MEMO TO THE BOARD OF DIRECTORS:
With the advent of new FAS 123(Revised) (herein, “FAS123(R)”), this memo will point out some items for the Board to consider in transitioning to FAS 123(R) and in granting future incentives:
Requirement for Compliance
- FAS 123(R) is the Financial Accounting Standards Board statement on sharebased payments and addresses expensing stock options and other equity awards to an entity’s employees.
- Due to a recent SEC change, FAS 123(R) becomes effective the start of a public company’s fiscal year after June 15, 2005.
- For private companies, FAS 123(R) becomes effective for fiscal years beginning after December 15, 2005.
Choice of Model
- Binomial Lattice models (vs. the Black-Scholes model) will likely result in lower values for stock options because of its flexibility to more easily reflect a particular company’s situation.
- Binomial Lattice models, unlike Black-Scholes, allow a company to model such things as stock volatility, black-out periods and forfeiture rate by year, which could be significant for some companies.
- Customizing a basic binomial model to handle real world demographic and behavioral assumptions requires more training than a basic Black-Scholes model.
- In most cases the money saved using the Binomial Lattice model more than compensates for any increased expense due to the additional complexity of the model.
How Modeling Impacts Value of Options
- Key variables of lattice models are: time to maturity, dividend yield, share price volatility based on future expectations, vesting period, forfeiture rates, blackout periods, and the choice of the optimal number of lattice steps.
- Boards should familiarize themselves with how key variables affect the stock option value, and adjust stock option grants and valuation methodologies appropriately.
For example:
1) Stock option value can be decreased by reducing the vesting schedule and/or the term of the option from the standard 10 years to 5 or 7 years.
2) The higher the forfeiture rate for a stock option, the lower the stock option value. The board should consider performance based vesting such as revenue or EBITDA growth, versus time-based vesting requirements, as this would have the effect of increasing forfeiture rates.
3) Blackout periods are the dates on which employee stock options cannot be executed, usually several weeks before and after an earnings announcement. If blackout periods occur frequently throughout the year, the option price can be decreased by as much as 25%.
4) Stock volatility is one of the most difficult input parameters to estimate. Care must be taken to use the correct period if using historical stock prices to calculate future volatility. Also the volatility must be annualized.
5) The choice of the optimal number of lattice steps is crucial in obtaining a valid options valuation result. Typically, the minimum number of lattice steps to obtain convergence is 1,000.
Use of Performance Criteria with Awards
- FASB Statement No. 123(R) no longer requires variable accounting treatment for performance based vesting, as the valuation is made at grant date, not when the condition has been met.
- Because of this, vesting may be performance based or service based or both, and, regardless, options must be valued and expensed as of grant date.
- Boards have more flexibility in assigning certain performance criteria to stock option grants without the worry of having to deal with variable accounting and the resulting earnings fluctuations that this can cause.
Accelerated Vesting
- If existing stock options are considerably “out-of-the-money”, many boards are voting to accelerate the vesting of these options to avoid recognizing future compensation expense associated with these options upon adoption of FAS 123R.
- Acceleration of these options prior to implementing FAS123R simply requires a new measurement date for the options, and, because they are “out-of-themoney,” no compensation expense is recorded.
Tax Considerations
- One of the most significant differences between APB 25 and FAS 123(R) is where windfall tax benefits will now be displayed.
- A windfall tax benefit is created if the deduction for tax purposes exceeds the compensation cost recognized in the income statement.
- Under the new statement, windfall tax benefits will now be displayed in the financing section of the cash flow statement, not in the operating section. Companies should consider if this will have an effect on existing bank covenants, which may be based on operating cash flows, as well as consider the effect on cash flow forecasts.
Record Keeping
FAS 123(R) requires that entities maintain income tax data by award, option holder, country, and vesting tranche so that the appropriate accounting entries can be recorded.
Typically, existing stock option accounting systems do not maintain this data. The costs associated with this maintenance could be significant for entities with extensive and complex equity compensation plans.
Employee Stock Purchase Plan (ESPP)
- Boards may wish to reconsider the continued viability of some employee stock purchase plans (ESPP’s).
- Under FAS 123R, if the provisions for ESPPs do not meet the following three conditions, the cost to acquire shares (over the employee’s contributions) will need to be expensed:
1) The purchase price is not discounted more than 5% of the fair market value on the purchase date (Note that the Internal Revenue Code allows a greater (15%) discount. )
2) There is no look-back provision in the plan (meaning that the shares are acquired based on the lowest price looking back over a certain time period, usually 2 years), and
3) The plan is broad based within the organization (meaning that all employees are eligible). Boards should consider changing provisions to meet these conditions.
Vesting Requirements
- If vesting requirements are based on time or performance, a company may adjust the original recognized expense if the actual cost is different than what was originally recorded.
- If vesting requirements are based on external market factors (stock price), the company may not adjust the recognized expense if costs are different.
Additionally, with the advent of new provisions of the Internal Revenue Code enacted by the American Jobs Creation Act of 2004 which impact “nonqualified deferred compensation plans,” here are some other items for the Board to consider in granting or changing future stock incentive awards:
No Options or SARs with Exercise Price Less Than FMV
Any option or stock appreciation right which is granted that has an exercise price that is less than the fair market value of the underlying stock will most likely be subject to harsh income tax consequences.
FMV Determinations
- Because of the additional importance of whether an option or stock appreciation right has an exercise price that is at least equal to the fair market value of the underlying stock, Boards will have to reconsider their mechanics for valuing company stock.
- For a non-publicly traded company, proposed regulations issued under the new tax law require that such mechanics include the use of an independent appraiser or a person with significant knowledge and experience or training in performing valuations.
No Options and SARS On Preferred Stock
- Stock options and stock appreciation rights based on preferred stock will subject the recipient to immediate income taxation plus an additional 20% tax.
Modification of Outstanding Awards
- Any change to an existing option or stock appreciation right award may result in the award being subject to immediate income taxation plus an additional 20% tax unless the exercise price of the award remains at least equal to the fair market value of the underlying stock subject to the award.
- Also, except for certain specific exceptions, any change which is an extension or renewal of an option or a stock appreciation right may subject the award to immediate income taxation plus an additional 20% tax.
- These changes may result in a new measurement date for existing options and stock appreciation rights as well under new FAS 123(R).
No Deferral Features with Awards
Any award which provides for a deferral feature may subject the award to immediate income taxation plus an additional 20% tax.
