Companies that grant stock options know that there are a few core challenges that have maintained their existence throughout the life span of these types of equity arrangements. Among them: how to handle the impending expiration of an in-the-money, unexercised grant.
Does it Really Happen?
Stock plan education site, myStockOptions.com, cites the issue of expiring options as one of the “top mishaps with stock options that can cost you money”. This issue of lost dollars creates a conundrum for many companies – if the option expires, there is risk for a disgruntled employee who may decide to litigate. Even if litigation doesn’t happen, many employees who find themselves in that situation often beg for reinstatement of the option, which is not without cost to the company (in the form of additional compensation expense that would need to be incurred for the reinstated option, which would be treated like a new grant in-the-money grant for accounting purposes). These scenarios usually motivate employers to prevent the options from expiring.
Preventing Expiration
While the issue of expiring options remains relatively unchanged – as long as there are stock options, there will be concern around the impending expiration of in-the-money grants – the approaches to handling this situation continue to evolve. The most common practices include outreach programs to remind optionees that their grant is about to expire. This communication can be performed by the company, or, via a third party service provider. Although these programs seem to reduce the number of expired grants, there are no guarantees that a grant will be exercised – the action still falls squarely upon the participant.
New Ideas
In recent years, a new approach has emerged as a practical solution to this age old problem: the auto-exercise. The essence of the auto-exercise is that an in-the-money, otherwise unexercised stock option will automatically be exercised at or shortly before the close of the market on the date of expiration. The “type” of exercise that will be executed is usually determined by the company in conjunction with the service provider who will perform the exercise, in compliance with the company’s plan terms. I don’t have any formal survey data on which auto exercise types are most popular, but I’d say net issuance and sell-to-cover are on my radar as the most logical methods, with an edge to net issuance.
This is not a new concept – auto exercise has been used for publicly traded options for years. However, in adopting this approach for internal stock plans, there are considerations – some of which were recently highlighted in a Fidelity memo titled “Safeguarding Your Employees’ Stock Option Grants“, available on the NASPP web site. This particular article heavily advocates the use of net issuance in these situations; I’ll recap some of the concepts (with my own flavor added) from that angle:
Cash Flow: Companies need to carefully consider their cash flow when determining which auto exercise method to use. Withholding of shares (net exercise) to cover the exercise costs means that the company will need to remit the tax payment, from its own coffers, to the IRS.
Plan Provisions: Again, regardless of which exact method is chosen, it’s important to ensure the chosen method is permissible under the plan terms. If there is no provision, it may be necessary to secure a plan amendment.
Treatment of Existing Options: When implementing an auto exercise program, a determination must be made as to whether this applies to all grants (existing and new) or only on a forward basis (new grants). Addition of this type of feature to an existing grant is considered a Type 1 modification for accounting purposes, but would be no incremental expense.
Threshold for Automatic Exercise: A determination needs to be made as to how far the options need to be “in-the-money” in order for the auto exercise to execute. Usually a threshold to net one share would be the minimum amount, since most plans and service providers wouldn’t permit a fractional share issuance in these scenarios.
What if the Employee Doesn’t Want Auto-Exercise?
Lastly, there’s the scenario of an employee who actually didn’t want to exercise their in-the-money options and complains that the company has now created a taxable event on their behalf. While that is a consideration, Fidelity points out that “the result of exercising in-the-money options still provides a net financial benefit to the employees, even after accounting for taxes. Moreover, companies routinely create taxable events by paying out full-value stock awards to employees, so a case can be made that the automatic exercise of in-the-money options should be treated no differently.”
Do YOU Have Auto-Exercise?
I do think this solution is slowly gaining traction. Let’s test that thought – take the quick poll below. I think it’s definitely worth consideration, especially for companies that seem to have a significant number of in-the-money options expire.
Many of us can identify with the era we grew up in by listening to music. There are songs that can still transport me back to my high school days. Just like I associate music with an era of my life, so do I associate stock options with a period of time as well. I “grew up” in equity compensation during the 1990s when the dominant form of stock compensation was stock options. I took my CEP exams when many of the questions centered on the treatment of stock options. I feel like the early memories of my career are heavily intertwined with stock options. Yes, I know their use is presently on the decline. Yes, I know full value awards and pay-for-performance have taken over. But knowing all of that still didn’t fully prepare me for an article in the Wall Street Journal last week titled “Last Gasp for Stock Options?” I felt my heart rate rise. Could the end of the road for stock options really be near?
