Question

If you were on the Board of Directors for a publicly traded company, what type of share-based compensation (Stock options, RSU’s, SAR’s, etc.) would you choose as part of your executive compensation packages and why?

Answer 1

Answer There are five basic kinds of individual equity compensation plans: stock options, restricted stock and restricted stock units, stock appreciation rights, phantom stock, and employee stock purchase plans. Each kind of plan provides employees with some special consideration in price or terms.

Stock options give employees the right to buy a number of shares at a price fixed at grant for a defined number of years into the future. Restricted stock and its close relative restricted stock units (RSUs) give employees the right to acquire or receive shares, by gift or purchase, once certain restrictions, such as working a certain number of years or meeting a performance target, are met. Phantom stock pays a future cash bonus equal to the value of a certain number of shares. Stock appreciation rights (SARs) provide the right to the increase in the value of a designated number of shares, paid in cash or shares. Employee stock purchase plans (ESPPs) provide employees the right to purchase company shares, usually at a discount.

Stock Options

A few key concepts help define how stock options work:

Exercise: The purchase of stock pursuant to an option.

Exercise price: The price at which the stock can be purchased. This is also called the strike price or grant price. In most plans, the exercise price is the fair market value of the stock at the time the grant is made.

Spread: The difference between the exercise price and the market value of the stock at the time of exercise.

Option term: The length of time the employee can hold the option before it expires.

Vesting: The requirement that must be met in order to have the right to exercise the option-usually continuation of service for a specific period of time or the meeting of a performance goal.

Kinds of Options

Options are either incentive stock options (ISOs) or nonqualified stock options (NSOs), which are sometimes referred to as nonstatutory stock options. When an employee exercises an NSO, the spread on exercise is taxable to the employee as ordinary income, even if the shares are not yet sold. A corresponding amount is deductible by the company. There is no legally required holding period for the shares after exercise, although the company may impose one. Any subsequent gain or loss on the shares after exercise is taxed as a capital gain or loss when the optionee sells the shares.

An ISO enables an employee to (1) defer taxation on the option from the date of exercise until the date of sale of the underlying shares, and (2) pay taxes on his or her entire gain at capital gains rates, rather than ordinary income tax rates. Certain conditions must be met to qualify for ISO treatment:

The employee must hold the stock for at least one year after the exercise date and for two years after the grant date.

The exercise price must not be less than the market price of the company's stock on the date of the grant.

Only employees can qualify for ISOs.

The option must be granted pursuant to a written plan that has been approved by shareholders and that specifies how many shares can be issued under the plan as ISOs and identifies the class of employees eligible to receive the options. Options must be granted within 10 years of the date of the board of directors' adoption of the plan.

The option must be exercised within 10 years of the date of grant.

If, at the time of grant, the employee owns more than 10% of the voting power of all outstanding stock of the company, the ISO exercise price must be at least 110% of the market value of the stock on that date and may not have a term of more than five years.

If all the rules for ISOs are met, then the eventual sale of the shares is called a "qualifying disposition," and the employee pays long-term capital gains tax on the total increase in value between the grant price and the sale price. The company does not take a tax deduction when there is a qualifying disposition.

If, however, there is a "disqualifying disposition," most often because the employee exercises and sells the shares before meeting the required holding periods, the spread on exercise is taxable to the employee at ordinary income tax rates. Any increase or decrease in the shares' value between exercise and sale is taxed at capital gains rates. In this instance, the company may deduct the spread on exercise.

Any time an employee exercises ISOs and does not sell the underlying shares by the end of the year, the spread on the option at exercise is a "preference item" for purposes of the alternative minimum tax (AMT). So even though the shares may not have been sold, the exercise requires the employee to add back the gain on exercise, along with other AMT preference items, to see whether an alternative minimum tax payment is due.

In contrast, NSOs can be issued to anyone-employees, directors, consultants, suppliers, customers, etc. There are no special tax benefits for NSOs, however. Like an ISO, there is no tax on the grant of the option, but when it is exercised, the spread between the grant and exercise price is taxable as ordinary income. The company receives a corresponding tax deduction. Note: if the exercise price of the NSO is less than fair market value, it is subject to the deferred compensation rules under Section 409A of the Internal Revenue Code and may be taxed at vesting and the option recipient subject to penalties.

