Page 420 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

406 The Complete Guide to Executive Compensation

Stock Options
A stock option is the right (but not requirement) given to a person (optionee) by a company
(grantor or optioner) to purchase (exercise) a stipulated quantity (number) of shares of the
company’s stock at a stated price (grant or strike price) over a prescribed period of time
(exercise period) in accordance with stated eligibility periods (vesting requirements). Thus,
there are five key dates in a stock option: date of grant, date to exercise or purchase, date
option expires, date of actual exercise, and date of sale. Each of these will be examined further.
The use of stock options dates back to the late 1800s. Some were granted at fair market
value, and others were discounted. However, the length of the option period was typically
three to five years. Little more information is available prior to the Securities Exchange Act
of 1934 because of limited reporting requirements. However, in the early 1920s, the Internal
Revenue Service (IRS) reportedly ruled that the spread between fair market value and
exercise cost on the date of purchase constituted income to the employee. Then, in the late
1930s, the IRS focused on intent. If compensation were not the intent of added value, the
spread at time of exercise would not be considered taxable income. This is similar to
compensatory versus noncompensatory plans described by APB 25 in 1972. It also laid the
seed for tax-qualified stock options, introduced with the 1950 Revenue Act. This legislation
may have been aided by the reversal in the IRS’s position in the mid-1940s, when it went back
to its position of the 1920s, eliminating the question of intent.
Stock options are either statutory (qualified) or nonstatutory, referring to the Internal
Revenue Code (IRC). Those options that comply with Section 422 of the IRC are said to be
statutory options and, therefore, qualified for favorable tax treatment. Namely, optionees are
not taxed at time of grant or at time of exercise but only at time of sale. If held long enough,
the entire spread between exercise cost and selling price could be treated as long-term
capital gains. The company has no tax deduction on long-term capital gains,. However, if
the optionee does not meet the required holding period before sale of a statutory option, the
difference between purchase cost and selling price will be considered ordinary income. This
is called a disqualifying disposition.
Options are non-goal-oriented plans (i.e., the company does not prescribe certain goals
that must be achieved in order to receive payment). This is, however, a two-edged sword:
market swings (probably more dependent upon investor view of equities in general than this
stock in particular) may make the option very lucrative or literally worthless. For example, a
rise in interest rates usually means falling stock prices as investors shift from the stock to the
bond market.
Some believe that options only motivate recipients to increase the price of the stock,
rather than improve company performance, which in turn should result in a higher price.
Cynics argue that improved performance leading to higher stock price is about as successful
as pushing on a string. Similarly, it is much easier to pull that string (and pull the stock
price down) by announcing glum news, since the stock price is essentially future earnings
discounted to a present value. With the stock exchanges, SEC, IRS, and the Financial
Accounting Standards Board (FASB) monitoring activities, stock price manipulation is
virtually impossible without some form of legal action falling on the company.
Many believe the market to be a good indicator of coming recession or recovery, namely,
that the market will drop prior to a recession. As the recession continues, stock prices increase
in anticipation of a recovery. Once the recovery has been assured, the stock is vulnerable to
dropping off again. This lag between economic performance and stock prices is important to