Medical Device Link.

Originally Published MX September/October 2001

FINANCE

To keep employee compensation attractive in a sputtering economy, public medtech companies can choose from a wide range of actions.

Matt Ward

In recent years, stock options have become a critical component of compensation for executives and top talent. Stock options provide recipients with an opportunity to create wealth far beyond what they could realize through ordinary salary and cash-incentive programs. For start-up and rapidly growing companies, they provide the "currency" necessary to attract and motivate talented executives and employees.

Stock options have become so widely accepted that virtually every public company offers them. Even start-ups offer options from nearly their first day of incorporation, using options and the hope of an eventual initial public offering (IPO) to recruit employees. Nowadays, 99% of executives and more than half of all employees in technology-related industries hold options.

Of course, stock options are most popular in rising markets—the times when companies can point to a record of climbing stock prices and employees can envision large gains. In a down market, though, options lose a lot of their luster, and in fact can be a millstone around the necks of companies and employees. Underwater options—options with an exercise price that is above the current stock price—can be demotivational, distracting employees from the critical work at hand and opening the door for them to jump to competitors.

Consequently, underwater options can become a serious burden for companies. At a time when a company needs to focus its energy on competitiveness and restoring and rebuilding value, the morale of option-holding employees can be adversely affected. For these reasons, company leaders need to know what can be done to address the problem of underwater stock-option grants. In particular, they should look for ways to nip the problem in the bud—before grants are made—to avoid having the bulk of option grants fall below market price. This article outlines various approaches that medtech company executives can undertake to prevent or address underwater options (see Table I).

Education

By far, the best approach to dealing with underwater stock options is to educate and remind optionees that their stock options are a long-term compensation device and that the typical 10-year option term allows more than enough time for their options to come back to life. The recent market correction and economic downturn have substantially curtailed their once-unlimited alternative employment opportunities, so now is the ideal time to teach employees to hold tight and let the options run their long-term course. Moreover, under most option programs, a new grant at current prices is usually only a year or less away for most optionees.

Repricings

In the past, the most obvious and previously most common approach to dealing with underwater stock options was to reprice them. A repricing is essentially a cancellation of the existing underwater stock-option grant followed by a replacement grant at the current lower market price. Always highly criticized by shareholder groups and pay critics, repricings got caught in the sights of the Financial Accounting Standards Board (FASB; Norwalk, CT), which was embittered by its defeated attempt to require a charge to earnings for stock options in the United States. Under the guise of clarifying accounting rules, FASB unilaterally decided that repricings of stock options would result in a charge to earnings—even though the accounting practice in this area had been very clear for more than 20 years.¹ As horrendous as this bit of politically motivated rule making is, it remains the rule of the land and companies must live with it.

So, in the current environment, repricings are expensive but still possible. As an example of the high cost, applying the new repricing rule at a certain technology company would have resulted in a $600 million pretax charge to earnings (assuming a 15% annual growth in stock price over the option term). Fortunately for the company, the repricing occurred before the new rule was in effect. If the repricing had occurred under the new rule, the charge would have represented a 50% reduction in annualized after-tax earnings and earnings per share.

In past years, the most common form of repricing has been a one-for-one repricing, where an optionee turns in one option at the old higher price and receives one option at the new, lower, current fair market value. However, one-for-one repricings have been waning in popularity because they are overly generous to optionees and thus aren't very fair to shareholders. As an alternative, companies can consider repricing with a less-generous ratio, say two old options cancelled in exchange for each new, lower-priced option. When the current market price of a share is $10, an optionee with 1000 options priced at $50 is generally very happy to cancel them in exchange for 500 new options.

As an alternative, shareholder-palatable repricings (such as the two-for-one ratio) are less expensive than one-for-one repricings.² Converting the above example to a shareholder-palatable formula (two old options for one new) results in a total pretax charge of $300 million, rather than $600 million under a one-for-one ratio. Best practices for shareholder-palatable repricing would also exclude executives, restart vesting, and include a reasonable blackout period following the repricing date.

