Shifting Options: Recent Developments Affecting Equity-Based Compensation

Wednesday, December 1, 2004 - 00:00

Two developments announced this year could impact how companies, including portfolio companies of private equity sponsors, structure equity-based compensation for their management teams. First, the Financial Accounting Standards Board ("FASB") has proposed mandatory expensing of stock options. Second, Congress enacted the American Jobs Creation Act of 2004 (the "Act") which significantly affects deferred compensation arrangements, including deferred compensation arrangements tied to changes in a company's equity value. Private equity sponsors should ensure that the boards and compensation committees of their portfolio companies review how they structure equity-based compensation in light of these developments.

Mandatory Expensing Of Stock Options

Background

In March of this year the FASB published an Exposure Draft of a proposed amendment to FASB Statements 123 and 95. This proposed amendment would require companies to expense the full fair market value of stock options at the date of grant (the so-called "fair-value-based" method) rather than the prevailing practice of only charging compensation expense at the date of grant to the extent the exercise price of options is lower than the then fair market value of the underlying stock (the so-called "intrinsic value" method). Currently, FASB Statement 123 allows companies to record compensation for stock options on the fair-value-based method. Over the past couple of years, an increasing number of U.S. companies have adopted the fair-value-based method and the International Accounting Standards Board has recently mandated the fair-value-based method for non-U.S. companies. Adoption of the fair-value-based method by companies currently using the intrinsic value method will likely result in such companies reporting lower EBITDA as a result of the compensation expense associated with stock option grants. This would have the greatest impact on those companies granting relatively large numbers of stock options, as has historically been the case for many high-tech companies.

Despite opposition from many industry participants and members of Congress, the FASB appears determined to adopt the proposed amendment and has recently directed its staff to draft final rules implementing the proposed changes. Unless mandatory expensing of options is blocked by Congress, it appears likely that the proposed amendment will take effect next year. The FASB made several decisions recently regarding the effective date for the new rules. Mandatory expensing of stock options by public companies would commence on a "modified prospective" basis for quarterly reporting periods beginning after June 15, 2005 and for annual reports including those affected quarters. Depending on a company's fiscal year end, the proposed new effective date would result in either a 3 to 6 month deferral of the new rules from the FASB's original proposal of fiscal years beginning after December 15, 2004. Mandatory expensing of stock options by non-public companies and "small business issuers" would become effective on a "prospective basis" for fiscal years beginning after December 15, 2005 (the same as the original proposal).

Proposed Modifications

The proposed amendment to FASB Statement 123 would require both public companies and non-public companies to account for stock options using the fair-value-based method. The expense would be spread over the vesting schedule of the underlying stock options. Companies would also be required to record as compensation expense any discount offered to employees under employee stock purchase plans.

The Exposure Draft does not require any particular method of valuing stock options on the date of grant. It does require that any method used, however, take the following items into account: (1) exercise price, (2) term of the option, (3) current value of the underlying stock, (4) expected volatility of the underlying stock, (5) expected dividends on the underlying stock and (6) interest rates. Non-public companies that are unable to calculate fair value of stock options due to an inability to determine volatility would be instructed to calculate fair value using the historical volatility of an appropriate industry index (as opposed to a broad market index) as an input to the option pricing model and to disclose the index and how it was selected.

Public companies would have to record compensation expense for stock options granted, modified or settled after the effective date described above. In addition, public companies would have to record compensation expense (as the options vest) for the unvested portion of previously granted awards that remain outstanding at the date of adoption.

Non-public companies would have to record compensation expense for stock options granted, modified or settled after the effective date described above, but will not have to record compensation expense for previously outstanding options that are unvested at the effective date.

Equity-Based Compensation Under The Act

The American Jobs Creation Action of 2004 contains significant new tax rules impacting deferred compensation arrangements. The Act generally applies to all nonqualified deferred compensation plans, which are broadly defined to include any deferrals of base compensation and bonus (mandatory or elective), as well as supplemental executive retirement plans, discounted stock options, phantom stock plans, restricted stock units, stock appreciation rights and similar arrangements. The Act is effective for amounts deferred after December 31, 2004. The new rules generally do not apply to deferrals made before January 1, 2005 or any earnings on those deferrals credited before or after that date unless the plan is modified. The legislative history indicates that the grandfather provision described above will only apply to deferred compensation earned and vested before that date. Given these effective date provisions, the new rules could possibly have retroactive effect in the case of outstanding awards which as of the effective date remain unvested.

