Companies have been following a new trend lately. They are no longer offering stock options to their employees. Some companies wanted to save money, but others had more convoluted reasons for ending the practice. There are actually three major issues that encourage companies to stop offering stock options, and they are the following:
First, the stock’s value may decrease a significant amount, and this would make it impossible for employees to exercise their options. Since every company must report its associated expenses, option overhang is a real danger for stockholders in this situation.
Second, employees are not as in favor of this method of compensation as they have been in the past. These people are aware that when the economy isn’t doing well, stock options can lose all of their value. People think of these options like a bet at a casino rather than cash.
Third, employees who have stock options also have exorbitant accounting burdens. Therefore, the costs of these options may be more than the benefits they can provide. Also, employees would rather have a higher salary than the stock options if they have a choice.
Are There Any Advantages?
Notwithstanding the above objections, stock options do have their advantages because stock options are better than equities, insurance and increased wages in the following ways:
- Stock options are so easy to comprehend. The value of stock options is equal to a higher salary for every employee.
- Since the stock options’ value increases if the company’s share value rises, employees have a clear incentive to ensure that the company succeeds. The employees will work harder to ensure that their customers are satisfied, but they will work just as hard to garner new business as well. They will also make improvements to the business so that they can offer better services.
- It may not be easy for a company to offer equities to employees because the IRS has several complicated rules that make this extremely difficult. This is usually the case when a company is putting a compensation package together for executives on the top rungs of the ladder. Shares also increase the amount of taxes that companies must pay while stock options do not.
What Is the Solution?
Companies that want to continue offering stock options to employees may do so if they have the right plan. The right plan would allow them to reap the benefits of offering stock options and keep them from paying excessive costs. The point must be to eliminate the overhang and all of the extra expenses that can continue on for years.
The preferable thing that companies can do is enact a barrier option that is known as a “knockout.” Knockouts are stock options that have the same time limits that regular stock options have. They also have the same vesting requirements. These are different from the traditional stock options because if the share value drops below a set point, the employee loses the options. In an example, an employee receives a five-year term option that lets her purchase stock for $150 per unit. With a knockout option, the stock has the potential to expire if the company’s stock value goes below $75.
It’s not sensible for a company to refuse to offer stock options because the company’s share price drops below a set point for a day or two. They can be cancelled if the share price stays in lower territory for at least seven days.
In the event that a stock price is experiencing volatility, the knockout will reduce costs in the beginning. This will be the case because the options will not be valid for as long a period of time.
When companies offer their employees knockout option benefits, investors who are not employees of the company will not be confronted with overhang threats from options that will not be exercised. In other words, present stockholders don’t have to worry about shrinking ownership shares as much.
Companies can report lower executive compensation figures on their yearly disclosure statements when knockout options are offered. As a result, the company’s earnings are reported more accurately on its annual proxy. The shareholders also appreciate how this looks.
Employees have the best incentive to keep the company’s stock value from falling lower than the forfeiture threshold. They know that their compensation increases as the share price goes up, but their compensation goes down when the share price falls.
What Are the Considerations?
Every problem cannot be solved by knockout options, but they neutralize many objections that people have to stock-based compensation. A company’s officials still need to examine the complications that stock options can create for employees.
It may be in a company’s best interests to offer new options six months after the existing derivatives expire. If they do not, the new options might impact the quarterly financial statement negatively. In this case, the accountants would have to treat the expenses as re-pricing costs.
About Jeremy Goldstein
Jeremy Goldstein received a Bachelor of Arts degree from Cornell University. He obtained his Juris Doctor from New York University School of Law and a Master of Science from the University of Chicago. He is currently a partner at the law firm of Jeremy L. Goldstein & Associates, LLC. Prior to that, Jeremy Goldstein worked at the law firm of Wachtell, Lipton, Rosen & Katz and was a partner. Jeremy Goldstein has worked on several highly important corporate transactions, and they include United Technologies’ acquisition of Goodrich and J.P. Morgan Chase & Company/Bank One Corporation.
Jeremy is also a prolific writer and speaker, and his subjects cover the topics of executive compensation issues and corporate governance. He has been listed in Chambers USA Guide to America’s Leading Lawyers for Business as a leading executive compensation lawyer. He is also on the Board of Directors for a charity that dedicates its time to helping women and men recover from mental illness.
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