In recent years, numerous corporations have decided to stop providing employees with stock options. Some firms did so simply to save money, but usually the reasons behind the decisions of most companies are more complex. Three major problems frequently persuade companies to curtail these benefits:
- The value of the company’s stock may drop significantly and make it impossible for employees to exercise their options. Nonetheless, businesses still need to report the associated expenses, and stockholders face the risk of option overhang.
- Many employees have become wary of this compensation method. They know that economic downturns often render stock options worthless and that during those times such benefits may seem to resemble casino tokens more than cash.
- Stock options can result in considerable accounting burdens, making the relevant costs more expensive than the financial advantages. Employees often don’t consider stock option benefits as valuable as higher salaries that an employer could pay instead.
The Advantages of Stock Options
Nevertheless, this type of compensation can still be preferable to additional wages, equities, or better insurance coverage. Why? Because it is relatively simple for staff members to understand stock options. They provide something of equivalent value to all employees.
Stock options only boost personal earnings if a corporation’s share value rises. This encourages employees to prioritize the company’s success at work. People may work harder to satisfy existing customers, attract desirable clients, or develop innovative services when they know their personal investment is on the line.
Certain Internal Revenue Service rules make it considerably more difficult to supply employees with equities. This is especially true when companies develop compensation packages for top executives. Businesses may face greater tax burdens if they provide equities, but not if they provide stock options to the employees.
A Solution to Limiting the Negatives of Providing Options to Employees
If a firm wants to continue awarding options to employees, it can gain the above-mentioned benefits and avoid excessive costs at the same time by adopting the right strategy. It must take steps to minimize overhang as well as the initial and ongoing expenses.
The best solution is to embrace a type of barrier option known as a “knockout.” These stock options have the same time limits and vesting requirements as usual; however, employees lose them if the share value falls under a specific amount.
For example, a staff member might receive an option that has a five-year term that allows them to buy stock at the price of $150 per unit. If it’s a knockout option, it that option can expire when the company’s share value drops to less than $75.
But it wouldn’t make sense to eliminate these benefits merely because the price plunges for a few hours or days. Employers can avoid this problem by only canceling options when the share value remains low for an extended period of time such as at least one week.
If a firm’s stock is comparatively volatile, the knockout mechanism will probably reduce initial accounting costs. This holds true because each option remains valid for a shorter period of time.
When corporations supply knockout option benefits, non-employee investors don’t face overhang threats from options that no one can actually exercise. This means that existing stockholders have fewer worries about shrinking ownership shares.
Knockout clauses often result in lower executive compensation figures on yearly disclosure documents. This causes a company’s annual proxy to reflect earnings more accurately. It also looks better to shareholders.
This solution gives employees a strong incentive to prevent a firm’s stock value from dropping below the forfeiture threshold. Staff members know that they can earn more when the share price soars, but they’ll completely lose this benefit if it plummets.
Considerations Regarding Knockout Options
Knockout options don’t solve every problem, but they do banish many of the biggest obstacles associated with stock-based compensation. Nonetheless, it’s crucial for company officials to communicate with auditors about the ramifications of supplying these options to employees.
Businesses may benefit from waiting more than six months to provide new options after the existing derivatives expire. Otherwise, the replacements might have a negative impact on the quarterly financial statement; accountants must treat the costs as repricing expenses.
When corporations need legal advice regarding employee benefits, they often turn to attorney Jeremy Goldstein. He has over 15 years of experience as a business lawyer. Goldstein independently established a law firm in New York after working as a partner at a similar organization.
He has played important roles in major transactions that involved top companies like Verizon, Chevron, AT&T, Duke Energy, Bank One, and Merck. Goldstein serves on the board of a prestigious law journal and a nonprofit known as Fountain House.