Stock Options 101: Restricted Stock Vs. Dynamic Employee Stock Options

Comparing the alignment costs of Restricted Stock with alignment costs of Dynamic Employee Stock Options.

The purpose of this article is to explain what the costs are of aligning the interests of employees and executives with the shareholders.

Assume 1000 plain restricted stock, and 2500 Dynamic ESOs are granted when the stock is trading for $40 making the exercise price $40 for the Dynamic Employee Stock Options.

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Dynamic ESOs are traditional ESOs where the only difference is the remaining “time value” is not forfeited at exercise but is returned to the exercising grantee in the form of new ESOs with a value equal to the otherwise forfeited “time value”. These new ESOs have an exercise price equal to the current stock price, a 3 year vesting period and 10 years maximum contractual life.

Assume that the vesting period is 3 years for the two grants and the maximum time to expiration of the DESOs is 10 years. It is assumed that DESOs are exercised and the stock sold with the stock $50 or higher. Expected volatility is .33 and there are no expected dividends.

Column 5 illustrates the approximate “time value” remaining before exercise and at exercise (which is returned to the holder of DESOs in the form of new ESOs). The alignment still exists after 3 years of vesting with DESO but ends at vesting with Restricted stock as any stock received from Restricted stock is sold.

The matrix above illustrates that actual costs for 3 years alignment is far greater for Restricted Stock unless the stock has advanced more than 62% upon 3 years vesting which has a probability of 23%. The remaining “time value” gives new options which aligns interests beyond 3 years.

For example:

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There is a 47% probability that the stock will be below $40 making the costs of 3 years of alignment far greater with Restricted Stock and RSUs than with DESOs.

There is a 26% probability that the stock will be between $40 and $60 making the cost of the 3 year alignment  for Restricted Stock between $10,000 and $40,000 greater than the costs of alignment  of the Dynamic ESOs.

There is only a 21% probability that the 3 year alignment costs will be less for RS than DESOs.

If the vesting period was 4 years, then the Alignment costs would be the same for the 4 years (but less per year) but the Remaining “time value” in Column 5 would be less. The probabilities in column 6 would be different with the higher stock prices more probable.

If the Restricted Stock had performance requirements that would delay vesting or eliminate the vesting in whole or part, the expected cost for the alignment of RS with the shareholders would be less. How much less depends on the probability of attainment of the performance requirements.

If the grantees were IRC Section 162(m) “covered” executives,  with more than $1 million annual compensation, then the amounts in column 2 would not be tax deductible and therefore much more costly (70-80%) than for non “covered” grantees.

It may be noted that the IRS has rejected back-dated ESOs from deductions over $1 million for “covered” executives, under the view that the in-the-money amounts precluded the compliance with 162(m) to get the deduction. It seems likely that the same reasoning should apply to spring loaded ESOs.

And Restricted Stocks are very similar to ESOs with very low exercise prices (i.e. where the stock is trading far above the exercise price on the day of the grant). So why aren’t Restricted Stocks treated just like back-dated ESOs, which were granted when the stock was above the exercise price?

In consideration of the above, it is easy to understand why executives like Restricted Stock and RSUs, whether they are performance based or not. Their alignment payments are far more than with ESOs or DESOs. But, in my view, it is unlikely that Compensation Committees and Directors actually understand the much higher alignment costs of RS, RSUs compared with traditional ESOs or Dynamic DESOs.