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Capped Stock Options: The Next Generation?

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March 22, 2012 | Jennifer Namazi

Capped Stock Options: The Next Generation?

I'm not ashamed to admit that I'm not an accounting expert. I have complete and utmost respect for those who are in the trenches of accounting for stock compensation, and even more admiration for those who actually enjoy it. As a result of being an accounting "simpleton", I appreciate it when an article crosses my desk that explains accounting concepts in interesting and understandable terms. On that note, last week we received an article titled "Using Capped Options to Collar Volatility", published by Radford and now posted to our Stock Plan Expensing portal, that seemed to highlight a new trend in stock option expensing: the "capped" option.

A Volatile World

One thing I do know about stock option expensing is that the increased volatility of our stock markets has, in many cases, increased stock option valuations. As a result, companies are searching for new ways to conquer a delicate task: minimize stock option expense without impacting the "perceived" value that employees associate with their equity awards. ("It's worth what I think it's worth.")

Capping Maximum Value

One way that some companies have addressed the impact of volatility on their stock option expense is to cap the maximum value that particular stock option can deliver to its recipient upon exercise. For example, a stock option priced at $10 with a cap of 400% would mean that the participant could not receive any additional value once the stock price exceeds $40 (yes, I pulled this example from the article - the terms are simple and easier to understand than any alternative I might make up). Using a cap that seems unattainable - and a 400% return would likely exceed the reasonable expectations of most employees - arguably keeps the employee's perceived value of the stock option intact, while simultaneously reducing expense. According to the experts who wrote the article, the single act of capping an option - even a seemingly high cap of something like 400% - can have a significant downward impact on stock option expense (assuming other variables in the expense calculation remain constant).

Is this a Trend?

Several companies have jumped on the capped option bandwagon, and there are indicators that more companies are on track to issue capped options. In addition to minimizing the expense component of the stock option, a peripheral benefit seems to be some high marks in the shareholder perception aspect of the equation. Shareholders tend to dislike large windfalls, especially when there are no performance requirements attached to a grant. Capping the maximum value a stock option could deliver certainly would help eliminate the prospect of a windfall. Time will tell in terms of staying power of this new trend. We've seen a lot of things emerge in recent years, with staying power (performance grants ring a bell?), so I wouldn't be surprised if this concept gains some traction.

I'm curious to know who has pursued capped options or is considering doing so. Take our poll below and see how you compare to what other companies are contemplating.

-Jennifer

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