Companies Eye Options-For-Restricted Stock Exchanges

As companies continue to tweak their executive compensation programs in light of the upcoming stock option expensing rule, some are considering options-for-restricted stock exchange programs.

Under such programs, companies typically grant restricted shares for options at ratios of one restricted share to three or four options. It’s a move experts say might make sense in the case of companies with high overhang—the number of options outstanding—or those that have lots of underwater options that they’d have to start expensing under the new accounting rules.

Under the Financial Accounting Standards Board’s now-infamous “FAS 123R,” most public companies must begin accounting for the costs of stock-based compensation as of their first fiscal year that begins after June 15, 2005. As Compliance Week has covered extensively for the past six months, companies have been tinkering with their equity compensation plans to reduce stock option expensing. Commonly cited tactics have included slashing option grants, narrowing the pool of employees eligible for stock options, and shortening the lives of options through faster vesting or shorter exercise periods.

Joy

“The rules are about to change for options for calendar year companies who will have to start expensing stock options, and many companies have been trying to figure out what they should do to minimize the expense, especially if their options are underwater,” notes Lynn Joy, a principal in the executive compensation consulting group at Buck Consultants. “Giving employees the ability to buy stock hardly has any compensation value if the options are underwater—with an options-for-restricted stock program, companies can convert those options into something meaningful.”

“We found about 10 examples of companies providing restricted stock in exchange for options over the past two years as of July, so it’s not that common,” notes Tim Ranzetta, president and COO of compensation research firm Equilar Inc. Ranzetta adds that the firm saw more companies making such a move in 2004 than in 2005.

Equal Value Propositions

In theory, restricted stock has retention value, because companies can put restrictions as to how long employees must stay to own their shares. “The employees don’t pay for the stock in any way,” says Joy, “but they only get it if they stay for a specified vesting period, perhaps three to five years.”

London

“There’s been a greater trend toward restricted stock because it has less of a dilutive effect for shareholders,” says Jeffrey London, a partner in the executive compensation practice of Sachnoff & Weaver in Chicago. “As a retention vehicle, underwater options don’t offer extraordinary retention value.”

“It makes sense for companies that have overhang issues [relative to their peers] and a significant number of ‘underwater options’ which have little retentive value,” says Ranzetta. “Completing such a plan may give a company breathing room when requesting additional shares for their equity plans from shareholders.” In addition, for those companies that have adopted FAS 123R, Ranzetta says that by providing “value for value exchange” there is no incremental cost to the company. “However,” he adds, “the restricted stock will typically have more perceived value to the employee as compared to the exchanged option.”

Unlike accelerating the vesting of outstanding stock options, which many companies have done in advance of the expensing rules, converting options to restricted stock won’t enable companies to avoid expensing the cost of options on their income statement. However, exchange programs are generally set up to be “equal value propositions,” says Joy. “From an income statement perspective, it’s a wash,” she says. “If the company was going to take an option expense anyway, they still take the same expense, but they’re replacing the option expense with restricted stock expense.”

While Joy says that exchange programs can be very advantageous because they introduce a true retention vehicle and can lower overhang, she also acknowledges that companies could face some investor relations issues if they choose to do an exchange. “Not many companies have taken this route,” she says. One reason may be because the swaps are difficult to explain to investors. “The whole purpose of stock options is supposed to be to get employees focused on increasing the stock price,” says Joy. “When it turns out that they didn’t increase the stock price, they’re supposed to get nothing—by exchanging underwater options for restricted stock, it may look to shareholders like companies are giving employees something of value for losing.”

HELPFUL QUESTIONS

According to compensation research firm Equilar, here is a list of "helpful questions" that companies should ask prior to implementing an exchange program:

Inclusion—Should executives and board members be included in the exchange program?

Impact—How significant will the impact of this exchange be on reducing the company’s overhang rate?

Assessment—How many full value shares does the company have available under its existing equity plans?

Changes—Which components of the company’s stock plan(s) will need to be amended in order to implement an exchange program?

Eligibility—Which options should be eligible for conversion?

Options with an exercise price below the current market price?

Options with an exercise price at a premium to the current market price?

Vested or unvested options?

Conversion—What should the conversion ratio be and to what extent should it differ based on the exercise price of the options?

Vesting—What vesting should the new restricted stock awards have?

Source: Equilar, Inc.

Instead, many companies have opted to accelerate the vesting of their underwater options, which pushes the expense into a footnote in the financial statements for fiscal 2005. “Companies that accelerate their options vesting can blame it on the accounting rules,” says Joy. “To explain to shareholders that you want to cancel worthless stock options and give employees something of value instead is a harder sell.”

Examples

While changes in the accounting rules have forced companies to look at such exchanges, but London at Sachnoff & Weaver warns against making decisions in a vacuum. “When companies think about an option exchange offer, they need to look at the overall scheme of what they want to offer in terms of equity compensation,” says London. “A company shouldn’t do an exchange if it is still tied to options as an incentive and retention vehicle. This shouldn’t be uniquely tied to the FAS 123R rules.”

Among those companies that completed such exchanges this year are Tenet Healthcare, Parametric Technology Corporation, and Zoran Corp.

In its proxy statement, Parametric said it wanted to amend its employee incentive plan to reduce overhang while also giving a boost to its equity compensation program. Parametric noted that some 58 percent of the outstanding options under its 2000 EIP and the 1997 NSOP were out-of-the-money; that is, they have exercise prices that are higher than the current fair market value of the company’s common stock.

“We believe that our employees view these options as providing little or no incentive, and the board wishes to reinvigorate our equity compensation program,” PTC’s proxy said. Assuming full participation in the exchange program, Parametric anticipated that the expected decreases in equity awards outstanding and shares available for future awards would reduce its options overhang from 32 percent to 20 percent, and its current potential voting power dilution (on a fully diluted basis) from 24 percent to 16 percent.

In an August press release announcing the completion of the exchange program, Neil Moses, PTC’s executive vice president and chief financial officer, noted that, when combined with options surrendered by PTC senior executives, PTC saw its options overhang fall to just under 20 percent.

$378.9 million Zoran Corp., in its latest proxy statement, laid out its case to shareholders. “Like many technology companies, our stock price has experienced a significant decline and high volatility during the last several years. As a result, many of our employees hold options with exercise prices significantly higher than the current market price of our common stock … These 'out-of-the-money' options are no longer effective as performance and retention incentives.”

Zoran continued, “We believe the Exchange Program will provide us with an opportunity to restore for eligible employees an incentive to achieve future growth and success for Zoran.” Stockholders approved the plan in July.

Meanwhile, Tenet shareholders approved an exchange program in May. In its April 15 proxy statement proposing the exchange program, the company said, “We believe … that we are at risk of losing, and have in some cases already lost, valuable employees whose stock options do not provide them with adequate incentive to continue to invest in our future. In order to provide an incentive for these employees to remain with us and to continue to have a vested interest in increasing the value of the company, we propose to amend the SIP to permit a one-time exchange of certain outstanding options by means of an exchange of such options … for a lesser number of shares of restricted stock units.