Recent technological advancements have propelled equity compensation administration and participation to new levels of convenience and effectiveness. Firms are now using “software as a service” to integrate brokerage platforms with equity compensation administration and financial reporting software. The growth in utilization of web-based software has improved results while reducing administrative hours.
Cloud computing, or the use of web-based software to access shared data, has long been a hot topic in the IT world. This model of network access eliminates the need for locally installed software while providing easier access to information. Recently, the focus of the “cloud computing” discussion has shifted from discussing the cloud itself to the utility and implications of moving to the cloud. In the context of equity compensation, the utility of the cloud includes ease of access for both participants and administrators to an always up-to-date, more cost effective online system. The questions become: at what pace should the equity compensation industry move to the cloud, and what model should it use? The debate over the pace of moving to the cloud stems from the perceived need to compromise between access and control. Companies want to give users the most flexible, user-friendly experience possible while maintaining data in a secure and controlled manner. Some firms are using a hybrid model combining locally installed systems with cloud computing, while others have been able to leverage the cloud fully to give participants and administrators the most convenient usage possible while maintaining data security.
Participants are rapidly increasing their use of tablet PCs and smartphones in a business context. As IT is increasingly “consumerized,” participants demand access via the device of their choosing, and expect connection on the go. The synergies between the consumerization of IT and the movement to software as a service are numerous: participants are able to view their award information in real time through participant portals and are able to take action in accepting grants and exercising awards. The end result is that participants have a greater sense of ownership over their awards, which enhances the effectiveness of the company’s equity compensation plan.
The user interface for equity compensation administration and compliance systems is changing along with the movement to a software as a service platform. Administrators expect customizable dashboard views that allow for quick and effective actions. Participants and administrators are increasingly intolerant of multiple sign-ons or dealing with separate interfaces for their equity compensation needs. Participants expect to initiate exercises via portal and to have access to tax withholding and scenario modeling information.
Our industry is poised to take advantage of these new developments to better communicate the value of equity compensation plans to participants. A more streamlined, accessible, and actionable system increases participant motivation, improves administrative accuracy and efficiency, and reduces expense.
Register for the 19th Annual NASPP Conference The 19th Annual NASPP Conference will be held from November 1-4 in San Francisco. The last time we were in San Francisco, the Conference sold out and this year promises to be just as exciting (but a lot roomier–we’ll be in a much bigger space). Register for the Conference today!
I recently attended a great presentation on perceived value at the Silicon Valley NASPP Chapter All-Day. The panel was moderated by Emily Cervino of the CEP Institute and included Fred Whittlesey of Compensation Venture Group, Keith Pearce of Intel, and Jason LeBovidge of Fidelity Investments. In today’s blog entry, I summarize some of the points they discussed.
Perceived Value ≠ Fair Value Perceived value is the value employees assign to the grants they receive. This value is often completely different than the fair value of the award or even the cash value of it. For example, employees often have a higher perceived value of at-the-money stock options with a low exercise price than those with a high exercise price–the exact opposite of how the fair values for those options would come out.
Perceived value is different than fair value because, as Keith explained during the presentation, the formulas for the two values are different:
Perceived value = signal value + cash value
Fair value = time value + intrinsic value
At-the-money stock options have no intrinsic, or cash, value, so all of their fair value is derived from time value. Yet when employees consider their stock options, they don’t include any time value in the equation.
The good news, however, is that employees will consider the signal value of their options and awards and, unlike time value, this value is something that you can influence.
Signal value is what the option/award signifies to the employee. It’s an intangible quantity that represents how valued the grant makes the employee feel and how meaningful the grant is to the employee. The information you provide to employees about their grants and how you deliver the message can increase signal value.
A Few Ways to Increase Signal Value
Make a big deal out of the grant. For example,you might include a letter from the CEO in the grant package and have the CEO discuss the stock program at company meetings.
Promote the stock program using a variety of media: email, company intranet, HR blog, employee newsletter, posters around the office, benefits statements, etc.
Make things personal. Meet with employees in person about their grants. If your company is too large for you to do this, have managers or local HR reps hold these meetings.
Have employees provide testimonials about what the program means to them.
Make sure employees understand the stock program.
Don’t oversell the program; disappointment has a devastating impact on perceived value.
It’s Not Too Late to Enroll in the NASPP’s Financial Reporting Course The NASPP’s newest online program, “Financial Reporting for Equity Compensation” started on Thursday, July 14, but it’s not too late to get into the course. All webcasts have been archived for you to listen to at your convenience.