Finally, if repricing appears to be the only effective way to address underwater options, companies should get shareholder approval in advance. Companies can also provide savvy shareholders with the opportunity to preapprove the outer boundary terms of any future option repricings (for instance, to permit repricings over a period of 5 years if there is at least a 75% drop in stock price that continues for a minimum of 6 months).

Make New Grants without Canceling Old

Another solution to dealing with the problem of underwater options is to make new grants to employees without canceling the old ones. This simple solution is great if a company has sufficient shares available under its existing plans. Unfortunately, in modern times, most biotech and technology-related firms do not have this luxury.

One approach for supplemental grants is to use stub grants to provide interim relief. Stub grants are short-term options, such as those with 12-month cliff vesting and a 13-month term. Although such grants use precious shares remaining available under a company's stock plans, their extremely short life can minimize the long-term dilution impact of the grants while still providing employees with interim relief from their underwater stock-option grants.

When share availability is a problem, many companies grant new options from a nonshareholder-approved "shadow" plan. The major stock exchanges and NASDAQ currently exempt broad-based plans from their shareholder-approval requirements. Companies that are listed on the NYSE should use up their treasury shares for new grants. When shares previously listed on the NYSE are used for new stock-option grants as an add-on without canceling the old grants, shareholder reapproval is not required. Although most tech and biotech firms are not listed on the NYSE, more have recently begun to shift over, and this may be a viable option for finding shares for new grants.

Replace Old Grants with a New 6+1 Grant

In light of FASB's recent interpretations, the most popular current alternative to underwater options has proven to be replacing the old grants with a new so-called 6+1 grant.¹ Under this approach, the company and the employee agree to cancel the underwater grants, and the company agrees to make new grants after 6 months plus 1 day from the date of cancellation at the then-current market price. FASB rules have created a 6-month window during which any grant cancellation is matched against any new grants to the same optionee, resulting in the new grant having a charge to earnings for the entire option gain over its life.¹ But by adding a day to that 6-month window, the 6+1 approach avoids the problem of having a charge to earnings altogether. There is no charge to earnings for a new grant made using the 6+1 model.

Prior to the recent market correction, many experts believed that optionees would be unwilling to cancel their options and then remain at a company for 6 months and a day before receiving another option grant. However, the severity of the correction and the corresponding increase in the unemployment rate have enabled companies to retain employees without giving them anything in return for the 6-months-and-a-day waiting period. An interesting twist on the 6+1 approach was recently implemented at Broadcom, which offered optionees the choice of a new, smaller current grant, or a one-for-one exchange under a 6+1 program.

Despite the fact that the 6+1 approach avoids a charge to earnings and involves substantial risk by the optionees during the waiting period, the practice is still criticized. Unfortunately, such criticism often comes from those whose opinions are formed without any clear understanding of compensation issues.

Interim Full-Value "Glue" Grants

Company leaders face a need to lock in their employees by using stock option grants, but must also avoid repricings during the tainted 6-month period that would trigger FASB charges against earnings. One way of accomplishing both of these goals is for the company to grant restricted stock that vests after the 6-month waiting period. Such restricted stock grants act as "glue" to retain optionees until such time as a new option grant is made to replace the underwater options canceled more than 6 months earlier.

Lower-price options granted during the tainted period are subject to "mark-to-market" variable accounting for the entire option life. By contrast, restricted-stock "glue" grants can lock in a much smaller charge to earnings whose amount is fixed on the date of grant. To be effective, the size of a glue grant must be substantial enough to retain former optionees until the new grant is made.

Because glue grants have strong value as retention tools, most experts believed that they would be the most popular approach to dealing with underwater options in the wake of recent FASB interpretations. Because of the severity of the recent market correction, however, 6+1 programs have actually become more popular.

