Mastering Mind numbing Modifications

Transcription

1 Disclaimer Mastering Mind numbing Modifications Elizabeth Dodge, CEP, Stock & Option Solutions, Inc. Raul Fajardo, CEP, Qualcomm, Inc. Nathan O Connor, Equity Methods, LLC The following discussion and examples do not necessarily represent the official views of Stock & Option Solutions, Inc., Qualcomm, Inc., or Equity Methods, LLC with respect to any of the issues addressed. Moreover, this presentation and the views expressed by the individual presenters should not be relied on as legal, accounting, auditing, or tax advice. The outcome of any individual situation depends on the specific facts and circumstances in which the issue arises and on the interpretation of the relevant literature in effect at the time. Anyone viewing this presentation should not act upon this information without seeking professional counsel and/or input from their advisors. -2- Agenda Intro To Modifications Common Termination Modifications Performance Award Modifications ESPP Modifications Employee Status Changes M&A Tips What is Modification Accounting? : A modification of the terms or conditions of an equity award shall be treated as an exchange of the original award for a new award. 1

2 Many Types of Modifications # Modification Type Repair Incentives Individual Needs Organization Change 1 Option exchange or repricing 2 Resetting of performance targets 3 Extension to post-termination exercise window 4 Allow vesting to continue post termination 5 Ad hoc full or partial acceleration to vesting 6 Employee to non-employee, or non-employee to employee 7 Incorporation of retirement eligibility provisions 8 Incorporation of clawback provisions 9 Incorporation of anti-dilution provisions 10 Award conversion in a spin-out 11 Assumption of awards in an acquisition 12 Inserting a net-settlement provision 13 Equity to liability, or liability to equity change 14 Incorporation of dividend protection feature 15 ESPP program with a reset or related feature Before A er Modification Probable Accounting for Vesting Modifications Improbable Probable Probable to Probable Type I (ASC ) FV of original award Other Modification measure incremental expense (new award) Improbable to Probable Type III (ASC ) FV of modified award only Other Modification included in FV of modified award Improbable Probable to Improbable Type II (ASC ) FV of original award Update forfeiture estimate Other Modification measure incremental expense (new award) Improbable to Improbable Type IV (ASC ) FV of modified award only Other modification included in FV of modified award No expense impact improbable How to Classify 1. Be sure it really is a vesting modification and not a different form 2. Speak to legal to obtain the exact language that will be used to consummate the modification 3. Understand when the modification occurred (e.g., not when shares move, but when the decision was made) 4. Compensatory or Non-Compensatory? Related to In contemplation of concept Timing is Everything Timing of a modification significantly impacts cost and treatment Can be enacted: In contemplation of an event (e.g. employee retirement, CIC); OR Proactively/preemptively - not in contemplation of event If in contemplation of event, net cumulative accounting charge based on fair value of modified award terms at modification Grant-date fair value accrued previously reversed In a period of changing stock prices, can be P&L friendly / unfriendly If enacted preemptively and not in contemplation of event: Must continue amortizing grant-date fair value; AND Compute incremental accounting charge as: Fair value of modified award terms (at modification) less fair value of original award terms (at modification) 8 2

3 Not All Mods Are Compensatory If mod is done purely to bring the plan in line with best practices and the company s compensation principles, good chance no incremental cost test is needed In this case, the modification may be non-compensatory Example: Addition of a Net-Settlement Provision Doesn t impact timing or amount of payout non-compensatory Extension of Exercisable Period - Example Company X grants 100 options on 1/1/11 Cliff vested on 1/1/12 Strike price of $10 Original fair value of stock options $7 On 7/1/2012, participant terminates Market Value $15 Modification Treatment: Before & After Valuation Before Expected Term = 3 months, inputs for 3 month period After Expected Term = 3 years, inputs for 3 years What if you re on a budget? Goal Seek Acceleration of Option Vesting - Example Company Y grants 100 stock options on 1/1/ year annual vesting Strike price of $10 Original fair value = $7 On 1/1/2015, participant terminates Company Y accelerates vesting of unvested shares Market Value $20 Unvested Shares Type III Modification (Improbable to Probable) New Fair Value Calculated as of modification date, prior expense reversed, new Fair Value booked 3

4 Acceleration of RSU Vesting - Example Company Y grants 100 RSUs on 1/1/ year annual vesting Original fair value = $10 On 1/1/2011, participant terminates Company Y accelerates vesting of unvested shares Market Value $20 Unvested Shares Type III Modification (Improbable to Probable) New Fair Value SET as of modification date, prior expense reversed, new Fair Value booked Cancellation of In-the-Money Options Company Q negotiates a cancellation of 100,000 outstanding in-the-money options with employee Smith Smith continues to provide service to the company Original Fair Value: $10 per share Accounting impact: Acceleration of remaining expense into current reporting period Expense reversal only happens when the employee fails to meet the required service giving up/back awards is much different What if it was a non-employee instead? Generally same, unless the cancellation can be linked back to a performance failure (akin to a performance condition not being met) Some diversity in practice Termination Modification Calculations The Good News: Often one-time calculations Spreadsheet Black-Scholes models widely available Assuming B/S model in use Depending on the modification expense may be immaterial The Bad News: Options - Expected Term = input driver Not always simple to calculate May require valuation model Even if the expense IS immaterial, you have to perform the calculation to PROVE it Pros & Cons of Different Methods for Expected Term Method Benefits Drawbacks Lattice/Monte Carlo Model Remaining Contractual Term Remaining Expected Term Will figure out expected exercise behavior in light of where the award is in its moneyness and remaining life May overstate expense if it is unlikely the option will be held to maturity Few/none Higher cost/complexity to implement Unnecessary if it is clear when the modified award will be settled (e.g., at expiration) Conservative, easy, and in many cases not at all unreasonable Arbitrary 4

