Page 421 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

Chapter 8. Long-Term Incentives 407

understand when using company stock. Unfortunately, it is easier to understand than to
utilize due to the uncertainty of predicting economic conditions, except on a historical basis,
at which time it is too late.
The consideration of downside risk is also important in stock option plans. The executive
is placed in a precarious position when having to borrow to exercise the stock option if the
intent is to hold it for some time. Consider this illustration: The individual borrows $100,000
at 10 percent interest to exercise a 1,000-share option at $100. If the market price were
currently $160, there would be a paper profit (and tax preference income, if a qualified option
of $60,000). Will the dividend be sufficient to cover interest costs? If the stock starts to slide,
concern sets in. With each drop, the bank becomes more vocal about additional collateral.
Obviously, if the price drops below $100, the executive has a paper loss. To the extent this
necessitates sale of the stock, the executive may have lost money at some point above $100 a
share (based on the manner in which the gain at exercise was taxed versus the loss realized).
While there is no federal governmental requirement that shareholders approve a
nonqualified stock option plan, it may be a requirement of the state in which the company is
incorporated or the exchange on which the company’s stock is listed. Furthermore, the
SEC may not consider exempt a grant of stock options under a plan not approved by share-
holders; therefore, shareholder approval of stock option plans is the rule rather than the
exception. Most shareholders want management to grant them the right to approve option
and other stock-based compensation plans because of their dilution potential. In addition,
shareholders must approve Section 422 stock option plans (ISOs) for them to retain their tax
status, and Section 162(m) also requires shareholder approval for the tax deduction.
An additional question is whether or not to register the stock. In those companies that
do not undertake the expense of registration, the executive must make an investment repre-
sentation before exercising the option. The negative aspect of such a representation is that
the executive cannot sell the stock for two years without incurring a high penalty discount on
the value. Not many executives find this restriction an attractive motivational compensation
technique.
If there is a stock split, the company adjusts the option accordingly. For example, an
option for 1,000 shares at $100 a share before split is adjusted to an option for 2,000 shares
at $50 a share following a two-for-one stock split. In each situation, the cost to exercise the
full option is $100,000.
If one company acquires or merges with another in a stock transaction, it is appropriate
to restate the option price for purchase of the acquiring company in relation to their respec-
tive prices. This is called a rollover or a redenominated type stock option. For example, assume
company B’s stock was selling at $100 and the executive had an option on 100,000 shares at
$60 a share when it was acquired by company A, whose stock is selling at $150 a share.
Accounting treatment depends on how the redenominated stock option is calculated. The
Emerging Issue Task Force issued EITF 90-9, which states that no compensation expense
is required because there is no new measurement date if (1) the option spread is not greater,
(2) the ratio of exercise price to market price is not reduced, and (3) the option and vesting
terms remain the same.
The ratio of company B to company stock is 0.67 (i.e., $100 divided by $150). By adjust-
ing the number of option shares by this ratio, the grant is restated at 66,666 shares. To deter-
mine the option price, one would determine the ratio of company B option price to fair
market value (i.e., $60 vs. $100, or 0.6). In this case, it would be 0.61 (i.e., 0.67 times $150).
The total option spread of the redenominated option is $4 million (i.e., $150 $90 times