Michael Sullivan authors "New Stock Option Practices Provide Welcome Flexibility"

By: Michael J. Sullivan

July 2007 

Changes to the accounting rules and tax code over the past few years have combined to remove much of the flexibility and appeal of stock options. However, many people are unaware that there is some good news amidst the gloom – some useful stock option practices that were previously impractical are now feasible, including:

• Repricing of Options
• "Net Exercise" of Options
• Performance-based Options

The accounting rules related to stock options have recently changed significantly. Prior to the implementation of the latest rules (FAS 123R – effective for most companies in 2006), companies generally did not record compensation-related accounting charges when stock options were granted with exercise prices equal to the market value of the underlying stock. However, certain practices (e.g., option repricings and net exercise provisions) triggered “variable” accounting – an undesirable result in which subsequent increases in stock prices resulted in new accounting charges. The consequence of variable accounting for option repricings was itself a fairly recent rule and prior to its implementation stock option repricings were common for companies that had experienced sharp drops in the value of their stock. After the implementation of variable accounting rules, option repricings quickly fell out of favor.

Under FAS 123R, companies are required to expense (take an accounting charge) for stock options and related equity-based awards. The expense is recognized over the vesting period of the option. An actuarial analysis (using the Black-Scholes method, for example) must be done to determine the financial cost of the options and other equity-based awards. While these charges have generally been unpopular in Silicon Valley, many companies are unaware of the good news — which is that the new accounting rules create flexibility to adopt a number of useful practices that until recently were impractical.

REPRICING OF OPTIONS

Stock option repricings, which involve the reduction of the exercise price of outstanding stock options, no longer trigger variable accounting, and there is no significant accounting or tax disadvantage associated with repricings generally. However, companies should be aware of these items prior to any option repricing:

• A repriced option is considered a “new” option for tax purposes. This means that the gain on exercise of a repriced incentive stock option (ISO) can only be treated as capital gains if the stock is held for at least two years from the date of the repricing and more than one year from the date of exercise.
• Only $100,000 (calculated based on the market value of the underlying stock) of an employee’s options that become exercisable in a year may be treated as incentive stock options. If an option is repriced, a company must count both the original option and the new, repriced option in making this calculation.
• Public companies may need to obtain stockholder approval if the plan under which an option was granted does not specifically allow repricing (e.g., see NYSE Rule 303A.08). Some companies have recently sought stockholder approval to permit future repricings under their option plans.
• The SEC considers some types of repricings to be tender offers, which can make those repricings more complex and time consuming.

"NET EXERCISE" OF OPTIONS

Prior to FAS 123R, options with “net exercise” provisions triggered variable accounting. Under a net exercise provision, an option holder is permitted to exercise an option without paying any cash. Instead, the option holder “pays” the exercise price by forfeiting shares subject to the option, based on the value of the underlying shares. For example, an option for 1,000 shares with an exercise price per share of $1.00 and an underlying stock fair market value of $5 could be exercised by forfeiting 200 shares ($1,000 aggregate exercise price divided by $5 fair market value).

Under the new rules, net exercise options no longer trigger variable accounting, and net exercise features present no adverse accounting or tax issues. Net exercise provisions are particularly useful for later stage private companies with relatively high stock prices, since their employees may not have the ability to finance significant exercise payments.  I don’t expect many companies to use net exercise across the board or as a general rule (for one thing, determining the fair market value of private companies’ stock can be complex and uncertain), but it can be very useful in specific situations – for example, in connection with the hiring of a senior executive with a significant option package. Most pre-2006 option plans do not provide the flexibility for net exercise of options, so companies should consider amendments to their plans to allow that flexibility.

PERFORMANCE-BASED OPTIONS

Performance-based stock options and other equity awards are awards that vest upon the achievement of a milestone or performance goal (e.g., achieving sales targets). Prior to FAS 123R, when the goal was achieved the company incurred an accounting charge equal to the number of shares multiplied by any increase in the stock price between the date of the equity grant and the date that the performance goal was met. The uncertainty as to future charges made performance-based equity unappealing to most companies.

Now, accounting charges are incurred over the vesting schedule of the option and are based on an actuarial analysis of the value of the equity at the time that it is granted. Future vesting based on performance does not trigger additional charges. In fact, the existence of a future performance vesting requirement will reduce the charge (calculated on the date of grant), because it reduces the likelihood that the equity will be earned. As a result, performance-based equity is now much more appealing in terms of accounting consequences.

For assistance or additional information on these issues, please contact Mike Sullivan (msullivan@howardrice.com).