Page 471 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

Chapter 8. Long-Term Incentives 457

Determining the Number of Option Shares Stated Number. The most common type is
when the number of shares are fixed at time of grant. All of the previous examples are based
on this approach. But there are other ways of setting the number of shares under option.
Indexed determined. This is similar to an indexed stock price. However, it is the number
of shares, not the option price, that is affected.
Performance determined. This is similar to the earlier-described performance-determined
vesting, except that instead of reducing vesting this approach increases the number of shares.
Reloaded. The reload option was reviewed earlier. FAS 123R considers this a new stock
option grant.
Percent of Total. The number of shares to be granted is determined by a stated percent-
age. For example, if the plan is expected to be in effect for 10 years then no more than 10%
of the total is approved each year.
Percent of Pool. Often this approach is a subset of “percent of total” shares with the pool
determined as a percent of the total shares available for the year.
Value of Shares. The number of shares is determined by the number needed to create a
stated value (such as might be determined by a present value formula such as Black-Scholes).
Why Stock Options? For years, stock options have been one of the more acceptable forms
of incentive compensation to shareholders because (1) the executive must put up some of
his or her own money, (2) the value, like the shareholder’s, is at risk with the price of the
company stock, and (3) assuming no discount, there is no charge to corporate earnings.
Options are a form of profit sharing that link the professional manager’s financial success to
that of the shareholder.
While such programs have been widely used in many companies, there are organizations
where they are not available as a compensation device because the company stock is not
publicly traded.
However, for those who are about to make an initial public offering (IPO), moving
the company from a privately held to a publicly traded company, there is a high degree of
interest in large stock option grants. Historically, stock prices increase dramatically in the
days and weeks preceding an IPO. Ideally, key employees will have options at lower prices;
however, such grants must be made with care. The SEC is likely to scrutinize grants made
below the IPO offering price to determine if such options were really granted at “true” fair
market value. If not, they are deemed to be “cheap stock,” therefore requiring the company
to take a charge to earnings for the difference between the option price and the deemed FMV
of the stock on the grant date.
As stated in Chapter 1, stock options are extensively used in the initial threshold, or start-
up, stage because of a lack of cash and the potential for long-term appreciation in stock price.
As shown in Table 8-39, there are significant differences between threshold and later stages
of the market cycle in terms of reason for, eligibility, dilution, vesting, price, repricing, and
definition of stock owned.
Since a company does not pay federal income tax on any profits it may realize in selling
its own stock, stock options are expensive to the company in direct proportion to the realized
value the executive receives in appreciation. Heavy use of stock options in such situations
results in a significant loss of income to the company. For example, assume an individual
receives an option of 1,000 shares at $100 a share. The individual exercises the option when
it is selling at $160 a share. The executive has a tax liability on $60,000 (i.e., 1,000 shares
$60). Similarly, the company has a tax deduction of $60,000 or a reduction in taxes of $24,000