Assignment 8 Flashcards
What is the difference between long term and short term incentives?
The essential differnce between long-term and short-term incentives is the length of the performance period. While short-term incentives are typcailly one year, long-term incentives are multiyear in nature.
What is the importance of the type of company in terms of long term incentives?
They type of company definetly affects the importance of long-term incentives. While they are very important in for-profit companies, they are virtually nonexisten in not-for-profits.
- For-Profit Sector:
- Companies with publicly traded stock are at an advantage over privately held companies due mainly to the more restricted market for the latter’s securities.
- Pulblicly traded for-profit companies place high emphasis on long-term incentives in the threshold and growth stages.
- Plans use either a for of stock and/or cash
- Stock plans may consist of publicly traded, privately traded or not traded stock
- Each can consist of full value or appreciation only. The full value may or may not requre an investment or purchase by the executive.
Long term plans typiclly require some form of discounting to give them a present value and thereby permit valuation vs salry and short-term incentive.s
How is eligibility determined for long-term incentives?
As with short term-inctives eligibilty may be determined by:
- Key Position
- Salary
- Job Grade
- Title
- Reporting Relationship
- Combination of these methods
Typically, the degree of organization penetration from the CEO down is not as extensive as with short-term incentive plans if the eligibilty basis is tied to those who have an impact on the long-term success of the organization. This criterion would relate to a time span measurement of decisions and actions. Namely: what is the length or span of time that must pass before measuring the appropriateness of the decision/action? Typically, this correlates well with organizational level since the longer term, larger risk decisions are handled at the top of the organization.
Briefly describe the accounting, tax and SEC implications of long-term incentive plans.
The accounting rules for long-term incentive plans are not as simple as with short-term incentives. All compensation is a charge to the earnings statement. Under FAS 123R, it is either measured at date of grant or on date of settlement.
- Date of Grant:
- Applies to stock-settled awards
- Accrues the fixed expense over the vesting period
- Date of Settlement:
- Applies to those settled in cash
- Variable accrual “trued up” at time of settlement
As for taxation, the basic rule still applies. Compensation is taxed as ordinary income when received, and the company has a like-amount tax deduction in that year. Two exceptions:
- Exercise gain on statutory stock options and long-term capital gains when stock has been held for the required period of time. There is neither income recognition nor a company tax deduction on the differece between grant price and fair market value at time of the exercise of a stuatory stock option.
- Companies receive no tax deduction on income gains to the executive taxed as long-term capital gains.
The SEC defines insiders, those with information not availabe to the public that could affect the price of stock, conditions under which they may buy and sell company stock, and what reports they must make regarding purchases, sales, and holdings.
Long term incentives are dependent on:
- Stock Price (Market Based)
- Independent of stock price (Nonmarket based)
Market Based Plans
Typically use common stock, which is traded on one or more stock exchanges. Plans either offer an option to buy an outright grant of stock. The stock may be received either in the form of an actual stock certificate or credited electronically to an account in the executive’s name. This is sometimes called a book entry form.
What is a stock option?
A stock option is the right given to a person, by a company to purchase a stipualted quanity of shares of the company’s stock at a stated cost of a prescribed periof of time in accordance with state eligibilty periods.
Five key dates are contained in a stock option:
- Date of Grant
- Date to exercise or purchase
- Date option expires
- Date of actual exercise
- Date of Sale
Stock options are either stautory (qualifed) or nonstatutory according to IRC. Those options that comply with Section 422 of the IRC are said to be statutory options and, therefore, qualifed for favorable tax treatment, such as optionees are not taxed at time of grant or at time of exercise but only at time of sale. If the optionee does not meet the required holding period before the sale of a statutory option, the difference b/t purchase cost and selling price will be considered ordinary income. This is called a disqualifying disposition.
Options are non-goal oriented plans; that is, the company does not prescribe certain goals that must be achieved in order to receive payment.
Many believe that the market is a good indicator or a coming recession or recovery, or that the market will drop prior to a recession. As the recession continues, the stock prices increase in antcipation of a recovery. The consideration of downside risk is also important in stock option plans. The executive is placed in a precarious posistion when having to borrow to exercise the stock option if the intent is to hold it for some time.
If one company acquires or merges with another in a stock transacation, it is appropriate to restate the option price for purchase of the acquiring company in relation to their respective prices. This is called a rollover or redenomnated-type stock option.
Dividends are payable only on shares of issued stock. Therefore, shares under option do not receive dividends. The receipt of stock option grant is not a taxable event. However, the exercise or purchase of stock under an option does have tax consequences.
Explain how stock options are valued:
- The Black-Scholes Model
- Most widely used model for estimating the present value of stock options granted by a company to its employeres. This model includes option price, price of an underlying security, stock price volatility, risk-free rate of return, divident yield and expeted term of the option grant. Other things being equal, the Black-Scholes Model will place a greater value on a higher priced stock option
- Binominal Model
- Quite similar to the Black-Scholes Model sicne it includes the market price of the stock on the date of grant, the exercise option, the expiration date of the option, the dividend yield of the stock, the volatilty of the stock and the risk-free interest rate. It is not as easy to use as the Black-Scholes method but may be more accurate.
- Minimum Option Value Method
- Calculates the present value as being equal to the current fair market value of the stock price discounted by a risk-free rate of return for the period of the option term as well as the expected dividends over the same period. It is essential the Black-Scholes method with 0 volatility.
