstanding stock grants are handled in a spinoff (“Keeping Your Equity Strategy in Balance Through a Corporate Spin‐Off,” originally published in workspan).
Gorski explains that, to minimize concerns over employee relations, companies should seek an outcome in which the pre-spin equity value is preserved. He breaks the approaches into various types, including the following two most common methods:
Shareholder (or Portfolio) Approach: Equity holdings are treated the same as those of a company shareholder in that they are divided into equity in both the remaining company and the spun-off entity on a one-for-one basis. For options, the exercise prices are converted, but the number of options remains the same.
Employee (or Concentration) Approach: Equity holdings are entirely in either the remaining company or the spun-off entity. This is the approach used most often as it ensures employees are aligned directly with the success of the company they are working for post-spin. For options, both the number of options and the exercise prices are translated to maintain the existing value.
Gorski provides a few examples from high-profile deals. For instance, when PayPal was spun off from eBay, it used the “employee approach” for employees staying with eBay or shifting to PayPal, but for executives in charge of a smooth transition, it used the “shareholder approach.”
When Kraft Foods spun off from Mondelez International, Gorksi notes that the transaction used the “shareholder approach” for options, SARs, restricted stock, and deferred stock units to encourage a collaborative environment between the companies. However, for performance shares, it used an “employee approach” to align directly with each company’s post-spin goals.
The FASB recently ratified an EITF decision and approved issuance of an Accounting Standards Update on “Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period” (their words, not mine).
What the Heck?
I was completely baffled as to when an award would have a performance condition that could be met after the end of the service period. After all, isn’t the period over which the performance goals can be met the very definition of a service period? So I spoke with Ken Stoler of PwC, who translated this into English for me.
Turns out, it’s a situation where the award is no longer subject to forfeiture due to termination of employment but is still subject to some sort of performance condition. Here are two situations where we see this occur with some regularity:
Retirement-Eligible Employees: It is not uncommon for companies to provide that, to the extent the goals are met, performance awards will be paid out to retirees at the end of the performance period. Where this is the case, a retirement-eligible employee generally doesn’t have a substantial risk of forfeiture due to termination but could still forfeit the award if the performance goals aren’t met.
IPOs: Privately held companies sometimes grant options or awards that are exercisable/pay out only in the event of an IPO or CIC. The awards are still subject to a time-based vesting schedule and, once those vesting requirements have been fulfilled, are no longer subject to forfeiture upon termination. But employees could still forfeit the grants if the company never goes public nor is acquired by a publicly held company.
The EITF’s Decision
The accounting treatment that the EITF decided on is probably what you would have guessed. You estimate the likelihood that the goal will be met and recognize expense commensurate with that estimate. For retirement-eligible employees, the expense is based on the total award (whereas, for other employees, the expense is also commensurate with the portion of the service period that has elapsed and is haircut by the company’s estimate of forfeitures due to termination of employment).
For example, say that a company has issued a performance award with a grant date fair value of $10,000, three-fourths of the service period has elapsed, and the award is expected to pay out at 80% of target. In the case of a retirement-eligible employee, the total expense recognized to date should be $8,000 (80% of $10,000). In the case of an employee that isn’t yet eligible to retire, the to-date expense would be, at most, $6,000 ($80% of $10,000, then multiplied by 75% because only three-fourths of the service period has elapsed). Moreover, the expense for the non-retirement-eligible employee would be somewhat less than $6,000 because the company would further reduce it for the likelihood of forfeiture due to termination of employment.
The same concept applies in the case of the awards that are exercisable only in the event of an IPO/CIC, except that, in this situation, the IPO/CIC is considered to have a 0% chance of occurring until pretty much just before the event occurs. So the company doesn’t recognize any expense for the awards until just before the IPO/CIC and then recognizes all the expense all at once.
Doesn’t the EITF Have Anything Better to Do?
I had no idea that anyone thought any other approach was acceptable and was surprised that the EITF felt the need to address this. But Ken tells me that there were some practitioners (not PwC) suggesting that these situations could be accounted for in a manner akin to market conditions (e.g., haircut the grant date fair value for the likelihood of the performance condition being met and then no further adjustments).
I have no idea how you estimate the likelihood of an IPO/CIC occurring (it seems to me that if you could do that, you’d be getting paid big bucks by some venture capitalist rather than toiling away at stock plan accounting). And in the case of performance awards held by retirement-eligible employees, my understanding is that the reason ASC 718 differentiates between market conditions and other types of performance conditions is that it’s not really possible for today’s pricing models to assess the likelihood that targets that aren’t related to stock price will be achieved. Which I guess is why the EITF ended up where they did on the accounting treatment for these awards. You might not like the FASB/EITF but at least they are consistent.
For today’s blog, I have another exciting smorgasbord of random stock plan related tidbits.
IRS Issues GLAM on Stock Compensation Deductions and CICs In January, the IRS issued general legal advice memorandum AM2012-010 clarifying that when NQSOs and SARs are cashed out due to a change in control, the tax deduction is attributable to the acquired company. This is because the obligation to make the payments became fixed and determinable at the closing and the payments were for services performed prior to the acquistion.
Two things to note here:
This is unfortunate because chances are the target company isn’t all that profitable, making the deduction less than useful.