The End or Just a Trend?
The WSJ article highlights a trend we’ve long been observing: that the use of restricted stock and performance based awards have overtaken the use of stock options. It’s not really a surprise, given Dodd-Frank and the migration to a pay-for-performance culture. Still, it’s hard to imagine that stock options could really be at risk of being wiped out, as explored in the article. After all, stock options still seem to have some traction, particularly in the lower ranks of the organizations where pay-for-performance philosophies aren’t rampant. Stock options are also still fairly popular in private companies where cash may be short, and desire for flexibility high. With stock options, employees can time the triggers for taxation (subject to vesting, of course) to a time that is desirable for them. So while I wholeheartedly agree that the overall use of stock options has decreased, I still think there is a still a long term place for stock options in our equity compensation mix. It seems that many companies still tend to agree – even if they aren’t granting many stock options right now. In the NASPP/Deloitte 2010 Domestic Stock Plan Design Survey, 97% of companies with an omnibus plan reported that stock options were available for issuance under the plan. Of course, one could argue that the allowance for stock options under a plan is much different than actually issuing stock options out of the plan. That is true, but the fact that companies have continued to permit stock options as an equity vehicle suggests to me that they haven’t written them off completely. The WSJ article also highlighted that some executives are still insisting to be compensated with stock options, like Pandora Media Inc’s new CFO Mike Herring – who asked for all of his incentive compensation to be in the form of stock options.
It’s Not Over…
Although it appears likely that the use of stock options may continue its downward trend in the immediate future, I don’t think extinction is near. There are still those who believe in the power of stock options as a compensation and motivation tool. The downward spiral could be reversed – perhaps more executives will follow in Mr. Herring’s footsteps and demand stock options as part of their compensation. We’ll be continuing to monitor this trend. We have some articles in our Surveys and Studies portal that dig further into the analysis as well. For now, I’d love to hear your thoughts on whether you think stock options are done, or have more life ahead. Take a moment to take our poll (a one question survey). I promise to share the results in a future blog.
-Jennifer
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I think it’s safe to generalize that in many companies, the level of compensation decision making made by the rank and file is limited, if they are involved at all. Those of us in stock compensation are used to grant approval processes involving managers, executives and board committees, and this has been a long-standing practice. A handful of companies, however, are taking a different approach to granting stock options, one that allocates decision making to the core of the organization.
Peer to Peer Grants
A recent article in the Wall Street Journal profiled companies who are taking new approaches to making determinations in employee compensation. These companies are creating internal programs that allow a broad base of employees to allocate stock options and/or cash to their peers who they feel deserve to be rewarded. The idea behind this concept is that the rank and file often have the most insight into how their peers perform. There are various shapes and flavors to how companies have approached this type of program. One company allocated 1,200 stock options to each of its employees with the idea that each employee would distribute their options to colleagues. Employees had control over who received the stock options – it could be a single allocation to one colleague, or divided among multiple targeted colleagues. There were a few ground rules, including that workers couldn’t reward themselves or company founders (who already presumably have significant grants or shares). It seems the companies are also keeping the details of these decisions confidential, releasing only general statistics and end results to participants. Employees will know they were rewarded, by not by whom.
Other varieties to these programs include internal virtual markets comprised of cash or stock options, where workers can allocate or transfer funds. Some companies have allocated imaginary dollars or shares that employees can use to recognize their colleagues. These programs may not be exchanging actual shares or cash, but management is able to see results, which may reveal some interesting perceptions coming out of the main street of the organization.
Pros and Cons
Supporters of these programs suggest that peer influence over compensation will inspire more accountability and ensure everyone contributes. Management may also gain better visibility into which employees seem to be the best performers, casting a spotlight on stars that may have otherwise flown under the radar. Skeptics warn that too much peer say in pay decisions may create resentment and fuel hard feelings for those who receive little or no rewards. Could it become a popularity contest? Those who have implemented these programs appear to remain firmly in support of them, but caution that this may not be the right approach for every company. As one business professor put it: “You need management that is comfortable giving up some say, and let’s face it, human nature isn’t all programmed that way.”