5 Black-Scholes Is Not Perfect The Black-Scholes formula should typically not be used to value awards that are deep in-the-money or deep out-of-the money This is the exact situation that often arises in modification valuations Problem relates to technical limitations of Black-Scholes, as well as difficulty in forming a reliable expected term estimate = Valuation date Grant Expiration Grant Valuation Date Expiration Performance Modifications Changing Goals Assess probability of vesting before and after to determine treatment (Often Type III) Removing Performance Criteria Assess probability of vesting before and after to determine treatment (Often Type III) May not trigger incremental expense, since performance criteria do not always impact fair value Service Period Changes Recognize remaining expense prospectively Some systems do not support (true down) Market conditions Monte Carlo should embed actual and simulated performance Adding performance/market conditions to existing awards Part Type 3, Part Type I?? Example: 100 units granted with EBITDA sliding scale of 0% - 200% Modification alters EBITDA watermarks Immediately before modification, expected payout of 75% Immediately after modification, expected payout of 100% Does this mean a Type 1 modification happened to 75 shares and a Type 3 happened to 25 shares? Reasonable parties may disagree on this Conceptually a tough position Unit of measurement is the number of units granted (100) Modification does not affect likelihood of those units vesting Analogy: cash-settled SAR modified to have a lower strike price This is not bifurcated into a Type 1 and Type 3 ESPP Expense Modifications Certain design features trigger modification accounting Resets resets lookback price Rollovers new offering with lower price Increases in contributions within an offering period Design features that do not trigger modifications, but require special attention Decreases in contributions IGNORE! Voluntary withdrawals without termination IGNORE! Salary changes, bonuses adjust expense Only true up to actual shares purchased for: Terminations Salary changes, bonuses, etc. Generally DO NOT True up to actual shares purchased -17- At-themoney At-themoney

6 Employee Status Changes Non-employee to employee Expense recognized as non-employee not adjusted Measure FV at modification date & recognize prospectively as awards earned as employee Employee to non-employee Expense recognized as employee not adjusted Follow non-employee accounting and recognize prospectively awards earned as non-employee (remeasure through vest date) What if service no longer required? Acceleration of expense Proxy Example 1: Type I modification Reducing strike price of underwater options Incremental cost must be presented in the proxy in year of modification (employees impacted, etc.) Example 2: Type III modification Someone not going to earn their award no reversal CD&A Disclose it twice b/c you only expense what is GRANTED M&A Quick Crash Course Main Issues / Treatment Acquisitions Often, buyer elects to assume target s awards to provide continuity and avoid depleting their own share pool Numerous variations exist with regard to modifications to award terms preclose Treatment depends on who is driving the action Plan data conversion carefully Material valuation and accounting hurdles Spin-Offs Two methods for splitting awards: Shareholder approach: employees gain awards in both entities Employment approach: employees only gain equity in firm they join (spinnor or spinnee). Usually for performance awards. Expect considerable data challenges Material valuation and accounting hurdles Treatment of Fair Value Allocation Attributed to pre-combination services: Included in consideration transferred in business combination (purchase price) Attributed to post-combination services: Recognized over service period of replacement award Acquisition Pre-combination services Post-combination services Relevant Accounting Guidance Authoritative guidance: Primary: ASC 805 Secondary: ASC 718, ASC 740, ASC 260 Non-authoritative guidance: minimal Authoritative guidance: Primary: ASC 718, ASC 740, ASC 260 Non-authoritative guidance: extensive reliance on industry best practices Recognized by acquirer at acquisition as consideration transferred Expense recognized by acquirer as over new remaining vesting period

7 Two-Step Fair Value Allocation 1. Calculate fair value attributable to pre-combination services as: Total fair value of acquiree awards 2. Calculate fair value attributable to post-combination services as: Total fair value of acquirer replacement awards Vesting years on original vesting period completed pre exchange MAX { total service period, original service period } Fair value attributable to pre-combination services Tips Gather your data Make sure your lawyers / accountants agree on what would happen to the grants without a modification (probable vs. improbable of VESTING) Document your company s perspective on the modification, and how it was developed Be cautious about over-reliance on Black-Scholes Vested vs. non-vested before/after modification When do you perform the acceleration in the system? Determining how much expense to reverse Contact Information Elizabeth Dodge, CEP Vice President, Product Management Bus: (408) edodge@sos-team.com Raul Fajardo, CEP Manager, Finance Bus: (858) rfajardo@qualcomm.com Nathan O Connor Director, Valuation Services Group Bus: (480) nathan.oconnor@equitymethods.com