The acronym for this type of IRS pronouncement is GLAM. That makes the whole thing sound way cooler than it actually is.
For more information see the WSGR alert we posted on this development.
ISS Theme Song: Coming Around Again? I’m sure you’ve heard about this by now, but just in case, ISS has announced that it will replace the GRId analysis system with a new system called “QuickScore,” which does have the advantage of sounding niftier and friendlier. If you are thinking “what the heck, didn’t they just switch to the GRId system,” time must be flying by for you just as fast as it does for me. ISS switched to GRId back in 2010 (I blogged about it, see “Will ISS Red Light Your Stock Compensation?” March 23, 2010). Still, it does feel like ISS is changing systems almost as often as they change their name.
Under QuickScore, companies will receive a relative ranking from 1 to 10 (1 is good, 10 is bad) by region and industry, instead of the color coded (red, yellow, green) score companies received under GRId. Which is similar to ISS’s Corporate Governance Quotient system that was replaced by GRId. Sort like how ISS changed to RiskMetrics and then changed back to ISS.
Backdating Bad for Your Career A recent academic study found that CFOs that lost their job as a result of option backdating have had a tough time re-entering the workforce. Only 18.7% found a comparable position (compared to 35.1% of CFOs that had lost their job for other reasons) and only 48.4% found any full-time corporate position (compared to 83.8% of other CFOs).
Which was a little surprising to me because how would a potential employer even know that’s how you lost your job? You wouldn’t exactly put “falsifying corporate records to reduce expense” under the skills listed on your resume and, in my experience, companies don’t give out that kind of information about former employees. But I guess a quick Google search these days can be very revealing about job candidates.
As those of you that have been keeping up with my blog entries know, for the past few weeks, I’ve been covering the executive compensation-related provisions of the Dodd-Frank Act, highlighting tidbits I learned at a presentation by Mike Andresino of Posternak Blankstein & Lund and David Wise and Sara Wells of Hay Group at the July Silicon Valley NASPP chapter meeting. This week I discuss some of the changes David thinks we can expect to see for stock compensation as a result of the Act. (If you’re keeping score, that’s three blog entries from one chapter meeting–now that’s what I call a productive meeting!)
Stock Compensation Under Dodd-Frank Here are a few changes we might see to stock compensation under the Dodd-Frank Act.
More Double-Triggers
In the NASPP’s 2010 Stock Plan Design Survey (co-sponsored by Deloitte), I was surprised by the number of companies with plans that provide for immediate acceleration of vesting on a change-in-control. With shareholders now given the opportunity to vote on executive pay packages and a separate vote for change-in-control provisions that haven’t previously been voted on, expect to see more companies move to a double-trigger (i.e., vesting accelerates only if the executive is terminated within a specified period after the CIC).
Greater Use of Performance Awards
With companies now required to disclose how executive pay relates to performance, it seems fairly clear that this will propel the use of performance-based awards. At the same time, the requirement to disclose the ratio of CEO pay to median employee pay may cause boards to look for ways to reduce the value of CEO pay. Since this disclosure is based on amounts in the SCT–rather than actual payouts–one way to accomplish this is to grant options and awards that are subject to performance conditions.
For LTI programs in general, David expects to see more interest in relative goals (because absolute goals have become so challenging to set), more use of multiple goals (e.g., an absolute goal with a relative goal), more companies using three measures instead of just two measures, lowering of plan maximums, and longer vesting schedules.
Premium-Priced Options
Options granted with a price above the grant date FMV have never really caught on, but do result in a lower grant-date valuation. Since this is the value reported in the SCT, premium priced options could help improve the CEO to median employee pay ratio, perhaps increasing their popularity.
Broad-Based Plans?
Another way to make the CEO to median employee pay ratio look better is to increase employee pay. Could this cause companies to consider expanding eligibility for stock compensation programs? Maybe–if you are looking at raising pay, seems like it would be easier to do this with a non-cash expense than with cash compensation.
Deferrals
More companies may also start requiring deferred payout for awards. David points out that deferrals serve two goals: (i) they can be of assistance in enforcing clawback provisions–now required under Dodd-Frank and (ii) they help facilitate enforcement of stock ownership/holding requirements–a primary means of risk mitigation in stock plans.
The 18th Annual NASPP Conference is Just Five Weeks Out! Scheduled for Sept 20-23, the 18th Annual NASPP Conference is timed perfectly to help our members prepare for mandatory Say-on-Pay and the other requirements of the Dodd-Frank Act. We’ve added a special Say-on-Pay track, featuring key advice and real-world strategies from in-the-know practitioners. Register for the Conference today.
NASPP New Member Referral Program Refer new members to the NASPP and your NASPP Conference registration could be free. You can save $150 off your registration for each new member you refer, up to the full cost of registration. You’ll also be entered into a raffle for an Apple iPad and the new members you refer save 50% on their membership–it’s a win-win! Don’t delay–this program ends on August 31.
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.
It’s a big week for NASPP Chapter meetings: don’t miss the meetings in Atlanta, Denver, NY/NJ, Orange County, Phoenix, and San Diego. Robyn Shutak, the NASPP’s Education Director, will be attending the San Diego meeting; be sure to say hello!