What do you think? I’d love to capture your reaction in the poll below.
I admit it – I’m a trend watcher. I like seeing where things are headed and what’s new and/or different. So my attention was captured when I came across a recent analysis of share utilization within Fortune 500 companies. In their annual review of equity incentive practices at Fortune 500 companies, Towers Watson revealed some interesting trends. I highlight some of the findings in today’s blog.
In Case it hasn’t Been Said Enough: Full Value Awards are here to Stay
The trend has been around for a while now, and this analysis seems to reaffirm that yes, more and more companies continue to migrate towards a model that heavily incorporates and even emphasizes full-value awards. “Full-value awards now comprise 47% of the number of shares granted and 75% of the grant-date fair value of all equity awards at the typical company, compared to 29% of the shares granted and 57% of the value five years ago.” While a significant majority (75%) of the Fortune 500 companies offer a mix of equity vehicles in their compensation programs, the percentage of companies granting only full-value awards increased from 16% to 19%, while the percentage of companies granting only appreciation awards decreased from 5% to 3% in 2010. The percentage of companies not granting equity awards remained constant at 3%. For companies granting a variety of equity vehicles in 2010, the median mix was weighted 53% appreciation awards (e.g. stock options) and 47% full-value awards (e.g. restricted stock awards, restricted stock units), based on the number of shares awarded. According to Towers Watson, these figures represent a seven-percentage-point shift from 2009 to 2010 in favor of full-value awards and an 18-percentage-point shift between 2006 and 2010.These figures suggest that full-value awards are still continuing to gain in popularity and that trend seems likely to continue.
Fewer Shares Issued: A Good Sign?
Another interesting result is a decline in run rate, with a 23% reduction at the median in 2010 over 2009, and preliminary results from 2011 sampling indicating that the downward trend will continue. A full two-thirds of the Fortune 500 companies sampled reported issuing fewer shares in 2011 than in 2010. This reverses the trend seen in 2009 where many companies granted more shares in an effort to mitigate the declining value of other awards. Could it be that companies becoming more confident about market conditions and possible signs of life in the economy?
Yes, Stock Options Can Generate Money!
It was heartening to see that stock option exercises were up in 2010. According to the analysis, an aggregate of 90% more stock options were exercised in 2010 than in 2009. I’m sure much of that is attributable to more favorable market conditions, but regardless of the reason, it’s nice to see employees reaping tangible benefits from their equity awards. In addition to recognizing and addressing the perceived value that employees place upon their equity awards, some real financial benefit (aka cash in hand) is always helpful in achieving the goals of the equity programs.
There are several other fascinating bits of information in the report, but alas, I’m out of time and room to list them all. You can find the full summary in our Surveys and Studies portal by clicking here.
2011 has been a year of many things, one being fresh signs of life in the dormant IPO market. One anxiously anticipated IPO on the radar is that of Zynga, the Silicon Valley based online game company. With rumblings of an imminent high value IPO, Zynga is certainly a hot employment ticket. So imagine the surprise when along came last week’s article in the Wall Street Journal that depicted Zynga as a company that gives and then takes away.
What’s the Fuss?
The issue at hand? Employee stock options. Who would have thought that plain old vanilla stock options would become the heart of a controversy? Well, yes, equity compensation has had its share of scandals (ah, but backdating is so 2006). However, this time is different. No one has been arrested, the SEC is not involved, and it appears, by nearly all counts, to be a situation that didn’t violate the law. So what happened?
Pony Up Your Options, or Else!
According to the Wall Street Journal and several follow up articles, Zynga reportedly wanted to avoid a “Google Chef” scenario in which an employee’s stock option gains upon IPO were disproportionate to his contributions and role within the company (the rumor is that a chef at Google made an estimated $20 million upon its IPO from the value of his stock options). In evaluating and re-evaluating employee performance, Zynga CEO, Mark Pincus, reportedly kept a list of employees whom he felt were over-compensated with equity, based upon their current role and contribution to the organization. As Zynga began to feel pressure on its share reserves and an obligation to shareholders to suppress dilution, employees who had been identified as over-compensated were approached and asked to agree to cancel the unvested portion of their stock options. This would allow the cancelled shares to be returned to the plan reserve and become available for future issuance to other employees. The catch? If the unvested options weren’t returned for cancellation, the employee would be fired. Ouch. Many wondered, is that possible? Is it even legal? Though not tested in the courts, the consensus seems to be ‘apparently so’.