Designed for non-accounting professionals, this course will help you become literate in all aspects of stock plan accounting, from expense measurement and recognition, to EPS and tax accounting. Register today so you don’t miss any more webcasts.
NASPP “To Do” List We have so much going on here at the NASPP that it can be hard to keep track of it all, so I keep an ongoing “to do” list for you here in my blog.
There isn’t a U.S. rule or regulation that gives a specific definition for the fair market value, either for creating an option exercise price or for calculating income on transactions, even though fair market value (FMV) is a fundamental measure for all awards. Section 409A regulations require that a consistent and reasonable valuation method be applied to stock grants. For private companies, coming up with a reasonable method for valuing company stock is complex, but for public companies it is generally accepted that the FMV for stock plans is based off the open market trading value of the stock.
Not so Definite
All stock plans should define the fair market value, but should also give the Plan Administrator the authority to determine FMV as needed. This is particularly crucial for companies whose stock becomes very thinly traded, but can also be an important piece of flexibility for other stock transactions.
The grant date fair value should, if at all possible, follow the plan definition. For transactions, however, there may be a need to have more than one definition for FMV. Most of applicable tax code (e.g., Section 409A, 422, or 83) focuses on the method used for determining grant date fair value. Section 409A is the most specific, permitting the use of an average sale price provided that the period used does not exceed (and is both set and irrevocable) 30 days prior to the grant date. However, 409A does permit the company to use more than one FMV, provided each application of FMV is consistent.
There may be situations where ESPP purchase or restricted stock vesting event dates fall on a non-market day and the plan defines FMV based on current day trading values. Alternatively, many companies prefer to define the FMV for transactions with a sale (e.g., broker assisted cashless exercise or immediate sale on vesting of restricted stock) as the sale price. There are also situations where the company has a unique need that justifies defining the transaction date fair value as something other than the plan definition. All of these are reasons why a company may choose to use more than one definition for fair market value.
Make it Official
Even if your company doesn’t plan on ever diverging from the plan definition of fair market value, you should still consider the possibility of a non-market day transaction and create an official definition of FMV for that circumstance. If you are currently using or considering using an different FMV definition than the one in the plan, assuming you have confirmed that the plan gives the plan administrator that authority, best practice would be to have that policy made official. In addition, even if you have created an official policy or procedure, the best way to show that the company is being reasonable and consistent with its definition of FMV is to have the Board or the Board’s designated compensation committee ratify the policy in a resolution.
What Other Companies Are Doing
Curious about how other companies define FMV? In the NASPP’s 2010 Domestic Stock Plan Design Survey, 78% of respondents use grant date closing price for option grants, but only 60% use closing price as the FMV for exercises. In addition, 80% use the actual sale price for broker-assisted cashless exercises.
The Buck Stops Here (Unless, of Course, It Stops Somewhere Else) by Marlene Zobayan, Rutlen Associates
These days, no discussion on the taxation of equity compensation seems complete without addressing the topic of mobile employees. For any one company, the numbers of mobile employees are usually small compared to the entire workforce, yet the administrative work caused by this small group of employees far exceed those of the fixed population.
The difficulties fall into three categories:
There is the administration burden of identifying and tracking who the mobile employees are.
Then there is calculating the correct taxes to apply. Of course, jurisdictions differ widely on what they determine to be their taxable portion resulting in a complicated tax calculation for each set of facts.
Finally there is the difficulty of getting the payroll and administration systems to administer what has been calculated, especially where the amount of income being taxed does not sum to 100%.
For the more advanced company, the impact of mobile employees carries through to the corporate tax deductions, which impacts deferred tax assets and ultimately the accounting expense of the equity compensation.
Although the technologies supporting these categories have come a long way, often manual intervention is still required to make sure the systems properly handle mobile employees.
To demonstrate these issues, the panel will focus on three specific examples of mobile employees who all receive similar equity grants. The examples follow common real-life mobility patterns, if there is such a thing. The audience will see how a mobile employee’s circumstances impact the taxation, employer withholding and reporting compliance, accounting, expense allocation and corporate deduction based on the countries involved and the type of mobility, e.g., whether someone is a temporary assignee, permanent transfer or a business traveler.
