Help! Our stock options are underwater – Part 1 of a new series - 12 Mar 2009
Help! Our stock options are underwater – Part 1 of a new series from JP Morgan
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Mar
12,
2009
In this new article series, we look at the difficulties of using stock
options for rewarding employee performance during a bear market. In
today's economic climate, most stock options that have been granted to
employees in the last few years have little if any value. In this
series, we will examine these "underwater" options, looking at the
good, the bad and the ugly. We begin with a refresher on the concept of
stock options generally in this article.
Stock options have been around as a tool for
rewarding employees, particularly executives, for many years. One can
argue why they are an appropriate form of compensation, or conversely,
why they are not. The 1990s saw an unprecedented use of stock options
as a sometimes primary means of compensating employees. As the stock
market ran upwards, options were all the rage in Silicon Valley and
were quite popular in other parts of the country.
While this phenomenon produced significant amounts
of wealth in that decade, stock performance generally has not been as
positive in this one. In fact, employees whose compensation is heavily
weighted to stock options are feeling underpaid. Why? Generally those
options are now “underwater.” Or, in plain English, for most of those
stock options, if an employee were to exercise them, he would lose
money.
One of the arguments in favor of compensating
employees, and especially executives, with stock-based compensation
such as options is that this aligns employee behavior with shareholder
interests. That is, if the value of company stock goes up, both
shareholders and employees who hold options are winners. However, when
the value of company stock goes down, while shareholders are certainly
losers, one could argue that since the employees have lost nothing, the
alignment of interests has ceased to exist.
In this series, we will explore the issues with
underwater options, looking at the good, the bad and the ugly. But,
before we get too far into any of that, it is worth a refresher on
stock options. What are they? How do they work? How much are they worth
and how do we know this? In this article, we’ll try to answer those
questions and a few more.
Types of employee stock options
In its most basic form, an option that is granted
to an employee gives him the right to purchase a stipulated quantity of
shares of company stock at some point in the future (or perhaps over a
period of time) at a specified price (without regard to the actual fair
market value of the stock). That price is often known as the strike
price or exercise price. Sometimes the strike price is set lower than
the market price of the stock on the day that the option is granted.
Such an option is known as a discounted option.
Employee stock options might fall into four broad categories:
employee stock purchase plans (ESPPs or 423 plans)
nonqualified employee stock purchase plans (non-ESPPs or non-423 plans)
incentive stock options
nonqualified stock options
ESPPs are described in Code section 423, thus one
of their alternate names. In a nutshell, options are granted to a broad
group of employees. These options may carry with them as much as a 15%
discount (there are some quirks in the rules that allow the discount to
be based on any of a few prices). Options under a 423 plan are limited
to $25,000 per year. Typically, these options are purchased through a
payroll deduction arrangement where employees have their compensation
reduced (after-tax money) by an amount which will be used to purchase
shares of company stock on the exercise date (often three or six months
out). ESPPs are eligible for favorable tax treatment for the employee
if they meet certain criteria, and favorable accounting treatment for
the employer if they meet certain other criteria. We’ll address those
treatments in a future article.
Non-ESPPs are similar to ESPPs, but they differ
not surprisingly in that they fail to meet at least one of the criteria
required of ESPPs. For example, they might not be offered to a broad
enough group of employees, or the discount on the options may be too
steep. Non-ESPPs do not provide the same favorable tax treatment for
employees. Similarly, they may not provide the same favorable
accounting treatment for employers.
Incentive (or qualified) stock options (ISOs) are
described in Code section 422. There are two key characteristics (ISOs
have other requirements, but we will limit to these two in this
article) in order for these options to be classified as ISOs:
Grants that are first exercisable by any individual during any calendar year are limited to $100,000 per person.
The options are not discounted.
ISOs generally are eligible for favorable
accounting treatment for the issuing employer and for favorable tax
treatment for the employees who receive the grants (again, we will
discuss tax and accounting treatment in later articles).
All other employee stock option plans are
nonqualified options. In general, these have the least favorable tax
treatment for employees and the least favorable accounting treatment
for employers. However, while heavily discounted options are far less
prevalent now than they once were, employees who benefit from heavily
discounted options will appreciate the high income potential and are
therefore less concerned that they will be taxed at ordinary income tax
rates.