What’s the Answer?
A key public opinion question is whether Zynga was justified in its actions. On one side of the argument lies the assertion that Mr. Pincus did what was necessary to fairly balance the load of wealth within the company. After all, compensation is frequently re-negotiated in companies, including pay reductions. The counterargument is that once given, a benefit should not be taken away. If the targeted employees really weren’t performing well, then why were they still around in the first place? Finally, the company could have avoided this situation altogether if it had considered attaching performance metrics to option vesting.
Having worked for companies whose successful IPOs created employee wealth, I can relate to both sides of the situation. Should a stock option with service vesting be an entitlement once granted (assuming the employee remains employed), even if the employee is under-performing, demoted or reassigned? This is a tough question to answer. I do give credit to Zynga for thinking outside the box in finding a solution, right or wrong.
Share Your Opinion
On which side of the argument do you reside? Share your anonymous opinion by taking our poll below, and find out how your peers feel.
For those of you with employees in San Francisco, keep your eyes and ears open for the outcome to the proposal brought before the city officials this Tuesday. If passed, it will eliminate the inclusion of equity compensation from income subject to the city’s payroll tax.
On a side note, while looking for more information on the city payroll tax I found this somewhat disturbing article from earlier in the year. What scares me about it is both the false statement that the federal government doesn’t tax income from stock options and the author’s apparent promotion of company withholding policies that assume tax regulations won’t be enforced.
Pay Ratios
Of course, executive compensation continues to be a focus in the news. From the reports, it really does look like executives’ pay (particularly CEO and CFO pay) is rebounding significantly faster than their companies’ profits are. It’s a difficult balance for companies to retain quality leadership and not make a bad impression on the media and investors. If you are watching this issue closely, CompensationStandards.com is keeping a great list of companies who have failed say-on-pay votes and also those who are combating negative reactions from proxy advisors through supplemental proxy solicitations.
Also, remember that difficult little requirement in the Dodd-Frank Act that companies disclose the ratio of CEO pay to the median pay of all other employees? The AFL-CIO recently launched its improved Executive Pay Watch site which dedicated to drilling down and making public these ratios. I would love to know what calculations they use and how they will ultimately compare to the calculations required in the final regulations once they are out.
I also wonder if a growing focus on the pay differences will be something that companies will need to address with their employees as well. Equity compensation is a major factor in executive pay levels. If your company has a broad-based equity compensation program, communicating the company’s compensation philosophy and practices is an important part of fostering employee satisfaction. As executive compensation practices become increasingly transparent, I think it’s the perfect time to take a closer look at your communication practices as they relate to your equity compensation policy and to initiate a dialogue with your investor relations team to better understand how the company will be managing the public perception of your company’s pay practices.
Financial Reporting for Stock Plan Professionals
Finally, I want to highlight the NASPP University’s upcoming course, Financial Reporting for Stock Plan Professionals. If you want to test your skills and see if this course is right for you, we’ve got a short financial reporting quiz to help gauge your financial reporting skills. It’s not too late to take advantage of the early-bird rate on this course!
I recently attended a San Francisco NASPP chapter meeting that featured a presentation by Yana Plotkin of Towers Watson on trends in equity compensation. Yana included some data from the Towers Watson “2010/2011 Report on Long-Term Incentives, Policies and Practices.” Here are a few highlights:
Portfolio Approach
More companies are granting at least two types of awards–73% of respondents indicated this practice, an increase of 10% from 2009. Larger companies are more likely to utilize three types of awards than smaller companies.
Pay for Performance
Towers Watson is seeing a strong trend towards performance awards, which are now the second most common type of long-term incentive offered by survey respondents, ahead of stock options. Full value shares (RS/RSUs) were the most common type of LTI offered. In the NASPP’s 2010 Stock Plan Design and Administration Survey (co-sponsored by Deloitte), we also saw a strong trend towards performance awards, although we did not see them outpace the usage of stock options.
