The Advisors' Blog

– Ed Burmeister, Baker & McKenzie

As we commence work on our umpteenth (more than 50th) option exchange, I am struck by a few thoughts:

1. It seems like a colossal waste of resources to have to go through the tender offer process in order to replace, for example, 1000 underwater options with a new 100 share option grant.

2. The motivation for these option exchange programs is principally to get rid of the dilution effects, and simply the bad morale effects, of having significantly underwater options hanging out there year after year, disclosed in financial statements, etc.

3. Many companies doing these exchanges add these shares back to the share pool, thus prolonging the use of the pool. Even if they do not due to institutional shareholder resistance, the exchange has the effect of eliminating the outstanding options. The new grants are a necessary add-on, otherwise employees would not voluntarily relinquish their underwater options, although they probably see little or no value in them.

Mulling all this over, I was wondering whether a new form of option grant might solve some of these problems down the road, should we have a similar situation where vast number of companies have significantly underwater options at the point of vesting. Here is how this would work. A company would make a normal option grant (for example, current fair market value grant with a 10-year term, vesting annually over 4 years). However, the terms of the grant initially would provide that if, at the end of the full vesting period (4 years), the options were underwater by more than a specified amount (this could be a percentage of the exercise price or it could be made with reference to the prior 12-month high trading price or other measure), the option would simply be forfeited at that point.

Because the option expense would have been amortized over the vesting period, I am assuming that there would be no significant accounting effect of this (other than perhaps the impact of such a provision in the original valuation of the option on the grant date, which, if anything, would decrease the fair value for accounting purposes).

The self-cancelling or forfeiture clause in the option would remove any need for a tender offer since there would be no employee consent involved and no consideration for the forfeiture/cancellation. Moreover, the options would no longer be outstanding for dilution purposes.

Whether the company chooses to return these shares to the share pool in the plan would be up to them. If resistance from institutional shareholders to a provision that would add all of them back to the share pool, is anticipated and they are not added back, this would still have positive effects. I would think, moreover, that the company could at least project forfeitures for these options and add that number of shares back to the pool. For example, if, at the 4-year vesting point, it is estimated that 40% of those options would be forfeited, then I would assume it would be acceptable to add back 40% of the cancelled shares to the share pool.

Because I am a lawyer and not a compensation consultant, I am sure that I have overlooked many reasons why this is a bad idea, but I thought I would stick my neck out and throw out this idea for others to comment on. I do know that if such a provision had been included in the grants of all the companies now doing option exchange programs, none of them would be doing these programs, with significant attendant savings.

Anyway, perhaps this will stimulate some discussion.