Page 460 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

446 The Complete Guide to Executive Compensation

After paying the $100,000 in cash, the optionee would still have 1,625 shares “at work”—
all owned. In the stock-for-stock transaction, the 625 shares tendered (worth $100,000)
would have exercised the full 1,000 shares under option. The executive would receive back
the original 625 shares with their original cost basis and another certificate for 375 shares,
representing the appreciation (1,000 shares at $160 625 shares tendered at $160 a share,
or $60,000 FMV of $160 a share 375 shares). In both the cash and the cashless exercise,
the company received $100,000 cash, whereas the executive was out $100,000 in the first
situation but up $60,000 (375 shares at $160) in the second. All of these numbers are before
taxable income considerations on the exercise to the optionee or before tax deductions to the
company. With the cash exercise, the company has an additional 625 shares outstanding, 375
more with the stock-for-stock exercise, and 1,000 additional shares with the cashless exercise.
Another device is the cash supplement. It provides the executive with cash equal to some
percentage of the spread between option price and fair market value. If the objective were
to ensure that the executive does not have to sell stock to meet tax liability, it would be
logical to give an amount comparable to the spread (on the assumption the individual is in a
50 percent marginal tax bracket). Needless to say, this can be rather expensive to a company
with extensive use of options, especially when the spread becomes appreciable.
A variation of the cash supplement is a buy-back program in which the company buys back
a portion of the exercised option, lessening the executive’s financing requirements and the
dilution of equity to the company. Thus, an executive who exercised an option to buy 1,000
shares at $100 a share when the market value was $160 would have to dig up $100,000 to
exercise the option plus an additional $30,000 (assuming a 50 percent tax rate) to meet
the tax bill. If the buy-back were designed to simply provide sufficient cash to meet the tax
liability, the company would buy back 188 shares at $160 a share (i.e., $30,000 160). Such
plans have to be examined very carefully for 16b-3 executives.
Forfeitures

Options that lapse (i.e., the period of exercisability is exceeded) are considered voluntary
forfeitures. The typical reason is that the option price is “underwater” (i.e., the option price
is greater than the fair market value at time the option expires). Typically, these unexercised
options are returned to the pool available for grant.
The other type of forfeiture is the involuntary forfeiture. The most common type relates
to a clawback clause in stock options or stock-award plans. It would require that all profits
received by the executive within a stated period of time (e.g., one year following exercise
or payment) be returned to the company if during that period, the individual violated a non-
compete clause or engaged in acts deemed to be injurious to the company. It is important to
determine if legal under state law.

Selling the Stock
Stock received may be held, passing from generation to generation, or more likely, the
optionee will sell at some point in time. This sale is a disposition, and if the acquired stock was
under a statutory grant, the sale is either a qualifying or disqualifying disposition.
A qualifying disposition means the stock has been held the prescribed period of time. If
this time period is equal to or greater than the long-term capital gains (LTCG) tax-holding
period, the favorable spread will be taxed to the individual at the favorable long-term rate,