Full Value Awards
Towers Watson reports that full value awards have outpaced stock options for grants to employees at the manager/individual contributor level. In the NASPP survey, we also saw an increase in full value awards and even performance awards to employees at these levels, but many respondents were still granting stock options.
Award Sizes
For employees earning under $200,000, award sizes (as a percentage of salary) remained flat from 2009 to 2010 in the Towers Watson survey. But for employees at higher salary levels, award sizes increased, although not quite to 2008 levels.
Award Design
In terms of performance award design, Yana mentioned that they are seeing interest in awards with shorter performance periods, e.g., two years, and some sort of trailing service requirement after the performance goals have been met. I am a proponent of this design; for executives, it helps facilitate compliance with ownership requirements and clawback provisions and, for everyone, it can simplify tax withholding procedures.
Interestingly, Towers Watson reports that 35% of respondents to their survey measure performance relative to peers or a market index. For the NASPP survey, this was about the same (41% of respondents). Both surveys also agree on how commonly TSR is used as a performance metric (25% of respondents in the Towers Watson survey, 29% of respondents in the NASPP Survey). Yana indicated that Towers Watson is seeing more companies use TSR than in the past and that certainly aligns with the buzz I am hearing from compensation consultants, etc.
Performance Awards Are the Future
The biggest takeaway I got from Yana’s presentation is that the Say-on-Pay, the disclosures required under the Dodd-Frank Act, and shareholder expectations are making performance awards the hottest thing going today in terms of equity compensation. If you aren’t fully up to speed on them, don’t miss the pre-conference session, “Practical Guide to Performance-Based Awards,” to be held on November 1 in San Francisco, in advance of the NASPP Conference. Register by May 13 for the early-bird discount!
Online Fundamentals Starts in Two Weeks–Don’t Miss It! The NASPP’s acclaimed online program, “Stock Plan Fundamentals,” begins on April 14. This multi-webcast course covers the regulatory framework and administrative best practices that apply to stock compensation; it’s a great program for anyone new to the industry or anyone preparing for the CEP exam. Register today.
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.
Register for 19th Annual NASPP Conference (November 1-4 in San Francisco). Don’t wait; the early-bird rate is only available until May 13.
The IRS began its Employment Tax National Research Project (NRP) this year (See our January 26th blog entry), auditing 2,000 randomly selected companies. Soon, the next 2,000 will be receiving their notices that they have been selected for 2011. In totally, the IRS will audit 6,000 companies over three years. This NRP comes on the heels of similar studies conducted on Subchapter S Corps in 2003 and 2004 and individual taxpayer returns from 2006 to 2008 returns). All are part of a Department of the Treasury’s commitment to provide updated estimates of the “tax gap” (i.e.; the difference between the taxes owed and the taxes actually collected). A full description of the efforts is included in the Update on Reducing the Federal Tax Gap and Improving Voluntary Compliance.
Don’t think that if you aren’t selected, you’re totally off the hook. These are just the random audits as a part of the evaluation process. Not only are regular tax audits still taking place, the results of the NRPs will be used to help identify which individuals and companies to target for regular audits and what areas of audits are most likely to result in the discovery of noncompliance.
The current NRP will focus on four main issues: fringe benefits, worker classification, executive compensation, and payroll taxes. The stock plan management team won’t have much, if anything, to do with an audit of fringe benefits. Worker classification (i.e.; determining if there are consultants who should be classified as employees) could spill over into stock plan administration. A quick review of your company’s policy on granting to nonemployees and an audit of the database to identify grants to nonemployees will help your company make a full assessment of classifications. Executive compensation sounds like an area that stock plan management would be involved in, but actually the main focus will be on owner-officers and the particular audits in this area may not apply to most corporations. So, the area where the stock plan management team can provide the most assistance is payroll taxes.
Payroll Taxes
At this point, you should already have a regular, at least annual, audit of your tax withholding and remitting policies that helps you identify areas of potential noncompliance. The NRP only increases the risk of your company being audited, but compliance should be a serious focus, regardless. Here are my top areas to review before the new year:
Timing of Tax Deposits
Social Taxes
Mobile Employees
ISOs and 423 ESPPs
162(m) and 409A Compliance
Why Now?
If you uncover areas where the company is not withholding correctly on equity compensation, the beginning of the calendar year is the perfect time to implement new withholding practices. This is especially true for mobile employee withholding and if the change will be prospective only
How Far Should You Go?