Exercising an Option

There are several ways to exercise a stock option: by using cash to purchase the shares, by exchanging shares the optionee already owns (often called a stock swap), by working with a stock broker to do a same-day sale, or by executing a sell-to-cover transaction (these latter two are often called cashless exercises, although that term actually includes other exercise methods described here as well), which effectively provide that shares will be sold to cover the exercise price and possibly the taxes. Any one company, however, may provide for just one or two of these alternatives. Private companies do not offer same-day or sell-to-cover sales, and, not infrequently, restrict the exercise or sale of the shares acquired through exercise until the company is sold or goes public.

Restricted Stock

Restricted stock plans provide employees with the right to purchase shares at fair market value or a discount, or employees may receive shares at no cost. However, the shares employees acquire are not really theirs yet-they cannot take possession of them until specified restrictions lapse. Most commonly, the vesting restriction lapses if the employee continues to work for the company for a certain number of years, often three to five. Time-based restrictions may lapse all at once or gradually. Any restrictions could be imposed, however. The company could, for instance, restrict the shares until certain corporate, departmental, or individual performance goals are achieved. With restricted stock units (RSUs), employees do not actually receive shares until the restrictions lapse. In effect, RSUs are like phantom stock settled in shares instead of cash.

The employer gets a tax deduction only for amounts on which employees must pay income taxes, regardless of whether a Section 83(b) election is made. A Section 83(b) election carries some risk. If the employee makes the election and pays tax, but the restrictions never lapse, the employee does not get the taxes paid refunded, nor does the employee get the shares.

Restricted stock accounting parallels option accounting in most respects. If the only restriction is time-based vesting, companies account for restricted stock by first determining the total compensation cost at the time the award is made. However, no option pricing model is used. If the employee is simply given 1,000 restricted shares worth $10 per share, then a $10,000 cost is recognized. If the employee buys the shares at fair value, no charge is recorded; if there is a discount, that counts as a cost. The cost is then amortized over the period of vesting until the restrictions lapse. Because the accounting is based on the initial cost, companies with low share prices will find that a vesting requirement for the award means their accounting expense will be very low.

If vesting is contingent on performance, then the company estimates when the performance goal is likely to be achieved and recognizes the expense over the expected vesting period. If the performance condition is not based on stock price movements, the amount recognized is adjusted for awards that are not expected to vest or that never do vest; if it is based on stock price movements, it is not adjusted to reflect awards that aren't expected to or don't vest.

Restricted stock is not subject to the new deferred compensation plan rules, but RSUs are.

Stock appreciation rights (SARs) and phantom stock are very similar concepts. Both essentially are bonus plans that grant not stock but rather the right to receive an award based on the value of the company's stock, hence the terms "appreciation rights" and "phantom." SARs typically provide the employee with a cash or stock payment based on the increase in the value of a stated number of shares over a specific period of time. Phantom stock provides a cash or stock bonus based on the value of a stated number of shares, to be paid out at the end of a specified period of time. SARs may not have a specific settlement date; like options, the employees may have flexibility in when to choose to exercise the SAR. Phantom stock may offer dividend equivalent payments; SARs would not. When the payout is made, the value of the award is taxed as ordinary income to the employee and is deductible to the employer. Some phantom plans condition the receipt of the award on meeting certain objectives, such as sales, profits, or other targets. These plans often refer to their phantom stock as "performance units." Phantom stock and SARs can be given to anyone, but if they are given out broadly to employees and designed to pay out upon termination, there is a possibility that they will be considered retirement plans and will be subject to federal retirement plan rules. Careful plan structuring can avoid this problem.

Phantom stock and cash-settled SARs are subject to liability accounting, meaning the accounting costs associated with them are not settled until they pay out or expire. For cash-settled SARs, the compensation expense for awards is estimated each quarter using an option-pricing model then trued-up when the SAR is settled; for phantom stock, the underlying value is calculated each quarter and trued-up through the final settlement date. Phantom stock is treated in the same way as deferred cash compensation.

In contrast, if a SAR is settled in stock, then the accounting is the same as for an option. The company must record the fair value of the award at grant and recognize expense ratably over the expected service period. If the award is performance-vested, the company must estimate how long it will take to meet the goal. If the performance measurement is tied to the company's stock price, it must use an option-pricing model to determine when and if the goal will be met.

The Companies shold opt for Stock Options as it provide benefits for both companies and employee.