Just When You Thought You Were Done: Modifications After Grant

Transcription

1 Just When You Thought You Were Done: Modifications After Grant June Anne Burke, Baker & McKenzie (US) Nathan O Connor, Equity Methods (US) Richard Reilly, Baker & McKenzie (US)

2 Agenda I. Introduction: A Primer on Modifications I. Types of Modifications II. Compensatory vs. Non-Compensatory III. Timing is Everything / Issues with Discretion II. III. Legal, HR, and Accounting Issues with Modifications I. Separation from service / Post-term exercisability extensions II. Addition of change in control provisions III. Underwater options (repricing/cancellation regrant, etc.) IV. Regulatory changes V. Modification of performance conditions Business Combinations

3 Agenda Valuation Impact on employee incentives Compliance & Reporting Considerations MODIFICATION DESIGN Regulatory and legal costs HR & Governance Considerations Impact on employee retention Tax Accounting Shareholder expectations

4 A Primer on Modifications WHAT Any change to the terms of an award after it has been granted Examples: accelerating vesting, extending posttermination exercise window, lowering strike price Circumstances change, causing the initial award terms to cease meeting their original objectives. WHY resetting can still be an important, value-enhancing aspect of compensation contracts, even from an ex-ante standpoint. Acharya, John, and Sundaram, Journal of Financial Economics, 2000 Depending on type of modification, tricky issues require detailed consideration: Does the modification set a dangerous precedent? Does the modification signal something about a firm s governance? Can only be resolved on a case-by-case basis

5 Modification Valuation What Types Exist Type I IV framework be careful, it doesn t always apply Aggregate FV at grant Type I Probable-to-Probable Vesting is probable pre and post modification. Compare aggregate FV after modification to FV before modification to compute incremental cost ( Before and After Test ). Type III Improbable-to-Probable Vesting becomes probable post modification. Apply Before and After Test, but result is incremental cost equal to FV of modified award (no other cost being accrued). Type II Probable-to-Improbable Vesting is probable pre modification but not post. Apply Before and After Test, but recognize expense as original vesting target would have been achieved. Type IV Improbable-to-Improbable Vesting improbable pre modification and remains improbable post modification. Apply Before and After Test; recognize expense only if award vests under original or modified vesting schedule. Before and After FV at modification

6 Timing is Everything The timing in which a modification is transacted significantly impacts its cost and treatment. A modification can be enacted: In contemplation of an upcoming event (e.g. employee retirement); OR Proactively/preemptively and not in contemplation of such an event. If in contemplation of an event (e.g., termination event), the net cumulative accounting charge is based on the fair value of the modified award terms at modification. Grant-date fair value accrued previously is reversed. In a period of falling (rising) stock prices, this can be P&L friendly (unfriendly). If enacted preemptively and not in contemplation of a turnover 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).

7 Post-Termination Window Extension Case: Large food services / restaurant firm: Large pool of underwater options. Group of approximately 20 employees with extensive service records who have stated intent to retire. Outstanding awards modified for group of employees meeting certain service requirements to provide a 2- year post-termination exercise window.

8 Post-Termination Window Extension (cont d) Area Accounting Tax and Legal Challenge/Requirement Complex and may require lattice-based valuation approach Specific treatment depends on whether implemented in conjunction with an acceleration to vesting Recognize incremental cost based on difference between After and Before value Incremental cost often expensed entirely on date of modification because modification performed on vested awards Review tax impact (qualified plans; withholding for former employees) Review EU age discrimination laws, acquired rights, severance

9 Addition of Change in Control Provisions Company is a takeover target Tax and Legal Accounting Tax and Legal May not be considered compensatory, since changes in control are treated as performance conditions and deemed improbable until they occur under ASC 718 Possible need to amend regulatory filings (e.g., Australia Offer Document, tax-approved plans)