Dollar-Cost Averaging through Grant Frequency

Another approach expected to become popular in addressing underwater options is to avoid the problem of having so many options go underwater in the first place. This can be accomplished by breaking the traditional annual option grant into several separate grants, essentially averaging the dollar-cost of the option exercise prices. For example, a company could grant equal pieces of its annual grant each quarter, thereby breaking a 10,000-option annual grant into four 2500-option quarterly grants. The total grant amount would be communicated to employees all at once—as it is today under traditional programs—and the grants would then trickle out in quarterly pieces. Purists can further refine the grant sizes by calculating the value of the option grant and the number of options quarterly, but this would add unnecessary complexity to the approach.

In this multiple-grant approach, vesting can be credited from the date of the first quarterly grant, so that all the options granted in a year are on the same vesting schedule. Alternatively, each quarterly grant can vest on its own terms, meaning that there would be quarterly overlaps in vesting until full vesting of the last quarterly grant occurred. Under either approach, modern stock-option-administration software can easily handle the quarterly programs without excess complexity after a brief transition period.

Interestingly, the market correction has also had a negative effect on the popularity of this approach. Most companies agree that the problem of underwater options can be addressed by dollar-cost averaging grants. But given the severe market price decline, no company wants to miss an opportunity to make full-sized annual grants now, when exercise prices are presumably at bargain-basement levels.

Extended Option Terms

Another way to eliminate the underwater option problem is for the company to offer longer-term options, say 15 years, to allow more time for options to get in the money. Except in the case of incentive stock options, which must expire within 10 years of grant, there is no limit on the life of options other than what the plan document permits.³ The value of a longer-term option increases over a 10-year term, but not on a straight-line basis. For example, a 15-year option's Black-Scholes, or fair market, value is not 150% that of a 10-year option, but approximately 115%. Extending option terms conflicts with the usual recommendation that companies should use shorter terms to reduce overhang, but in this case it's possible to please either the accountants or the shareholders—but not both.

The best approach may be to grant extended-term options only to senior management. This would at least eliminate the need to consider repricing their options in the future. Such an approach also assumes that company leaders have the economic wherewithal to stay in for the long term, and that they have the vision to understand that a longer option term has a better chance to get out from being under water than a shorter option term. However, making customized grants to executives runs contrary to the egalitarian approach so prevalent and successful in tech and biotech firms. There is merit to the practice of offering identical option terms and conditions for all employees—from the highest-paid down to the lowest-paid—so company leaders should consider this seriously before changing their terms.

Shortened Option Terms

Shortened option terms move shares through the system more quickly. Under the provisions of most option plans, this would result in the possibility of underwater options expiring unexercised, and thus becoming available for new grants. This is especially true for the stub grants discussed earlier. Shorter terms free up more shares for new grants in the future, thus alleviating the need to reprice. This option can be attractive for preventing underwater options among lower-level employees, since they are less likely to take advantage of longer-term grants.

Conclusion

Medtech executives have at their disposal many approaches for addressing the problem of under water stock-option grants. If necessary, company leaders can resolve the problems surrounding grants that are currently under water. They can also address the problem for the future, before grants are made, and perhaps avoid having the bulk of option grants fall below market price.

In the meantime, the best approach for company leaders is still to educate optionees to the facts that options are a long-term compensation device and that 10 years allows a long time for their options to come back to life.

REFERENCES

1. "Accounting for Certain Transactions Involving Stock Compensation: An Interpretation of APB Opinion No. 25," Financial Accounting Standards Board Interpretation no. 44 (Norwalk, CT: Financial Accounting Standards Board, 2000).
2. M Ward, A West, and M Kazmierowski, "Repricing Options: Best Practices for Your Dirty Laundry" [on-line] (San Francisco: WestWard Pay Strategies, 2000 [cited 10 August 2001]); available from Internet: http://www.westwardpay.com/repricoptns.htm.
3. United States Internal Revenue Code, Sec. 422.

Matt Ward is senior consultant, CEO, and chairman of WestWard Pay Strategies (San Francisco), a consulting firm specializing in executive compensation and plan design matters for high-growth and high-technology industries.

Copyright ©2001 MX