I’m going to start this discussion from the end and start with the company’s tax deduction. Certain employee stock compensation transactions that result in taxable income (e.g., non-qualified stock option exercises and restricted stock vests) are eligible for a corresponding company tax deduction. For example, if an employee realizes $1,000 income on an NQSO exercise and the company’s applicable tax rate is 40%, the company is eligible for a tax deduction of $400.
However, under FAS123(R), a company can’t just wait for the transaction to take place and then book the entire tax deduction. Instead, it must try and anticipate what that tax benefit will be and book it over the same schedule as the expense accrual for the award. Because the company can’t know for sure what income will result from eligible transactions, FAS123(R) details how to go about anticipating that unknown with as a deferred tax asset (DTA).
DTA, unlike the actual tax deduction, is calculated based on the FAS123(R) valuation of the grant using the company’s current tax rate and is generally booked over the vesting schedule. For example, if the company is expensing $5,000 for an NQSO each year over a four-year vesting schedule and the company’s tax rate is 40%, the company books a DTA of $2,000 each year of the same schedule (adjusted for expected forfeitures until the actual vest date).
Back to the End
When a transaction does take place the company can calculate the actual tax deduction, which will most likely be either more or less than the DTA amount. The company reverses the DTA that was previously booked and takes the actual tax deduction. However, the difference between these two numbers must also be reconciled. If the DTA is less than the actual tax deduction (i.e., the company realized more than the anticipated tax benefit), the company adds the excess tax benefit to the paid in capital account–often referred to as the APIC pool. However, if the actual tax deduction turns out to be less than the booked DTA (i.e., the company anticipated more tax benefit than it realized), then the company reduces the existing APIC pool by the unrealized tax benefit amount–or takes a tax expense if the APIC pool isn’t sufficient.
This is, of course, just the beginning of tax accounting for equity compensation under FAS123(R)–or even just a full conversation on deferred tax assets. We have a wealth of information on the NASPP’s Stock Plan Expensing portal. We also have an in-depth webcast in the NASPP webcast archive, “Practical Guide to Tax Accounting Under FAS 123(R).” However, if you are looking for the total information package on financial reporting, including accounting for tax effects, I highly recommend the NASPP’s course, Financial Reporting for Equity Compensation. The first class is today at 12:00 PM PT, but if you miss it, don’t worry. Not only are there four more fact-filled sessions, you can catch up on the recording of today’s class and take advantage of all the bonus materials. Register now!
Today’s blog entry is guest authored by Jon Burg of Radford, who will be moderating a discussion on designing performance-based equity programs using market conditions at the 19th Annual NASPP Conference in November. The panel will include Gloria Estrada of Agilent Technologies, Susan Stemper of Biogen Idec, and Kathryn Neel of Frederic W. Cook & Co. We asked Jon to give us a sneak peak at what the panel will cover.
Taking the Difficulty Out of Setting Performance Goals By Jon Burg of Radford
Designing a performance-based equity plan can be one of the bigger compensation challenges companies face. Limited line of sight and unforeseen obstacles impacting financial results make choosing a metric and determining the appropriate target an uphill struggle.
With increased pressure to align shareholder and executive interests, I anticipate that market-based plans will continue to be implemented for the following reasons:
They do not depend on the ability to set long-term operational or financial goals;
The payouts are directly linked to stock price performance (absolute or relative) which allows for higher perceived alignment between shareholders and award recipients;
The accounting treatment is more predictable since the expense accrual is fixed at the time of grant and not adjusted, regardless of eventual outcome; and,
They are simpler to administer than plans with other internal performance conditions, and they are measurable at any time for regular and frequent communication to plan participants and the Board
Agilent Technologies was one of the early adopters of a relative total shareholder return program in 2004. In fact after a brief two-year experiment of using a combination of relative TSR and SAGE (must be present to understand) metrics, Agilent has since focused solely on relative TSR. Relative TSR plans come in many shapes and sizes, but the basic premise is the same–award holders receive a higher (or lower) level of payout for excess (or under) performance in TSR as compared to a peer group or benchmark. Gloria will share with us Agilent’s plan design, the continued evolution, and lessons learned over the past seven years.
But relative TSR is not necessarily the answer for all companies. Biogen Idec considered relative TSR as a primary metric for their performance-based plan before opting for a Market Stock Unit (“MSU”). An MSU is a unique equity instrument that effectively combines the upside opportunity of a stock option with a limited downside protection of a restricted stock. Given Biogen Idec’s business model and market position, MSUs were considered a more appropriate replacement of stock options, which are not viewed as performance-based by ISS. Susan will take us inside the compensation committee discussions as well as share a wealth of experience she has gained over the years from literally hundreds of one-on-one executive meetings about equity awards.