The new statutory restrictions imposed by the Act will curtail several common practices, including (i) late elections made by participants to defer their compensation; (ii) changing scheduled payment dates and permitting early distributions of deferred compensation; (iii) discretionary exercise of discount stock options and certain other equity-based incentive arrangements and (iv) the use of certain mechanisms to segregate and protect executive deferred compensation from creditors. The United States Treasury has not yet issued regulations implementing the Act and until such regulations are issued the impact of many of the provisions of the Act will not be clear.

The Act will directly impact the use of certain types of equity-based compensation, including the following:



Stock Options: The Act would tax vested options which were granted with an exercise price less than fair market value on the date of grant and which are exercisable at the holder's discretion. This new rule will likely have a more significant impact on private companies because public companies generally grant stock options with an exercise price equal to fair market value. As a result, private companies will need to ensure that they have appropriate valuation procedures in place to ensure that options are properly valued at the time of each grant. The Act does not specify what valuation procedures may be utilized to determine the appropriate exercise price for options of private companies and it is not clear at this time what methodologies or standards the Treasury will require. The failure to properly determine the fair market value of the stock underlying options could give rise to immediate taxation, penalties and interest for the option holders.



Stock Appreciation Rights: The Act appears to classify stock appreciation rights ("SARs") as a form of deferred compensation. If SARs are ultimately covered under the Act, then the Act would require SARs to be taxable when they vest and are exercisable. Employees would no longer be able to determine when to exercise an SAR without being currently taxed on the incremental value each year.



Deferral of Equity-Based Compensation: The Act's new timing requirements make deferral of equity compensation impractical. For example, elections to defer payment of SARs or restricted stock units will have to be made at least twelve months in advance of the scheduled payment and be deferred for at least five years from the previously scheduled payment date. The rules would equally apply to the deferral of any gains on the exercise of stock options.

The Act also imposes a number of additional requirements on deferred compensation which are beyond the scope of this article.

Impact On Private Equity Sponsors And Portfolio Companies

Private equity sponsors and their portfolio companies should review existing executive compensation arrangements to determine how they may be impacted by the new option expensing and deferred compensation rules and how they should structure equity-based compensation arrangements going forward.

In light of the FASB proposal, stock options will likely become less attractive over time due to the adverse impact on a portfolio company's EBITDA. However, the current alternatives to stock options for incentivizing management have limitations as well. Restricted stock has certain tax advantages in that the appreciation in value of the stock can be taxed as capital gains rather than ordinary income. However, such stock must be paid for at fair market value in order not to create current income and many managers either do not have the resources to pay for the stock or are reluctant to put a substantial portion of their assets at risk to a drop in value of the stock. The Sarbanes-Oxley Act has also limited the flexibility for many companies to loan management the funds needed to purchase restricted stock, which further complicates the restricted stock alternative. SARs are also an alternative to options and restricted stock but they create variable accounting issues for portfolio companies. Moreover, SARs are taxable as ordinary income to participants and it appears would have to be structured differently from traditional SARs (i.e., to include a fixed payment/exercise date (e.g., termination of employment)) to avoid taxation and penalties under the Act.

As the FASB proposal has not yet been implemented and regulations have not yet issued under the Act, it is difficult at this point to predict precisely what impact these changes will have on how management compensation arrangements are structured. Private equity firms should be cognizant of the upcoming changes, however, because of the potential impact on management incentives and their portfolio companies' financial statements.

Steven M. Peck is a Partner in the Boston office of Weil, Gotshal & Manges. His practice is focused on private equity execution and administration, mergers and acquisitions, and securities law. Kevin J. Sullivan is a Senior Associate in the same office.

Please email the authors at steven.peck@weil.com and kevin.sullivan@weil.com with questions about this article.