Photo by Bill Selak.
When a company decides to offer equity compensation in lieu of cash in order to align the interests of the shareholders with those executives/employees, it has to make some choices.
It must choose to grant either Employee Stock Options (or Stock Appreciation Rights which are hybrid ESOs) or Restricted Stock (or Restricted Stock Units, which are hybrid Restricted Stock). Or it may decide to issue both types. In some cases, the company allows the executive or employees to choose between the two. The decision to be made as to which to use must be done with the following in mind:
- Taxes: What are the tax consequences to the grantee and the company/grantor?
- Value: What are the values of each type of equity compensation?
- Risk: What are the risks to the grantee of losing that value?
- Potential Gain: What is the chance of a large gain for the grantees?
- Cash Flows: What type generates the largest and quickest cash flows to the company?
- Earnings: Which type causes the largest potential and more probable dilution of earnings?
- Interest Alignment: Which type does the best job of aligning the interests of the shareholders with the interests of the employees or executives?
Taxes
Employee Stock Options: Benefits to the grantees and to the company.
Tax benefits to the grantee:
No taxes are assessed to the grantee on the day of grant as the ESOs are generally considered to not have a readily ascertainable value and therefore pursuant to Section 83 b) and e) IRC are not taxable until they do.
Taxes are assessed upon the grantee holding non-qualified ESOs (NQESOs) when and if he/she exercises the NQESOs. Generally, the taxable income is compensation income equal to the “intrinsic value” (i.e. the difference between the exercise price and the market value of the stock on the day of exercise) of the NQESOs when exercised, although taxes can be delayed under some conditions.
In the case of Qualified ESOs (ISOs), if there have been no disqualifying dispositions, the “intrinsic value” is long term capital gain. However, the AMT comes into play and diminishes the ISOs tax advantage somewhat.
Tax benefits to the company:
Nothing can be deducted from the company’s income for tax purposes on the day of grant. In the case of NQESOs, the “intrinsic value” of the NQESOs when exercised is a deduction against the company’s income for tax purposes. In the case of ISOs, there is no deduction by the company, assuming no disqualifying dispositions are made. If there is a disqualifying disposition, then the ISOs are treated as NQESOs for taxes to the grantee and deductions for the employer.
The tax effects to the grantee and the company for SARs is exactly the same as for NQESOs.
Restricted Stock (and RSU): Benefits to the grantees and to the company.
Tax benefits to the grantee:
No taxes are assessed to the grantee at grant. Taxes are assessed when the Restricted Sock vests as they are now transferable or not subject to risk of forfeiture, Section 83 b) IRC. The taxable income generally equals the value of the Restricted Stock when the Restricted Stock or RSUs vests.
Tax benefits to the company:
The company generally takes a tax deduction when the Restricted Stock (or RSUs) vests and are transferable or are not subject to a substantial risk of forfeiture, Section 83 b) IRC.
The deduction equals the “fair market value” of the Restricted Stock when it vests and becomes transferable or is not subject to a substantial risk of forfeiture. Section 83 b).
Summary of taxes:
- No taxes when ESOs, SARs, RSs, or RSUs are granted. No company deductions when granted.
- Taxes for ESOs occur when exercised subsequent to vesting. Company gets a deduction against taxes when exercise is made in the case of NQESOs. Taxes for Restricted Stock (or RSUs) are generally assessed to grantee at vesting and deductible by the company at vesting.
- Therefore the grantee is taxed earlier for Restricted Stock (or Restricted Stock Units) than for grantee holding ESOs (or SARs) and the company gets tax deductions earlier with Restricted Stock (or Restricted Stock Units).
- This works to the advantage of the grantee holding employee stock options because he/she can delay taxes for up to 10 years after the grant, whereas with Restricted Stock are taxed at vesting.
Values of Grants
Employee stock options and SARS can be valued and must be valued using theoretical pricing models if the company wants to report GAAP earnings. The values depend on such factors as the exercise price relative to the current market price, the expected volatility, the expected time to expiration, the expected risk free interest rates, and the expected dividends.
The value of the employee stock options at grant day can equal anywhere from 25% to 70% of the value of the underlying stock. A reasonable value may be 40% of the underlying stock. When that is the case, a grant of ESOs or SARs to buy 250 shares has a value of about 100 shares of tradable stock or perhaps 105 shares of Restricted Stock or Restricted Stock units, because the Restricted Stock on grant day has a value discounted at about 5% to tradable stock.
The value of the grants perceived by the grantee, especially with regard to ESOs (or SARs) may be far different than the value allocated to theoretical costs to the company. This is so because companies tend to under-value the ESOs at grant day, and the expected time to expiration of the ESOs may vary considerably in the estimation of each individual.
