It’s time to return to my ongoing series on how to account for award modifications. Today’s topic is modifications to extend the time to exercise options when employees terminate employment. This one is kind of a doozy.
This modification is similar to a repricing in that it doesn’t impact the vesting conditions of the award and, thus, doesn’t change the vesting probability of the award. In this case, however, the award will be vested—you wouldn’t extend the exercise period for an award that is going to be forfeited. [If the award isn’t vested and you are also accelerating vesting, that is accounted for as an acceleration of vesting—more info below.)
Barely. This is a probable-to-probable (Type I) modification:
The primary difference between the two values will be the expected life of the option. Before the modification, the expected life will usually be close to zero (maybe a few months) because the option is about to expire. After the modification, the valuation will be the new period in which the option can be exercised. That increases the time value of the option and results in a higher valuation.
Say that an employee terminates while holding an option to purchase 10,000 shares that is fully vested. The option is scheduled to expire three months after the employee’s termination, but the board approves an extension to allow exercise for three years.
Let’s assume that the original grant date fair value of the option was $10 per share, so the company has recognized expense of $100,000 for the option. None of this expense is reversed.
In addition, the company will recognize incremental cost for the modification. When calculating the value of the option before the modification, the company will assume an expected term of three months, since that’s how long the former employee has in which to exercise. After the modification, the expected term will increase to three years, which could in turn affect the interest rate, expected dividend yield, and expected volatility. I came up with a before valuation of $15 and an after valuation of $19.* This results in incremental cost of $4 per share, or $40,000 in aggregate, which will be recognized immediately in the period in which the board approved the modification.
Just like with acceleration of vesting, this will be a facts and circumstances determination. If the post-termination exercise period is modified at a time when there isn’t an expectation that the option holder will terminate, the modification would likely have no impact on the expected term of the option and would not result in any incremental cost.
In most cases, this question is a non-starter. Under Section 409A, if an in-the-money option is modified to allow exercise beyond its original contractual term (or longer than ten years after the grant date, if earlier), this is considered to be the addition of a prohibited deferral feature. It causes the option to become subject to Section 409A retroactive to the date of grant. That’s going to be a lot of years of 409A penalties that suddenly apply to the option. The accounting consequences would be the least of your worries.
Section 409A allows an exception, however, for options that are underwater or at-the-money. The accounting consequences are the same as described above: no expense is reversed, incremental cost equal to the excess of the “after” value over the “before” value, and the incremental cost is recognized immediately.
This is something to keep in mind when extending the post-exercise termination period; if the option is in-the-money, you don’t want to extend that period beyond the earlier of (i) the original contractual term of the option or (ii) ten years after the grant date.
For this modification, you have to look at the vested and unvested portions of the option separately.
The vested portion is accounted for exactly as I have described above (Type I, probable-to-probable modification). If none of the option is vested (or if the vested portion of the option has already been fully exercised), there’s nothing to account for here.
For the unvested portion, the acceleration of vesting drives the accounting treatment. This will be an improbable-to-probable (Type III) modification:
You bet! To learn about the securities law, tax, and other considerations that apply to award modifications, check out my blog entry “5 Things to Know About Award Modifications” and this handy table summarizing the considerations for various types of modifications.
Thanks to Dan Kapinos of Aon Rewards Solutions for helping me understand how to account for a combined acceleration of vesting and option term extension.
* Want to try this at home? I used this valuation model and assumed the following:
Accounting for Accelerating Service Conditions of Performance Awards
This week, I return to my series&...Read More
Optimizing Equity Awards in a Down Market
Can equity awards be optimized for insulation against market declines? If 2020 is teaching us anything, it’s that companies may need to get creative in figuring out how to restore broken i...Read More
Accounting for Cash Settlement of Equity Awards
This week, I return to my Read More
Accounting for Option Repricings
For this week’s blog entry, I continue my Read More
Accounting for Acceleration of Vesting Upon Termination
For this week’s blog entry, I continue my series on how to account for ...Read More