Advice for companies planning to issue stock options.

The stock option is by far the most useful long-term incentive an employer can provide to its employees.

Total Plan Shares

Institutional investors (including venture capitalists) have established a "market standard" to limit the total number of options a company should grant its employees and directors. This standard calls for companies to have no more than a 10% stock option "overhang." An overhang percentage is calculated by dividing the number of options available (granted and available to grant) by the sum of the total number of shares outstanding and the number of options available.

Example: A company has 100,000 shares of stock outstanding and adopts an option plan that permits grants of stock options for up to 11,111 shares. The company will have an option overhang of approximately 10% (11,111/(100,000 + 11,111)). The market standard stock option overhang expands to 15% for companies with a smaller market capitalization.

Allocation Between Directors and Employees

Companies must decide how to allocate options between employees and outside directors. Typically, the board of directors sits in an oversight position rather than taking an active role in managing the company's business.

Because the role of outside directors is limited, they typically receive between 10% and 40% of the total number of stock options available, with employees receiving the rest.

Key Employees

More often than not, stock options are best used as a compensation device only for those employees with the greatest potential to significantly affect the company's future financial performance. The main question is whether a prospective grantee can personally affect the company's outcome. If so, the prospect is an acceptable grantee; if not, chances are that another compensation device will work more effectively as a performance incentive.

Broad-based plans work most effectively in a high-tech company in which the average employee has a master's degree in computer science. These plans, therefore, are clearly the exception rather than the rule. In a typical company, granting options to a broad base of employees, in a total amount that satisfies the market standard, serves only to dilute the options' incentive power. The number of options an individual employee receives will not have enough upside potential to provide a meaningful incentive; cash would work better.

Allocating Among Key Employees

In allocating options among key employees, the first step should be to determine whether "tiers" of potential exist within this group. That is, are all key employees equally capable of influencing successful financial performance, or is there a hierarchy?

Usually, there is a hierarchy, indicating that awards should be allocated based on a formula tied to an employee's base compensation level, title or position. For example, option shares can be granted to a particular key employee using a factor obtained by dividing his base compensation by the aggregate base compensation of all key employees, or options could be granted so that vice presidents get 1,000 shares, senior vice presidents 2,000 shares, executive vice presidents 3,000 shares, and the president 4,000 shares.

A more complex, but frequently effective, approach is to employ a multivariable formula. For example, 25% of the award may be based on compensation level, 25% on service to date, 25% on future service and 25% on the previous year's performance.

Granting Shares

It is important to reserve shares for future option incentives. Employers should plan to reserve 15% to 40% of the total options available to use in later grants. New people will join the company; existing employees may rise in (or fall out of) favor in the organization. Remaining flexible is important.

Second, employers should grant options on a regular basis; a five-year annual grant program seems to work well. This tactic helps maintain employees' interest in the option program.

Moreover, assuming that the company's stock price increases over time, subsequent grants will be at higher exercise prices. This should keep stock option grantees focused on continuous performance improvement.

Benefits of Vesting 

Vesting can be used to do two different things. First, if retention is a real issue for a company, it can design a vesting schedule that will certainly encourage retention, especially when coupled with recurring annual grants. Under a vesting option plan, the longer the employee stays, the more expensive leaving becomes--both for the employee and for another potential employer trying to hire the employee away from the company.

Vesting can also be used to link the ability to exercise options with the achievement of performance objectives, while avoiding the adverse accounting expense associated with performance-contingent stock option plans.

Exercise Periods

Too many companies issue their options with unnecessarily long exercise periods. An exercise period that is more than five years is likely to be too long. The problem with lengthy option exercise periods is that the longer they are, the more likely it is that employees will hold on to the options without exercising them, to build wealth without risk. When this happens, the company's option overhang becomes inflated and its ability to issue more options in the future is impeded by the logjam of previously issued options.

A company's option-overhang management objective should be to encourage earlier exercise of options to make shareholders out of employees and free up overhang potential for more grants. Some companies, however, need to allow a longer exercise period. Start-up high-tech companies, for example, often need to have a 10-year exercise period to provide a meaningful opportunity to the employee-option holders.

Accounting Treatment

Company managers caught up in the excitement of creating a "performance-driven" stock option plan will frequently produce a plan design that can have a disastrous accounting impact on the company's future earnings. The reason is the required accruals for compensation expense.

The smart plan design will avoid any compensation expense. To do this, the plan must be structured so that the number of shares actually exercisable by each individual employee is "fixed" at the grant date, and the exercise price is set at (or above) the fair market value (FMV) of the company's stock on that date.

While this sounds simple, mistakes are common. For example, suppose the maximum number of shares that a particular employee can receive is fixed, but the exercise of those shares is contingent on increases in the company's return on equity. The result is a potentially huge compensation expense charge that will have to be accrued year after year until the options are exercised or expire; the return on equity performance requirement creates variability in the number of options the employee will actually be able to exercise. Therefore, under accounting principles, the company must expense the growth in value of the option shares.

A time-accelerated stock option is a way to achieve performance contingency without adverse accounting expense. A company can grant options with a 10-year "cliff" vesting schedule that can be accelerated when an employee achieves one or more performance goals (e.g., share value growth or a target level of sales or profitability). Cliff vesting means that, if the employee terminates employment with the company before the grant's tenth anniversary, he forfeits all of the options. The vesting of the shares or portions of the shares will occur earlier, however, if the performance targets are reached.

Chances are, if the performance targets are important enough to the company's success and they are not reached, the employee will not be around to see the vesting anyway.

The accounting literature does not consider time-related vesting to create variability in the number of shares that an employee can receive, and performance-based acceleration does not affect the number of shares; it only affects the timing of the exercise.

Tax Treatment

The tax treatment of a stock option depends on whether it is an incentive stock option (ISO). If the option is not an ISO, the employee will have to report ordinary taxable income on exercise, equal to the excess of the FMV of the stock received over the exercise price paid. The company takes an income tax deduction in an equal amount.

ISOs have to meet a number of qualification requirements that are typically not troublesome. An employee exercising an ISO can usually plan the exercise so that he will not have to pay any tax until the stock received on the exercise is actually sold. The gain on that sale will be all capital gain, qualifying for application of the special, lower capital gains tax rates. No deduction is available to the company.

The key requirement is that the stock be held for at least one year after exercise to avoid tax on the exercise, and more than 12 months to use the lower capital gains tax rates. Most (if not all) employee stock option plans should be drafted to allow for both ISOs and non-ISOs to be granted under the same plan. ISOs, however, are only available for grants to employees, not to outside directors.

As with most significant corporate initiatives, planning is necessary to help ensure a successful program that drives corporate success while avoiding potential pitfalls. Done right, stock options can be an inexpensive way to provide meaningful employee compensation closely linked to the company's financial performance and to elevate shareholder value.

FROM GLENN JAMES, CPA, PHILADELPHIA, PA