Kathryn has worked with numerous companies to perform an assessment of business strategies and performance in order to identify optimal performance metrics that drive sustainable performance. This often involves a balancing act of setting goals that are fair to executives and shareholders. While not always the end result, market-based performance metrics are always a central component of the discussion and the fastest growing area. Kathryn will share her perspective on why she believes the pace has quickened the past few years and possibly even prognosticate on where we are headed.
Collectively, this panel will demonstrate that a well-designed market-based program can both mitigate the most troublesome flaws with traditional equity vehicles, and provide better compensation delivery.
Learn Even More About Performance Awards Round out your knowledge of performance based awards by attending the pre-Conference program, “Practical Guide to Performance-Based Awards,” offered on Nov 1, in advance of the NASPP Conference. This intensive one-day program will cover everything you need to know to implement and administer this complex emerging form of compensation.
On June 23, the IRS and Treasury proposed new regulations under Section 162(m) relating to the requirements for options and SARs to be considered performance-based compensation and the transition period for newly public companies.
Not-So-Surprising Proposed Regs for Section 162(m) (Well, Maybe a Little Surprise for IPO Companies)
Section 162(m) limits the tax deduction public companies can take for compensation paid to specified executive officers to $1 million per year. As I’m sure you all know, however, performance-based compensation is exempt from this limitation.
The recently issued proposed regs are not nearly as controversial as the IRS’s 2008 surprise ruling on 162(m), but are still worth taking note of–especially since, as the Morgan Lewis memo we posted on the proposal points out, some of these clarifications are the direct result of compliance failures the IRS has encountered during audits.
Stock Options and SARs
Normally, for compensation to be considered performance-based, it must meet a number of rigorous requirements. At the time that Section 162(m) was implemented, however, at-the-money stock options and SARs were considered inherently performance-based, so the requirements applicable to them are significantly more relaxed (a decision I can only imagine regulators regret today, given current public sentiment towards stock options). The primary requirements are that the options/SARs be granted from a shareholder approved plan, individual grants are approved by a committee of non-employee directors, the exercise price is no less than the FMV at grant, and the plan states the maximum number of shares that can be granted to an employee during a specified period.
The proposed regs clarify that, for this last requirement, the plan must state a per-person limit; the aggregate limit on the number of shares that can be granted under the plan is insufficient (although, the stated per-person limit could be equal to the aggregate limit).
For all performance-based compensation, including stock options and SARs, the regs already require that the maximum amount of compensation that may be paid under the plan/awards to an individual employee during a specified period must be disclosed to shareholders. For stock options and SARs, it’s pretty hard to determine what the maximum compensation is, since this depends on the company’s stock price over the ten years or so that the grant might be outstanding. The proposed regs clarify that it is sufficient to disclose the maximum number of shares for which options/SARs can be granted during a specified period and that the exercise of the grants is the FMV at grant.
Newly Public Companies
For a limited “transition” period, Section 162(m) doesn’t apply to arrangements that were in effect while a company was privately held (provided that the arrangements are disclosed in the IPO prospectus, if applicable). This transition period ends with the first shareholders’ meeting at which directors are elected after the end of the third calendar year (first calendar year, for companies that didn’t complete an IPO) following the year the company first became public (unless the plan expires, is materially modified, or runs out of shares or the arrangement is materially modified before then).
For stock options, SARs, and restricted stock, the current regs are even more generous–any awards granted during this transition period are not subject to 162(m), even if settled after the transition period ends. The proposed regs don’t change this, but they do make it clear that RSUs and phantom stock are not covered by this exemption. My understanding from some of the memos we’ve posted in our alert on this is that this reverses a couple of private letter rulings on this issue (see the Morrison & Foerster, Morgan Lewis, and Edwards Angell Palmer & Dodge memos). The current regs specifically state that the exemption applies to stock options, SARs, and restricted stock, but are silent as to the treatment of RSUs and phantom stock–providing the IRS/Treasury with the leeway to exclude them now.
Several of the changes are pretty subtle–so subtle that when comparing the proposed regs to the current regs, I couldn’t figure out what had changed. So I used the handy-dandy document compare feature in Word to create a redline version of the new regs, which I’ve posted for the convenience of NASPP members.