Grant Thornton - Underwater Equity Newsletter - Feb 2009

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Insight
on executive compensation plan design and strategy from

Grant Thornton LLP's compensation and benefits professionals

Underwater
options:

How the economy is drowning
compensation packages and what companies can do about it

By Don Nemerov and Kevin McLaren, Chicago



Stock prices have been battered by the slumping economy, leaving option awards
underwater and companies struggling to find new ways to retain top talent.



Over the last decade, equity awards like stock options, restricted stock units
and performance shares have played a significant role in the compensation
strategies of many companies. However, the past year has brought a dramatic fall
in stock prices to, in many cases, record lows. This economic downturn has left
many employees holding equity awards with no current value and little potential
for value in the foreseeable future.



Option awards often take the biggest hit of all forms of compensation in a
downturn. Employees will always realize value from a restricted stock grant, and
they often have direct control over potential value gained from performance
share awards. However, realizing a gain from an option award is not always
certain. When the value of the stock drops below the option’s exercise price,
the award is “underwater,” effectively worth nothing. Some awards may be so far
underwater in the current economic climate that it is unlikely that share prices
will ever rise enough to restore any value to the options before the options
expire. This can have a significant negative impact on a company that is
striving to retain and motivate its key employees. Thus, a revitalized
compensation strategy is critical to addressing these issues.



What can companies do?

Companies can take a variety of approaches in addressing underwater options. The
most common approaches are exchanges in the form of options-for-options,
options-for-stock (restricted stock or restricted stock units) or
options-for-cash. These approaches, along with their advantages and
disadvantages, are summarized in the table below.

In any option exchange or re-pricing, companies should consider the effects on
both internal and external stakeholders. Important considerations include the
financial accounting cost of the exchange, employee personal tax impact, and the
reactions of shareholders and employees to the exchange. Each type of exchange
has advantages and disadvantages, as depicted in the chart above. A re-grant of
new options leaves employees in control of the timing of taxation, but may not
be well received by employees who had earlier awards that went underwater. An
exchange of options for restricted stock rather than for new options would
eliminate the potential for underwater options, but removes the upside of stock
options and takes the control over the timing of taxation out of the hands of
employees. An exchange of options for cash provides the immediate value to
employees, but requires cash from the employer in a potentially difficult time
and lacks retention value unless there is a vesting program.



A thoughtful approach will balance these considerations and result in a
well-designed program. Exchange program considerations include:

• 
  

  Which option holders should be
  eligible to exchange their options?
  

  
  


• 
  

  Which options should be eligible
  for exchange?
  

  
  


• 
  

  Should the vesting terms of the
  new awards change?
  

  
  


• 
  

  If options are exchanged for
  stock, how many options should be exchanged for one share of stock?
  
  

  
  

In cases where shareholders may view a re-pricing or
exchange in a favorable manner, a company may begin the process by suppressing
the potential shareholder criticism. By considering the potential views of
shareholders, the company may better achieve a balanced approach. The table
below lists possible shareholder views.

Companies should also consider the signals an option re-pricing or exchange may
send to the market and how it could adversely affect an already depressed stock
price. For example, suppose a firm makes options with an exercise price of $15
or greater eligible for exchange. If the company’s stock is trading at $10, the
market may feel that the firm does not believe it is able to achieve a value of
more than $15 in the near future. Thus, selecting the exercise price is a key
decision.



Accounting treatment

Tendering underwater options for a replacement award or cash is considered a
modification under FAS 123R. If the fair value of the new award exceeds that of
the old award at the modification date, the company must recognize additional
compensation cost. The modification valuation of the old award is based on
current option valuation assumptions, which are measured immediately before the
modification (i.e., exchange date). The additional compensation expense
recognized is equal to the difference between the modified value of the new
grant and the modified value of the old award.



Final thoughts

Equity incentive practices have changed dramatically over the past few years and
will continue to do so going forward. The expensing of options for financial
statement purposes and other factors, such as share dilution, have been
significant drivers. These are important, but retaining top talent may be more
important now than ever. A compelling case exists for addressing underwater
options, especially with the current economic downturn.

***

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The information contained herein is general in nature and is based on
authorities that are subject to change. It is not, and should not be construed
as, accounting, legal or tax advice or opinion provided by Grant Thornton LLP to
the reader. This material may not be applicable to, or suitable for, specific
circumstances or needs, and may require consideration of non-tax factors and tax
factors not described herein. Contact Grant Thornton LLP or other tax
professionals prior to taking any action based upon this information. Changes in
tax laws or other factors could affect, on a prospective or retroactive basis,
the information contained herein; Grant Thornton LLP assumes no obligation to
inform the reader of any such changes. All references to “Section,” “Sec.,” or
“§” refer to the Internal Revenue Code of 1986, as amended.

Questions?

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information on how you can benefit from our services, contact:

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Patricia Hale Botoff, Senior Manager, Atlanta


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Jim Gandurski, Manager, Chicago

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