Page 484 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

470 The Complete Guide to Executive Compensation

Another form of fixed cost and fixed basis for payment is the debenture. The company
typically sells this debt security with a fixed interest rate to an individual. That individual could
be an executive, but it has limited appeal for those wanting an equity position in the company
unless it contains a convertible feature. If it were convertible into company common stock, the
instrument would stipulate the conversion rate (i.e., number of shares in relation to each
$1,000 of note face value). Under FAS 123R, a fair value would be determined at time of grant.
There is no expense charge at time of conversion. For tax purposes, the difference between
market value and cost at time of purchase would be ordinary income, and subsequent gains
after conversion would be subject to long-term capital gains at time of sale.
The instrument may also require meeting certain financial objectives over a prescribed
period of time before permitting the conversion (e.g., a minimum compound 10 percent EPS
increase over a five-year period). Such a requirement would make the convertible debenture
a fixed-cost-and-variable-basis-for-payment type of plan. This will be reviewed next.
Fixed Cost and Variable Basis for Payment (FCVBP). Given an amortization schedule
to retire a loan, a company may establish a formula indicating the portion of annual
payment that may be canceled by corporate performance. These loan forgiveness amounts
are charged to company earnings, reported as income to the executive, and taken as a
company tax deduction.
As an example, the schedule may call for an annual $10,000 payment over five years
toward retiring the loan on the purchase of 500 shares. However, this amount would be
reduced by $1,000 for every 1 percent increase in EPS above 10 percent. Thus, a 15 percent
increase in EPS in one year would reduce the payment to $5,000, with the other $5,000 being
“forgiven.” This is illustrated in Table 8-49, where the purchase price was halved, thereby
effectively reducing the purchase price to $50 a share. In this example, the vesting schedule
is 20 percent a year, so the $60 gain in relation to market price would be recognized as
ordinary income for one-fifth of the shares, or 100 (i.e., 20 percent of the 500 purchased).
After seven years, the executive sells these 100 shares at $210 a share and receives long-term

Purchase Vest Sell
Time Lapse Today One year Seven years
Stock price
• Fair market value $100 $110 $210
• Purchase price $100 $50 $110

Individual
• Ordinary income * $60 —
• Long-term capital — — $50
gains
Company
• Tax deduction — $60 —
• Expense* $30 —

* Accrued over period of vesting
Table 8-49. Stock purchase plan—fixed cost and variable basis for payment