10 Repricing / Exchange No two repricing/exchange programs are identical. Common design (high technology firm, $600mm market cap): Value-for-value exchange For broad-based employees: options exchanged for restricted stock For executives: options exchanged for options 20% underwater For all: vesting extended by one year ISO tax treatment eliminated Area Accounting Tax and Legal Challenge/Requirement Expense floor provision: award may forfeit per modified vesting date but would have vested per original vesting date (two policy approaches for handling, but in either, must expense full award) Risk of incremental cost despite value-for-value structure stock price movements during tender offer period may produce unintended incremental cost May need to amend regulatory filings (e.g., Australia Offer Document, taxapproved plans)

11 Regulatory Changes Changes in the tax and legal requirements applicable to equity awards are often retroactive, making it necessary or desirable to modify the terms of the award, cancel it and substitute a new award, or cash out the existing award Area Challenge/Requirement Accounting Appropriate accounting treatment will depend on the particular change in regulation and the associated award modification. Tax and Legal Weigh to cost/benefit of avoiding onerous filings, impractical administrative practices or adverse tax result Consider award modification (e.g., amend vesting schedule, restrict exercise methods/settle in cash or cash out awards) If new law retroactive, what is company s exposure?

12 Resetting Market Condition Target Case: Mid-cap REIT: Issued RSUs with market condition based on absolute return over 8-year period Because share price performance was considerably above peer group, reset performance targets to consider relative total shareholder return (Company considered merely resetting absolute targets to be more achievable but preferred switching to altogether new performance design)

13 Resetting Market Condition Target (cont d)

14 Resetting Performance Condition Target Case: Large mining company: Issued RSUs with performance condition based on cash flow Reset cash flow target so that instead of only 25% of payout being probable 75% was considered probable Modification occurred approximately 1-year prior to end of performance period

15 Resetting Performance Condition Target (cont d)

16 ASC 805: Key Concepts and Terms Acquiree / Target and Acquirer / Buyer Replacement awards = consideration for: Pre-combination services Allocated to purchase price Post-combination services Recognized as compensation cost by acquirer over remaining service period, if any Is acquirer obligated to issue replacement awards? Two-step process for allocating fair value to pre-combination & postcombination services Total service period vs. original service period

17 Assumed Options in Acquisition Case: Large pharmaceutical company: Acquires a peer firm and assumes their options (vested and unvested) Vesting schedule unchanged Acquirer uses straight-line amortization, acquiree uses graded amortization Accounted for under ASC 805

18 Assumed Options in Acquisition (cont d)

19 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 Recognized by acquirer at acquisition as consideration transferred Expense recognized by acquirer as over new remaining vesting period

20 Avoid Inappropriate Use of the Black-Scholes Formula 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 Value is impacted by option being underwater AND the effect of this on exercise behavior. At-themoney At-themoney = Valuation date Grant Expiration Grant Valuation Date Expiration

21 Total Service Period vs. Original Service Period Total service period Vesting on acquiree s awards pre-acquisition Plus: vesting required by acquirer post-acquisition Original service period Original vesting period on award issued by acquiree For example, assume acquirer shortens vesting by one year: Total service period Original service period Year 0 Year 1 Year 3 Year 4 Grant Date Acquisition Date Revised Vesting Date Original Vesting Date

22 Two-Step Fair Value Allocation 1. Calculate fair value attributable to pre-combination services as: Total fair value of acquiree awards Vesting years on original vesting period completed pre exchange MAX { total service period, original service period } 2. Calculate fair value attributable to post-combination services as: Total fair value of acquirer replacement awards Fair value attributable to precombination services

23 Conclusion Resist pressure to oversimplify the accounting and legal issues surrounding transactions The risks can be very large, depending on the number of grants involved The standards do not always provide clear guidance on how to handle one situation or another. 1. Get your auditors on board with your approach early 2. Prepare for the accounting process well in advance of the planned modification 3. Remember that assumption techniques that worked perfectly in the past may not work now 4. Perform due diligence in reviewing potential tax impact of transactions to avoid adverse tax treatment, comply with securities filing requirements, obtain employee consent Auditors and Regulators will think your modification through carefully