Explain frequency of grants
It used to be common practice to grant options every 3-5 years. Annual grants are now by far the most common action. Fewer shares on a more frequent basis minimizes the impact of risking compensation and swings in the price of the stock, as well as the visibility of large grants to insiders. If options are not grated on an annual basis, the company will need a mechanism for interim, that is off-year, grants to new hires and the recently promoted.
When interim or catch-up grants are made b/t normal grant dates, the regular stock option grant guidelines are adjusted by:
- The estimated future market value
- The previous grant ( # of shares and option price)
- The extent of lapsed time since the regular grant
- the current option price
Regardless of the formula being used, the basic logic is to give options to recent hires and those promoted that equate to the major grant optionees only for the reamining time until the next grant.
Explain the waiting period in terms of the exercise period.
The stock option grant specifies a beginning date. Typically, this date is the date of the grant. It also has an ending date, which is when the right to purchase the shares expires. Within this period, typically ten years, there is a date when first eligible to purhcase, which is called the waiting period, before any shares may be exercised. The grant will also specify the maximum number of shares that may be exercised on or after that date.
While most plans have a fixed exercise period, some use a failure to meet stated financial targets or stock prices at prescibed dates during the exercise period to automatically cancel this option.
This is one way to minimize, if not completley avoid, underwater stock options ( the option price is above the market price). Some refer to this as a truncated stock option for its shortened period of exercisablity.
Explain vesting as it relates to the exercise period.
Many plans have a one year waiting period after which all shares granted might be exercised. Others have additional eligibilty requirements typically called a vesting period.
- Cliff Vest- sets a waiting period before which no shares are exercisable and after which all shares are exercisable. A typical example five years on a ten-year option.
- Installment Vest- Typical approach would be to vest 20% or the shares are one year, 40% after two years, 60% after three years, 80% after four years, and 100% after five years- designed to penalzie optionees who leave shortly after receiving a stock option sicne they will have to forfeit their unvested portion
- Performance Vest- Prescribes the conditions under which an option will vest. when the option is not exercisable unless the performance criteria has been met, it is identified as a performance requirement vest or an earn-it or lose-it option
- Backward Vest- A stock option vests 100% on the earlier of a prescribed vest date, or when the company stock trades at or above a specifed dollar amount on average for a prescribed period of time. This is called a performance-accelerated stock option plan (PAYSOP). The performance feature could be expressed in mutiple terms. Rewards the optionee for a signficgant increase in stock price sooner. Performance-accelerated vesting
If the option is intended as a golden handcuff, then a long vesting period is approprate. It could also be combined with an additional foreiture clause suh as the requirment that the optionee sell the stock back to the company at exercise price if the individual leaves before a stated period after exercising the option.This is sometimes called a clawback option.
What is the effect of terminating employment during the exercise period?
Should the individual terminate employment, many plans provide a very limited exercise window. In cases where the individual is quitting or being terminated for cause, the option may logically cease on date of termination. Periods of six months to one year, are not uncommon after terminating due to disability or death. Many nonqualfied plans simply use the IRS rules for qualified plans, 90 days from date of termination except for disability (one year) or death where it runs the term of the option.
If disability status does not constitute termination of employment, eligibility continues until service ends, at which time the exercise eligibilty will continue for one year unless the indivdual has retired, in which case retirement provision apply.
As for death, some pland distinguish between death while an active employee or as a retiree. With both, the grant may be fully vested, but the while-active exercise period may extend for a year whereas the while-retired would extend for the full term of the grant
How does one exercise the stock option?
If the terms of the option are met, the optionee has a unilateral right to buy the stock at the price stipualted. The exercise or purchase may be accomplished in one of several ways:
- Paying cash
- Tendering Company Stock and/or
- Simultaneously buying/selling the stock- a cashless exercise
What is a cash exercise?
If cash is used, it may come from the sale of company stock or from other sources. Once exercised, the stock is transferred to the optionee who then decides whether to keep all, sell all, or sell enough to pay the taxes. Companies can use the stock option exercise proceeds to buy back a portion of the shares issued with the exercise of the option. The greater the difference between market value at the time of the exercise and grant cost, the smaller the percentage that may be bought back.
Explain tendering company stock.
Rather than selling company stock and having to pay taxes, it is more advantegous to tender, that is, turn over the company shares of company stock owned, or attest, that is, confirm in writing the number of shares owned whose value without reduction for taxes is sufficient to exercise the option. This is called a stock-for-stock exchange or a stock swap. It enables the optionee to defer tax on the value of shares tendered until they are acutally sold. This form of payment may also be used to exercise a statutory option; however, both the shares tendered and new shares must meet the one-year and two-year requirements of statutory options to avoid a disqualifying disposition. It permits the optionee to use stock already owned to meet a portion of the exercise cost.
Tendering stock to exercise an outstanding stock option and then immediateley retendering the shares received, continuing this virtual simultaneous exchange of shares received in ever increasing amounts to exercise remaining shares, is called pyramiding.
it would be possible to exercise the option by tendering one share and then engage in the rapid fire pyramid unitl the entire option was exercised. Sicne the tendered stock has not been owned for at least 6 months, the company is subject to recognize a charge to earnings on appreication.
Such an action would be precluded for 16(b) executives. Section 16(b) of the SEC stipulates that any profit made by an officer or director of a company by purchasing shares of the company within 6 months of selling similar shares must be returned to the company.
