Repricing and option exchange programs have long been a controversial practice. A study released earlier this year looks at whether repricings boost company performance.
The Repricing Controversy
In the NASPP’s 2010 Stock Plan Design Survey, although 61% of respondents indicated that more than 50% of their options had been underwater in the past two years, only 7% had repriced (another 4% exchanged underwater options for full value awards, cash, or a combination of stock and options). Critics argue that repricing underwater options rewards employees for poor performance while proponents counter that repricing is necessary to retain employees and motivate future performance.
Repricing and Company Performance Studied
The study, “Employee Stock Options and Future Firm Performance: Evidence from Option Repricings,” co-authored by Ron Kasznik of Stanford University’s Graduate School of Business, Nicole Bastian Johnson of the Haas School of Business at UC Berkeley, and David Aboody of UCLA’s Anderson School of Management, looked at over 1,300 companies whose stock had declined by 30% or more annually from 1990 to 1996. Approximately 22% of those companies repriced; the study compared the performance of companies that repriced to those that didn’t.
Overall, the study found that the companies that repriced performed better over one, three, and five years. More specifically, the study found that companies that repriced only options held by executives outperformed the companies that did not reprice. On the other hand, companies that repriced only options held by non-executives did not outperform the companies that did not reprice.
Broad Implications for Stock Options
The authors hypothesize that this indicates that granting options to rank-and-file employees doesn’t enhance company performance. I haven’t read the whole study (not because I’m lazy–although that’s certainly a contributing factor–but because I can’t seem to access a copy of it for a nominal cost and, given how inscrutable the last study I blogged about turned out to be–see my August 18 entry, “Section 6039 and the Recession,” I’m not willing to make much of an investment here), but, according to the abstract, the authors assumed that once the options were underwater, any incentive effect they were having disappeared and that repricing the options would restore this incentive. If company performance didn’t improve after the repricing, I guess (emphasis on “guess,” as the reasoning that led to the conclusion isn’t clear from the abstract) the authors assumed that the options weren’t creating any incentive to begin with.
I Have Some Doubts
I’m not sure I’d make that leap–granted, I know next to nothing about conducting studies like this, but it seems to me that if you’re going to argue a point about the incentive effect of stock options, you ought to include some companies that don’t grant options as a control in the study.
It also seems like there are any number of other reasons why the repricings might not have improved company performance. For example, the rank-and-file employees could have lost faith in the options as a result of their being underwater and, while the repricing may have fixed the immediate tangible problem of the options being underwater, it may not have done anything to address the larger intangible issue of employees no longer believing in the company’s future growth potential. While this would impact the incentive effect of the repriced options, it doesn’t necessarily mean the options weren’t having an incentive effect before they were underwater. Or employees could be anticipating future repricings if the stock price declines further. Or, an even simpler explanation could be that the repriced options didn’t remain in-the-money–it isn’t clear from the survey abstract that the authors considered this.
The study also doesn’t say anything about retention–one of the primary reasons companies cite for undertaking repricings and option exchange programs. Valuation specialists have told me that in-the-moneyness is an important factor in estimating expected forfeitures, which leads me to believe that repricings could have their intended impact when it comes to retention.
Moreover, I’ve got to believe that the number of companies that repriced options held by executives only is a pretty small sample. Seriously, who does this? So I wonder how meaningful that data is.
Finally, what about the companies that repriced both executive and non-executive options? How did they perform?
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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
Tags: option exchange, options exchange, repricing, research, Study, underwater
We have seen increasing interest in the use of restricted stock over the past few years; RSU grants in particular. In our 2007 Domestic Stock Plan Design and Administration Survey, co-sponsored by Deloitte, 58% of the companies responded that they had increased restricted stock or RSU usage. For many companies, restricted stock awards and units are seen as having more retention power than options because they will continue to retain real value through market volatility. Additionally, restricted stock grants typcially require fewer shares than option grants, which helps reduce a company’s burn rate and overhang.
The latest in this trend are companies that are exchanging underwater options for RSUs. In Radford’s underwater exchanges research, 33% of the companies exchanged options for restricted stock or RSUs, making this the second most popular exchange approach. Recently, we’ve seen Marvell Technology wrap up their exchange of underwater options for restricted stock units. Just yesterday, eBay shareholders approved an exchange of options for restricted stock units. EBay proposes to exchange underwater options for an RSU grant that is 90% of the fair value of the exchanged option. In June, Zoran shareholders will be asked to vote on an options-for-RSUs exchange, and we can expect to see more companies with similar proposals. For more information on option exchanges, visit our Underwater Options portal.
