Page 437 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

Chapter 8. Long-Term Incentives 423

to the discount for the optioned shares. Assume a grant is made when the FMV is $100 a
share. For a 15 percent discount, the grant requires the optionee to pay the company $15 for
every share under option. The price and number of shares granted are both known on date
of the grant, and there is no real discount since the combination of the $85 option price
and $15 payment by the optionee equals FMV. The fair value earnings charge will be based
on the $85.
Above Market Value. Setting the option price above the FMV on date of grant is done
either with preset prices at specified dates (sometimes called a premium-priced option) but
more correctly identified as a fixed-price premium option (FIPPO) or by a prescribed formula
tracking percentage change in the consumer price index (CPI), the Dow Jones Industrial
Average, or some other readily available index or perhaps the stock prices of peer companies.
Not surprisingly, these are often called index options but are more correctly defined as
variable-priced premium options (VAPPOs). Both FIPPOs and VAPPOs are premium options.
Under a FIPPO option, prices are set for specified future dates. This can range from a
one-time adjustment (e.g., price of $105 when at time of grant the fair market value is $100)
to the far more difficult performance hurdle when grant prices are increased annually (e.g.,
by $5 a year for each of the 10 years). And although the future prices of the grant are known,
it is unknown at what price the option will be exercised. This is unlike the single premium-
priced option with price effective at end of vesting period; in the latter case the exercise price
is known. Both FIPPOs and VAPPOs are equity awards and eligible for grant-date account-
ing. Because of the future variables, an open model such as the binomial lattice formula might
be most appropriate.If an optionee terminates before the option vests, the accrued expense
cannot be reversed; however, any remaining future charges may be avoided. In both situa-
tions the company can take a tax deduction on the spread between fair market value and
option price at time of exercise since the optionee has a like amount of taxable income.
As a rough rule of thumb, option pricing models typically value a premium-priced option
at about half that of a fixed fair market price grant—less for an aggressive premium and more
for a conservative one. To illustrate using the values in Table 8-13, if after four years the fair
market value of the stock is $174.90 a share (a 15 percent compound growth) but the grant

Compound Growth Rate
Year 5% 10% 15%
1 $105.00 $110.00 $115.00
2 110.25 121.00 132.25
3 115.76 133.10 152.09
4 121.55 146.41 174.90
5 127.63 161.05 201.14
6 134.11 177.16 231.31
7 140.71 194.87 266.00
8 147.75 214.36 305.90
9 155.13 235.79 351.79
10 162.89 259.37 404.56

Table 8-13. Compound growth rate comparisons