Stock Options Pitfalls and Strategies Du Jour

Companies scramble to remedy ailing incentive compensation plans.
BY PAUL SWEENEY

EXECUTIVE SUMMARY
AS THE STOCK MARKET SLUMPED , the use of stock options as the ideal form of employee compensation lost some of its luster. To fill the breach, companies are scrambling to find remedial compensation strategies to protect their employees from market losses. These alternative methods include repricing, reissuing options “six months and one day later” and issuing restricted stock.

COMPANIES CHOOSING THE REPRICING STRATEGY must act carefully because of FASB Interpretation no. 44, Accounting for Certain Transactions Involving Stock Compensation (interpretation to APB Opinion no. 25, Accounting for Stock Issued to Employees ) adopted in July 2000. The new accounting rule discourages companies from making a quick leap to reprice stock options in response to a market downturn. Repricing becomes much more painful.

COMPANIES THAT CANCEL THEIR OPTIONS and wait six months and one day (sometimes called “slow motion options”) can reissue them at a lower price and preserve fixed income accounting treatment.

THE LEAST POPULAR INCENTIVE COMPENSATION formula, because of its tax consequences, is to cancel options and replace them with restricted stock. For employees, restricted stock consists of grants of actual shares that can be forfeited unless vested by continuous employment.

UNDER FASB INTERPRETATION NO. 44, companies must apply variable award accounting to otherwise fixed stock options that are modified to reduce the exercise price of the option. Any rise in the value of the option above its new, lower strike price must be charged against earnings.

PAUL SWEENEY is a freelance writer in Brooklyn, New York. His e-mail address is pswe865002@aol.com .

s the stock markets have slumped, the use of stock options as the ideal form of employee compensation has lost some of its luster. Companies may choose to redesign their compensation plans due to the wholesale losses in their stock value. In an upside-down investing world, financial managers, option holders and CPAs need to be aware of alternative stock option plan strategies.

Tax Advantages

In 1999 (the most recent year for which data are available), 162 large companies reporting options-related tax deductions also reported a total of $15.3 billion in options-related tax savings.

Source: TIAA-CREF, New York City, www.tiaa-cref.org .

Until last year, many companies looked at stock options as a no-lose proposition for everyone. Statistics compiled by the National Association of Stock Plan Professionals (NASPP) and PricewaterhouseCoopers LLP quantify that enthusiasm. In 2000, 44% of the 345 U.S. companies participating in the survey offered stock options as compensation to employees at the nonexempt level, compared with just 34% in 1998. Now, particularly in the technology, telecommunications and dot.com industries, many employees’ stock options are “underwater” (below the strike price and out of the money) and, at least for the present, are considered worthless. To fill the breach, companies are frantically scrambling to find remedial compensation approaches to protect employees from market losses while also addressing accounting, tax and corporate governance concerns. These alternatives, discussed here, include repricing stock options, canceling options and reissuing them at a lower strike price after a six-month-and-one-day waiting period and substituting underperforming stock options with other payment programs, such as restricted stock.

“The complexion of employee incentive programs is already changing,” says John Boma, CPA and senior vice-president at Mullin Consulting Inc., in Minneapolis, which advises businesses on compensation strategies. Stock options, the most widely used form of incentive compensation, give employees the right to buy a set number of shares of company stock at a set price for a certain period. They became ubiquitous because compensating employees with stock options entails no cash expenditures. At the same time, the business receives favorable accounting treatment since there are no charges to earnings. Stock options that are performance-based, moreover, offer the company a way around paying taxes on cash compensation for the CEO and other top officers, for whom no more than $1 million in annual cash compensation, not tied to performance, is tax deductible (for more on this subject, see “Planning for the Cap,” JofA, Oct.00, page 39). Employees also benefited when they exercised their stock options and held on to their shares. When the two-year holding-period stipulation was met, cashing in one’s shares allowed for taxation at the 20% capital gains rate, not at the higher marginal income tax rate.

REPRICING NO LONGER ROUTINE

Until recently, when markets went south, many companies would hand out more options at lower prices—an acceptable and simple means to protect employees from a business’s poor performance. But new accounting rules discourage companies from making a quick leap to reprice stock options in response to a market downturn.

Most companies choosing the repricing strategy, typically formerly high-flying technology and dot-com companies, have little or no earnings and include (according to Institutional Shareholder Services (ISS) in Bethesda, Maryland) Amazon.com, Broadbase Software, Interwoven, Critical Path and Network Associates. These entities must act carefully because of FASB Interpretation no. 44, Accounting for Certain Transactions Involving Stock Compensation, (an interpretation to APB Opinion no. 25, Accounting for Stock Issued to Employees ). Under Interpretation no. 44, adopted in July 2000, routine repricing becomes much more painful for companies. Simply lowering the exercise price of existing options or perhaps canceling them and regranting a new set of options now forces companies to mark the value of the awards to the market price each quarter for the entire life of the options.

