Consider Using Net Exercised Stock Options and/or Stock-Settled SARs - April 22, 2010 by Anthony Eppert

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Consider Using Net Exercised Stock Options and/or Stock-Settled SARs

I spent a fair amount of time this proxy season advising public companies on nuances associated with net-exercised stock options and/or stock-settled stock appreciation rights ("SARs").  The purpose of this Post is to highlight some advantages and disadvantages of these types of awards.

Background

In the stock option context, a net-exercise is similar to a broker-assisted cashless exercise except in the former there is no open market transaction.  Instead, a portion of the exercised shares equal in fair market value to the exercise price is tendered to the company in lieu of paying the exercise price in cash.  For example, assume a holder is granted a stock option to acquire 8 shares of stock with an exercise price of $1.00 per share (its then fair market value).  Assume further that at the time of exercise the fair market value of the underlying stock is $4.00 per share.  In this example, a net exercise means the holder would tender 2 of the 8 shares of common stock to the company in exchange for paying the exercise price of $8.00.  Immediately thereafter the holder would own 6 shares of common stock having a then fair market value of $24.00.

Stock-settled SARs generally provide the holder with a number of shares of stock equal in fair market value to the accumulated appreciation in the underlying stock from its fair market value at the date of grant; however, unlike net-exercised stock options, no shares are tendered to the company with stock-settled SARs.  Using the above example, the accumulated appreciation of the underlying stock from the date of grant would also provide the holder with 6 shares of common stock (i.e., $24.00 of accumulated appreciation divided by $4.00 per share). 

Advantages 

Compared to stock options utilizing a cashless exercise feature, the advantages of using net-exercised stock options and/or stock-settled SARs generally include:

  • Assuming the plan document contains appropriate share counting provisions, the life expectancy of the share reserve under the plan should be longer because a lesser number of shares are issued.  This could lessen the frequency within which shareholders are asked to increase the plan's share reserve.
  • Reduced shareholder dilution because only the net shares are considered issued and outstanding.
  • The holder receives the same economic benefit as stock options with a cashless exercise feature. 
  • Broker fees associated with cashless exercises are avoided.
  • There could be less problems associated with insider trading blackout periods since net-exercises and/or stock-settled SARs do not use open market transactions.
  • More favorable treatment in calculating basic earnings per share.  

Disadvantages 

Compared to stock options utilizing a cashless exercise feature, the disadvantages of using net-exercised stock options and/or stock-settled SARs generally include:

  • Company may have decreased cash flow because no monies are paid to the company in conjunction with an exercise.
  • The holder may be unable to obtain favorable incentive stock option treatment.
  • Depending on the underlying facts, it may become more burdensome for the company to satisfy its withholding obligation.
  • Shareholder advisory services such as RiskMetrics Group might assign a higher cost to the awards than it would traditional stock options. 

Given that many of the disadvantages could be lessened with careful planning, companies should consider whether it makes sense to utilize net-exercised stock options and/or stock-settled SARs.  At least don't wait until next proxy season!!

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Edited Mon, May 3, 2010 8:42 AM

Replies to this Topic

Assuming the stock option being exercised is a NQ, and the company issues only the net shares, withholding shares to cover the option price + taxes, it looks and smells much like an RSU release where the company does the net issuance. In my experience, not many are exercising and holding their shares, hence the cashless exercise. So while employees might recieve the net shares, they'd likely go to the broker and sell those shares anyway. At the end of the day, however, less shares would be hitting the marketplace, and to your point lessening the dilution factor, prolonging the plan reserves etc. . . I'm re-entering the stock plan administration world and have much catching up to do. Would love to learn more about about the subject.

 

We've been doing this in the UK for several years now. At first it took some time for brokers to develop appropriate processes but that seems to be in the past now.

It is actually not strictly correct that it reduces dilution of shareholder funds, although it certainly reduces the number of shares in issue.

Using the above example, one way of looking at it is to say that the conventional "gross" settlement involves issuing two shares at fair market value and six shares for no cost. "Net" settlement simply involves issuing six shares for no cost.

So the difference is that two shares are issued at fair market value. Strictly speaking, issuing shares at market value does not dilute shareholder funds, because the value per share in issue is exactly the same before and after.

Adding to the comments above, I certainly see how net exercises can work well for smaller companies.  In the same breath though I would add that for multinational companies reporting under US GAAP or IFRS2 the accounting impact could make this unfavorable, burdensome or simply impractical. Under IFRS2 the netted portion is going to be accounted for as a liability, which is going to turn many companies off the idea.  Under US GAAP you've got the old para 35 of FAS123R issue (the "minimum statutory rate") to deal with. Tread carefully...

I'm not an accountant, although I work for an accounting firm. Any company doing net settling should certainly consult its auditors.

However, I would say that net settling has been happening in the UK for years and I am not aware of any major audit firm taking the view that the netted portion would be accounted for as a liability under IFRS 2.

The view I have seen auditors express is that, since the value being delivered to the employee is the same whether the option is gross or net settled, and in both cases it is being settled in equity there is no additional value being delivered and therefore no incremental accounting charge.

Thanks Aidan, appreciate the clarification.  I'm equating this to net share settling RSUs to cover the withholding taxes (picking up Taeho's analogy), and I would similarly add that I'm not an auditor so anyone reading this should consult their own auditors rather than take my word for it, but the concept makes me nervous based on my understanding and what I have seen/heard.

The accounting issue relates specifically to the shares netted back to settle withholding taxes.  I would not expect auditors to take a view that shares netted to cover the exercise price alone would taint the accounting. 

Mark, good, I think we are violently agreeing thenSmile

There is an important distinction between settling net of the exercise price, and settling net of the taxes.

If the company issues fewer shares to the employee and then pays the employee's withholding taxes, then effectively the option is being partly equity-settled and partly cash-settled. There will be an incremental accounting cost for the cash-settled portion under IFRS 2.

What I see companies doing is to issue shares equal in value to the gain, net of the exercise price, and then sell sufficient of those shares to cover the withholding taxes.

This should not have any additional accounting cost - but speak to the auditors first!

Aidan and Mark:

Thanks for this lively discussion.  The UK is leading the pack in many areas of share-based compensation.  I look forward to more information coming in from UK experts.

This type of combined net-settled / shares sold transaction can work very well.  I have seen it in both RSU and RSA plans, and, for a while in the late 1990's, some option plans.

Additional problems is dealing with exercise timing and employee education. Since most companies have reduced education budgets to practically nil and most resources on exercise timing are written by brokers, plan participants are at an extreme disadvantage when it comes to information.

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