Risks to Grantees
Generally there are vesting periods that must be served out prior to actually owning the ESOs, ISOs, SARs, RSs, or RSUs. There is always the risk that the grantee will not achieve that vesting and therefore never own the granted equity value and lose it all.
Another risk, in the case of ESOs and SARs, is that the stock is lower or unchanged from its exercise price on expiration day and the grantee will receive nothing. The probability of that event is about 40% to 55% depending on the volatility of the stock and the assumed expected return.
On the other hand, with RSs or RSUs, if the stock in lower or unchanged years after the grant, the grantee will probably get a large part of the grant day value. So the risk of losing the grant day value is less with RSs and RSUs than with ESOs and SARs.
Potential Gain
When the Employee Stock Options are granted, the number might be 250% more granted than shares of Restricted Stock would have been granted.
Therefore if the stock advances 300% after 5 or 6 years from the day of grant, the value of the 250 ESOs would be far more than 100 shares of Restricted Stock, especially when considering the fact that the Restricted Share grantee must pay a tax on the day of vesting (after 1-4 years), which is usually covered by selling sufficient shares. So the ESOs have more potential gain than the same valued RSs on the day of grant.
Cash Flows
A consideration that companies make when granting equity compensation is the possibly future cash flows to the company, although it is seldom mentioned by the company executives at the time of the grants.
When ESOs are exercised, the exercise price is paid to the company by the grantee and the company issues new shares. The company also gets a tax credit from deducting the “intrinsic value”. These two cash flows are often a large percentage of the total company cash flows. A good article on this point can be found here.
These credits are partly the reason of why the companies and wealth managers encourage early exercises of ESOs and discourage hedging which delays the cash flows.
When RSs vest, the only flow to the company is the credit of the tax deduction, but it comes sooner than with ESOs. It comes when the RSs vest, whereas the tax credit from ESOs comes when they are later exercised after the vesting.
In the case of SARs and RSUs, the companies can choose to avoid dilution and forfeit the cash flow credits by settling the exercise or vesting by a cash payment without issuing new stock.
In the Case of ISOs, which have not had a disqualifying disposition, the “intrinsic value” is not deductible by the company but the company does issue new shares, which does create a new cash flow.
Probable Dilution of Earnings
The grants of RSs have a quite large probability of causing dilution of earnings, because no matter where the stock is trading, the RSs will be owned by the grantee after vesting and the number of shares increase, whereas, there is a good chance that the ESOs (or SARs) are never exercised because there is a chance that the stock will be trading below the exercise price near expiration. There is also a chance that the grantee never becomes vested for the ESOs.
However, if the stock advances a reasonable amount, the dilution will be grater with ESOs because more ESOs are granted relative to the number of RSs that are granted, if equal valued grants are sought. Of course, if the companies grant RSUs or SARs, they can design the grants so that they “intrinsic value” is paid in cash and there is no dilution. But that reduces the cash flow and cash positions.
Alignment of Interests
Which type of grant best preserves the alignment of interests between the grantee and the shareholders? After all, that is the major purpose of the compensation plan.
In the case of RSs, most grantees generally sell their unrestricted shares immediately after vesting to pay the tax liability and lock in their profits on the remaining shares, although some plans require that a part of the stock be held for years after vesting. Of course, the sale of the shares eliminate any alignment that may exist from holding those shares. So with RSs, there is usually an early termination of the alignment of interests as the shares are sold immediately after vesting.
But with ESOs, especially with ISOs there is generally a longer term of alignment of interests, as any informed grantees should hold their ESOs and ISOs for long periods of time after vesting.
For example famous CEOs like Steve Jobs of Apple, James Dimon of J.P. Morgan, Larry Ellison of Oracle and John Chambers of Cisco (and increasingly more CEOs) all held and are holding their ESOs till near expiration, thereby extracting maximum value from the grants.
Summary
There are many considerations to make when deciding on which type of grants to make. Today we see some very sophisticated companies issuing combination of grants trying to grant the highest value both real and perceived to the grantees for the lowest costs to the grantor company.
With the above in mind, I have created a new type of ESOs, which is designed to increase the positive benefits to the grantee while at the same time enhancing the objectives of the grants and keeping the costs to the grantor modest. It also allows the wealth managers a way to efficiently manage their clients ESOs and get assets under management called Dynamic Employee Stock Options (DESOs).
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There is a conference scheduled for April 30, 2012 at the BioInnovation Center featuring some of the world’s foremost experts on equity compensation, where topics similar to the above and much more will be presented by Optrack. Click here for more information or to register.