24 Speaker Information June Anne Burke Partner, Global Equity Services Baker & McKenzie LLP June Anne Burke is a partner in Baker & McKenzie s Global Equity Services Group in New York. Most recently, Ms. Burke was head of the Global Equity Group at Mercer Human Resource Consulting LLC. Previously, she was a global equity consultant at Hewitt Associates. Ms. Burke has spoken and written extensively on global equity topics. She is currently serving her second term on the board of directors of the Global Equity Organization and is secretary of the board. Ms. Burke has been recognized by Legal 500 for excellence in employee benefits and executive compensation. Ms. Burke is proficient in global equity compensation, cross-border taxation, executive compensation and employee benefits. She advises clients on the tax, legal and accounting considerations of awarding equity and other long-term incentive vehicles to employees and non-employees around the world. She also advises on plan implementation, ongoing plan compliance, and tax and legal considerations with respect to incentive awards in the context of corporate transactions, such as mergers, IPOs and redomestications. Additionally, Ms. Burke provides guidance on the taxation of equity and other incentive compensation awards in cross-border situations.

25 Speaker Information Richard R. Reilly Partner, Executive Compensation & Employee Benefits Baker & McKenzie LLP Richard R. Reilly is a member of the Firm's Global Compensation & Employment Law and the North America Corporate & Securities practice groups. For over 25 years, Mr. Reilly has worked on myriad employment, executive compensation and benefits issues. He joined Baker & McKenzie from Coudert Brothers LLP, where he served as chair of its Employment and Employee Benefits Practice Group. Mr. Reilly advises clients on the establishment and administration of employee benefits plans, as well as compliance with ERISA's fiduciary responsibility and prohibited transaction rules. Mr. Reilly assists clients in designing executive compensation plans to comply with tax and other rules governing such plans. He also advises on the employee benefits and executive compensation aspects of corporate transactions, securities offerings, and financings. Mr. Reilly advises investment fund sponsors and investors on ERISA's plan assets regulations. He also represents employers and executives in the negotiation of executive employment and severance agreements and non-competition agreements, post-employment restrictions and other related employment law issues.

26 Nathan O Connor Director of Valuation Services Equity Methods (480) nathan.oconnor@equitymethods.com Speaker Information Nathan O Connor is Executive Vice President and Director of Valuation Services at Equity Methods. In his role as the national valuation practice leader, Nathan oversees all client delivery, operations, and R&D in support of more than 200 valuation clients. Nathan also works closely with the Financial Reporting Group and Business Development team at Equity Methods, and is responsible for formulating the firm s policy positions on all technical topics related to equity compensation valuation. As a Certified Base SAS programmer, Nathan has regularly contributed to the firm s intellectual property through the design, development, and testing of new valuation models and processes. He also has authored or served as a contributing author to many of Equity Methods white papers and industry practice alerts. Nathan is a nationally recognized speaker at industry events and frequently leads instructional webinars on industry best practices and recent trends in equity compensation valuation. As an expert in the valuation of equity compensation instruments, he has directly consulted senior executives at several Fortune 50 companies and more than 100 companies of all sizes on the compliance requirements of ASC Topic 718. Prior to joining Equity Methods, Nathan trained in the doctoral program in finance at the University of Arizona, where he lectured in investment securities and financial management and actively participated in consulting and research projects. He brings a background of experience in financial analysis, programming, instruction, and data management to Equity Methods. Nathan holds a B.A. in International Relations from Purdue University, an M.B.A. in Derivative Securities from Loyola University Chicago, and an M.S. in Finance from the Eller College of Management at the University of Arizona. He currently serves on the Board of the Las Vegas NASPP as Program Chair and the Phoenix Chapter of the NASPP.