Administering a plan with restricted stock and/or restricted stock units can be tricky. If your company has a restricted stock program, or will be implementing one in the future, I highly recommend registering for the NASPP Restricted Stock Essentials that will be offered November 9th immediately preceding our 17th Annual NASPP Conference. We’ve updated our Restricted Stock Essentials course to include performance-based restricted stock as well as global plan considerations. So, even if you participated last year, you should consider updating your expertise at this year’s program. Take advantage of our special pricing that will be available through May 22nd on both the Conference and the RS Essentials.
Perhaps the most talked-about issue surrounding restricted stock programs is the tax withholding obligation. Each company situation is different, and there is no ‘perfect’ approach that will work across the board. Here are some of the issues to consider.
Cash: Coordinating cash tax payments can be onerous, especially if you have a broad-based grant process, because the exact tax withholding in most arrangements can’t be known in advance of the vesting event. Implement a process on how to handle vests when the employee has not delivered the tax payment.
Payroll deductions: Consider the timing of vesting events vs. payroll dates as well as how to handle situations where the taxes due may be a large percentage of, or even more than, the employee’s paycheck.
Selling shares from a restricted stock vest to cover the taxes: This may not be compliant in all situations, and ties you to ensuring that each participant has a current brokerage account from which to sell the shares. You will also need to have a process in place to accomodate timely tax deposits when the cash from the sale may not be available until after settlement.
Withholding shares: Aside from the need to have the cash flow prepared to cover employee tax withholding, the most difficult issue with share withholding is how to handle the fractional share difference between the tax amount and the closest whole-share value. Additionally, withholding shares to cover the taxes due means that you must have accurate tax rates; withholding shares in excess of the statutory rate triggers liability accounting under FAS123(R).
Whichever approach, or combination of approaches, your company uses to fulfill tax withholding obligations on restricted stock, it does mean diligent coordination with your payroll department. You will need to ensure accurate tax rates, which can be particularly complicated internationally or with mobile employees. Additionally, coordinating timely tax deposits can be a challenge, especially in the U.S. in situations where the vesting creates a cumulative tax liability in excess of $100,000. We recently posted a white paper from Barbara Baksa’s Computershare FreeSMARTS presentation, Tax Reporting and Withholding on Restricted Stock and Unit Transactions, to the site that provides some fantastic tips and considerations. Check it out today!
-Rachel
Tags: option exchange, Restricted Stock Award, Restricted Stock Unit, RSU
Underwater options; they’ve been a problem that companies have faced before, but companies are seeing a much larger impact right now. Not only has equity pay become a larger percentage of executive salaries, it is also making its way down the operational chart of companies. Stock prices have been on a decline. In August, Financial Week reported that 40% of the Fortune 500 companies had options that were then underwater; these numbers can only have increased with our recent financial crisis.
Stock options and other equity-based compensation are a great way to provide incentive for employees. They provide employees with a path to ownership in the company even if employees are selling their shares as soon as they vest. The benefit of shares is still tied to the success (or lack of success) of the company. The obvious problem is that when the whole market is sliding down, companies will find their individual stock prices sliding right along. Employees may feel particularly disenfranchised, since there is little they can do individually to impact the success of their own company, let alone the entire market. They may begin to feel underappreciated and, as their income level falls, undercompensated.
Fortunately for many employees, we have also seen a trend toward greater shareholder acceptance of option exchange programs. What once was an ideological battle is now a tangible issue, as both NASDAQ and the NYSE now require shareholder approval for most option exchange programs. Part of this greater acceptance is that FAS123(R) has made it possible to create an option exchange program that has less of an accounting impact than before. An option exchange program allows a company to take worthless stock options from employees and exchange them for new options, restricted stock or RSUs (with reduced share amounts) or cash. The upside for the company is reduced dilution and overhang as well as restored employee ownership, satisfaction, and alignment with shareholder interests.
Engaging in an option exchange program to deal with underwater options is not a decision to be taken lightly. It requires intense employee education; and any communications sent to employees about the exchange must be included in the Schedule TO filing required by the SEC. Companies will need to structure the option exchange in a way that shareholders are most likely to approve. This means paying special attention to the ratios of the exchange as well as determining who may participate. Shareholders will be more likely to feel an option exchange is in their best interest when it involves only the rank-and-file employees. There is an increased negative focus on executive compensation recently, with growing resentment of arrangements that allow executives to profit when the company declines. If you are struggling over how to handle your company’s underwater options, check out these articles from our Practice Alerts:
Addressing Underwater Options: Measured Responses to a Contentious Problem
Dealing with Underwater Stock Options: Some New Twists on a Timeless Quandary.
Stock option exchange programs may help limit the impact of the market downturn in the short run, but companies must start thinking now about how to design stock plans that can better withstand market volatility. Don’t miss your opportunity to get valuable tips and information on redesigning equity compensation plans in at our 2008 Annual Conference session In the Thick of the Storm: Compensation Redesign in a Turbulent Environment.
-Rachel
Now – check out our new Underwater Options portal!
Tags: option exchange, stock options, underwater