FASB Interpretation no. 44 requires companies to apply variable award accounting to otherwise fixed stock options that are modified to reduce the exercise price of the award (see “Variable Accounting in Compensation Plans,” below). Thus the options become variable for accounting purposes and any rise in value above the new, lower strike price must be charged against earnings. The charge is open-ended and impossible to predict. “As a drag on earnings, that can amount to as much as a penny in earnings per share, which can be significant in light of current market conditions,” says Andy Gibson, CPA and tax partner at BDO Seidman LLP in Atlanta. Even so, as Patrick McGurn, vice-president and director of corporate programs at ISS notes, Interpretation no. 44 has not stopped repricing dead in its tracks. In a survey of company proxy statements, ISS found that among 75 companies that took some action on stock options, more than 35% engaged in repricing in the first half of this year. That appears to be a startling increase over the past: for example, the NASPP found that only 1% of the companies surveyed had repriced in 1999, down markedly from 6% in 1998.

Variable Accounting in Compensation Plans

Companies view stock option plans with features subject to variable accounting as at a disadvantage because, with variable accounting, compensation costs are charged to earnings. In fixed option plans the option price and number of shares are known on the grant date and only the intrinsic value (a discounted price) needs to be expensed on financial statements. Most fixed option plans have no intrinsic value at grant date and no compensation cost is recognized for them under APB Opinion 25. Variable plans result from changes to an existing option grant, or when the options are performance based, and future appreciation must be expensed until the options become fixed. For example, any modification or sequence of actions by a grantor which directly or effectively reduces the exercise price of an option award (a “repricing”) requires variable accounting for the repriced award for the remainder of the award’s life.

Because repricing options is available to employees and not shareholders, the method is a governance issue; FASB Interpretation no. 44 tries to address it by making it more difficult for companies to reprice. Paula Todd, CPA and principal specializing in executive and stock-based compensation at Towers Perrin, a consulting firm in New York, says even though there were always reasons against repricing options, it still may be the best course of action for companies with sophisticated investors. “If you really want to use options and there is a need to do something immediately, just counsel people to reprice and then help investors understand the funky accounting. There are worse things than noncash accounting expenses,” she says.

For many of the Internet and Web-based companies that relied most heavily on stock options to lure and retain employees, “the big topic now is what to do with your underwater stock options,” observes Gibson. “The fear of large, open-ended earnings charges has led many of these firms to cut the costs of the new grants by shortening the life of their replacement awards,” McGurn notes. Several of the repricings have been done on a “value-for-value basis,” McGurn adds, with the option-holder sometimes giving up more than half the underwater grants to obtain smaller grants with “sea-level” prices (those that are at the strike price and in the money). In this scenario, the company pays the employee, but less than if the options had a higher strike price. But employees are getting paid, and there is likely to be less stock dilution.

REISSUING “SLOW-MOTION” OPTIONS

For companies with actual earnings, the six-month-and-one-day option exchange—what some call a “slow-motion” option exchange—is another strategy. The good news is this technique allows companies to reprice their shares at no cost and without diluting the stake of existing shareholders. It is also a way to avoid the potentially costly complications of repricing options subject to FASB Interpretation no. 44. There’s a big drawback to this method, however. A lot can happen in six months, leaving employees with a gamble and guesswork in volatile markets.

Under accounting rules, companies that cancel their options and wait six months and one day can reissue stock options at a lower price and preserve fixed accounting treatment. This is clearly the strategy du jour: according to ISS, the majority of companies it surveyed, as many as 55, employed this tactic during the first half of 2001.

In practice, slow-motion exchanges, which are treated as a tender offer in the proxies, are controversial. McGurn calls them a “dodge.” If a stock option is exercisable at 50 and the stock today trades at 20, the employee is put in the odd situation of hoping for the stock price to go down still further in the intervening half-year. Even though most companies exclude top executives from such option exchange programs, “the irony is that for the six-month period, the employee has no incentive for the stock price to go up,” notes Gibson. “That goes against the principle of creating incentives for people to grow the value of the company.”

Among the raft of companies using this strategy, according to ISS, are Actel, Ariba, Commerce One, E.piphany, Macromedia and Vitra Technology. Sprint’s use was perhaps the most prominent: It permitted 24,000 of its employees to turn in their old options. Most companies provided share-for-share swaps at 100% fair market value on the new grant date, McGurn reports.

LEAST POPULAR REMEDY

Perhaps the least popular incentive compensation formula because of its tax consequences, but one that some companies have deployed this year nonetheless, is to cancel options and replace them with issues of restricted stock. The chief advantage to a company of issuing restricted stock, which ISS calculated at least 8 of 75 companies used to alter their stock option plans, is that the technique acts as a retention tool because of the partial vesting feature. At the same time, the company can expense the stock over four years and avoid variable accounting. For employees, restricted stock consists of grants of actual shares that can be forfeited unless fully vested by continuous employment for a specified term. Usually restricted stock vests incrementally over four years at 25% a year. Armstrong Holdings, Avid Technology, Infonautics, Priceline.com and Toys ‘R’ Us all used this course of action, reports ISS.