When you do identify an area that your company has been out of compliance with, the big question is whether to make policy changes that are prospective or retrospective. Even if you aren’t going to be changing retrospectively, it’s a good idea to at least audit back a minimum of three years, but no specific length of time is appropriate across the board. For example, if you discover that you haven’t been making timely tax deposits, there isn’t a way for you to go back in time and make them any earlier. But, you can go back and audit the instances of noncompliance to help give your company an idea of what fees could result from an audit.
States, Too!
The federal government isn’t the only one with a tax gap to close; states are also looking to find lost tax revenue. What’s more, the IRS has reciprocal agreements with many states to share audit findings. That means that if you are audited by the IRS as part of the NRP or as a regular audit, state and local tax authorities may not be far behind.
Across the globe, governments are working to improve financial stability, resulting in additional efforts to increase tax revenue. This means that countries are looking to capture incorrectly reported income or insufficient tax remittance and also update the timing or method for income reporting and tax withholding. Equity compensation is often top on the list for countries looking increase tax revenue, which can lead to some pretty drastic changes (think Australia).
Canada 2010 Budget
In case you missed it, Canada’s 2010 Budget proposes changes that will tighten tax rules for stock options. There are two changes that together will have a large impact on the administration of stock option programs in Canada. First, employees will no longer be able to defer income from options exercises to sale date. Rather, income will be realized, reportable and taxed at the exercise. In addition, the “undue hardship” exception for income tax withholding on option exercise income will no longer be available after 2010, meaning the employers will now be required to withhold income tax on option exercises. Stock plan management teams will need to get started as soon as possible establishing new tax withholding procedures and communicating changes to employees. There’s more to the 2010 Budget as it relates to equity compensation. Find out all the details in this alert from Deloitte and make sure you’re signed up to receive updates as they come in.
Ireland 2010 Finance Bill
Prior to the 2010 Finance Bill, employers in Ireland were generally only required to report on the grant and exercise of stock options and ESPP; reporting stock-based awards like restricted stock and RSUs was only required upon notice by the Irish Revenue Commissioners. However, after the 2010 Finance Bill, employers in Ireland must now report on the grant and vesting of all forms of equity compensation including restricted stock and restricted stock units. For companies already reporting both at the request of the Revenue Commissioners, the good news from this Bill is that the forms for reporting equity compensation will be combined to a single form. Reporting is generally due by March 31, but because the composite form isn’t available yet, the filing deadline for 2009 reporting has been extended to July 9, 2010. For more information on the Finance Bill 2010, check out this alerts under the Ireland Country Guide.
Testing UK Residency in the Courts
We’ve also seen a few ground-breaking rulings regarding UK residency. If you have employees on assignment in the UK, these recent rulings mean that now is a good time to take a closer look at the residency status of mobile employees working in the UK or who have left the UK on assignment. The HMRC is in the process of reviewing residency claims. With these rulings (from litigation that is the product of the HMRC’s efforts), some existing assumptions about claiming non-resident status in the UK have been challenged. Residency has never been a concrete idea in the UK. Although there are definite and obvious lines that disqualify employees from claiming non-resident status, there is still a significant amount of grey area. When reviewing residency, the HMRC takes all facts and circumstances into account, which means that companies determining how to withhold and report must also assess each mobile employee individually.
For employees leaving the UK to work abroad, the most significant implication of two recent rulings is that it will be more of a challenge to claim non-resident status if there isn’t a clear break with social or family ties in the UK. For employees on assignment to the UK, one recent ruling implies that when reviewing cases where the status of resident and not ordinarily residence (see my prior entry on UK mobile employee vocabulary), the original intent of the individual can be trumped by the actual outcome of the assignment. You can find more on these recent rulings in the alerts under the UK Country Chapter Guide.
Keep Up!
Have you been keeping up with international developments? There’s a lot on the move these days, and to stay ahead of the curve, you need to know what’s going on. The NASPP Global Stock Plans portal taps into resources from all of our Task Force members to provide you the latest alerts on global legislation, litigation, and other changes that impact equity compensation. If you’re not already on the list to receive global alerts by e-mail, sign up now!
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:
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.