Page 485 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

Chapter 8. Long-Term Incentives 471

capital gains treatment on $100 (i.e., $210 $110). Under FAS 123R, a fair value must
be determined; given the variables, an open pricing model (such as the lattice) may be
preferable to a closed model such as Black-Scholes.
In addition, or in lieu of, the performance variable, a time-in-job factor could be
designed. For example, $1,000 might be forgiven each year for each year of service since
receiving the stock. Thus, $9,000 would be required after the first year, $8,000 after the
second, and so on. This accelerated “earn-out” makes staying with the company very
attractive to the executive.

Variable Cost and Fixed Basis for Payment (VCFBP). Rather than set purchase price
at the time of purchase, it is possible to determine in advance the cost of the shares to be
purchased that year. The amount of annual discount is taken as a charge to company
earnings, reported as income to the executive, and identified as a company tax deduction.
For example, the formula might set the cost to 50 percent of market value each year for
five years. If 500 shares of stock were involved, installment vested over five years, this would
mean that the value of 100 shares would be determined each year in relation to the then-
current market value. This is illustrated with the example in Table 8-50, where after the first
year, the stock is selling at $110 a share, and therefore the executive’s cost is $55. This $55
profit is income to the individual and a tax deduction to the company. Under FAS 123R, a
fair value must be determined; given the variables, an open pricing model (such as the lattice)
may be preferable to a closed model such as Black-Scholes.

Purchase Vest Sell
Time Lapse Today One year Seven years

Stock price
• Fair market value $100 $110 $210
• Purchase price — $55 $110

Individual
• Ordinary income — $55 —
• Long-term capital — — $100
gains

Company
• Tax deduction — $55 —
• Expense* $25 —
* Accrued over period of vesting
Table 8-50. Stock purchase plans—variable cost and fixed basis for payment

Alternatively, or on the assumption that price should really be a function of earnings,
the formula could use some multiple assigned to EPS. For example, if the formula called
for a multiple of 20, the cost for year one would be $60 for each share (or $6,000 for
100 shares) if the EPS were $3.00, whereas it would be $66 per share in year two, or $6,600
for 100 shares, if the EPS were $3.30.