Rather than using any of the three methods, several companies chose simply to issue more stock options on top of underwater options. Cisco Systems, Lucent Technologies, Microsoft and Intel were among the seven companies cited by ISS as preferring this course. By not canceling the underwater options, companies spared themselves the trouble of doing variable accounting.

Clearly, businesses that relied on stock options are in a fierce bind and must now struggle to retain talent. Max Michaels, cofounder and CEO of KnowledgeCube Ventures, a New York venture capital firm with 11 early-stage companies in its portfolio—two of which are on “life support,” he acknowledges—says the bloom is clearly off the stock option rose. “We have repriced everyone’s options,” Michaels says. “Valuations of our companies came down and nobody would have been in the money. There’s no question about that. Employees are also insisting on a 30% cash bonus (whether it’s to remain at the company or for new hires). It used to be that stock options were equal to cash. But that’s no longer true.”

KEEPING EVERYONE HAPPY

When stock prices were rising relentlessly, U.S. companies, employees and even restive shareholders were all in accord (see the exhibit below). Employees shouldn’t look for a good replacement in compensation plans anytime soon, counsels Todd, who says there is no magic bullet. “Companies went option-happy,” he says, “and options became a sexier form of compensation. Employees coveted them, expected and demanded them, and they became a powerful currency to attract and retain people. They also made good cocktail party talk: people liked to brag about options more than money. Options had cachet.”

Moreover, stock options became an important retention tool. “Employee retention is the number one issue right now,” notes Stewart Reifler, director of the Northeast compensation group at PricewaterhouseCoopers LLP in New York. “When you’ve got people who are good, you want to keep them.” But options only work as a retention device when the price goes up. “Our fathers worked for 35 years for one company,” says Reifler. “Now it’s not unlikely to work at 12 companies or have three or four different occupations. What’s a stock option that hasn’t vested? It’s a retention tool.”

Shareholders were also kept happy. They applaud plans in which top officers’ interests are aligned with theirs, because as top executives were rewarded with stock options that were exercisable at a higher strike price, they would be “in the money” only if they worked to make the company’s stock price perform well. Shareholder activists who might have fretted more about outsized salaries to top executives were quiet when they themselves were benefiting.

But in recent months all U.S. stock markets have sagged, and none more than the Nasdaq, which by mid-August declined approximately 60% from its record high in March, 2000. The Nasdaq trades the bulk of those high-technology companies that are the most avid employers of stock option compensation for nonmanagerial employees.

For Internet companies, the news was even worse. The stocks of most e-commerce firms plummeted. Among myriad examples, Priceline.com sold for $51.50 a year ago before swooning to as low as $1.0625, and is now trading at about $7; StorageNetworks traded as high as $154.25 last August before skidding back to $7 and is now at about $18; Amazon.com was at $56.25 in midyear 2000 only to fall to $8.10 in 2001 before going back to $16 in June. And a startling number have gone belly-up.

Some employees at e-commerce and technology companies not only have watched the value of their stock plunge after the options were exercised but also came to owe a significant amount in federal taxes calculated on the value of the options. This dilemma created howls of protest (for a related article, see “Sunk by Options” ).

Stock options, like other forms of incentive compensation, are intended to motivate employees to perform better than they might without the added incentive. But instead of relying on stock options and using the rise in stock prices as a yardstick, Boma notes anywhere from one-third to one-half of his firm’s clients are returning to performance-based cash bonuses tied to sales increases, return-on-equity or profitability. The benefit is less dependence on stock, which can carry obvious disadvantages. When share prices plummet, employees can wind up empty-handed. “Individuals say they’ve done a great job this year but the company’s stock is in the tank,” says Boma.

CPAs who advise on financial planning matters can help to guide their clients through incentive compensation pitfalls. Paul Bronzo, a financial adviser and senior vice-president at Prudential Securities, says, “Properly educating employees on how to efficiently exercise their stock options and thus avoid unfavorable tax consequences is one of my most important tasks.” He recommends option holders consult with a CPA, a financial adviser and an attorney, ideally all at the same time.

Company management, employees and ultimately shareholders do not always find the option alternatives—repricing, slow-motion exchanges and issuing restricted stock—satisfactory. Although these strategies are measurably better than simply paying employees additional cash (which is a problem for start-ups, for example), they all might carry undesirable accounting, tax or public policy consequences, making them much less appealing to companies and employees than issuing stock options in a different market environment.

There’s no such thing as one-size-fits-all when it comes to incentive compensation plans. And long-term incentive pay is not effective when the market slumps. Financial managers need to find ways to reduce the effects of stock volatility in their compensation programs without costing their companies additional money.

Wide Use of Stock Options at S&P 250 Companies
Source: 2000 Report on Long-Term and Stock-Based Grant Practices for Executives and Directors at the Top 250 Companies in the S&P 500 Index, Frederick W. Cook & Co., www.fwcook.com .

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