A recruiter promises a prospective employee a grant and forgets to notify you about it, so you aren’t able to include the grant in the list of awards to be approved by the board or compensation committee. Now the newly hired employee is asking where her grant is. Here’s what you can do about it.
When a grant is inadvertently omitted from the recommendations submitted to the board, committee, or delegate for approval and the omission isn’t discovered until after the grant recommendations have been approved, this error can’t be fixed by simply changing the recommendations and modifying the meeting minutes. It also isn’t possible to retroactively issue a grant.
Companies were subject to significant penalties for retroactively granting options in the backdating scandal circa 2005 to 2008. In some cases, companies had to restate financial statements and were unable to rely on their Form S-8 filings to issue shares under their stock plans until the restatements were filed. In a few cases, people even went to jail. The article “Why I Did Not Go to Jail” by Ben Horowitz of Andreessen Horowitz is a great reminder of why it is dangerous to retroactively change grant approvals (and why the word “backdate” elicits gasps of horror from stock compensation veterans).
The only way to fix an error like this is to submit a new grant recommendation to the appropriate authority (board, committee, or other delegate) for the omitted grant. This can be a special recommendation or you can simply include the grant in the next scheduled group of grants that will be submitted for approval (assuming that this will happen in a reasonably timely manner).
The grant date of the award will be the date it is approved, not the date it should have originally been approved. Likewise, the fair value of the award will be determined on the grant date and, for public companies, will most certainly differ from what the fair value would have been if the omission had not occurred. Finally, if the grant is a stock option, the exercise price must be at least equal to the FMV on the grant date.
Depending on the type of award and the trajectory of the underlying stock price during the intervening period between when the error occurred and when it is corrected, the employee may be economically disadvantaged as a result of the mistake. It may not be possible to make the employee entirely whole, but here are some ways that employees might be compensated for the error.
1. Use Earlier FMV to Calculate Shares Granted: Where the employee is to receive a grant worth a specified dollar amount, it is permissible to use the FMV from when the grant should have been approved to determine the number of shares. For example, say that an employee was to be awarded an RSU for $10,000 worth of stock when the FMV was $10 per share and that by the time the omission is discovered, the FMV has risen to $12 per share. It is permissible to use the $10 FMV to determine the number of shares the employee will receive, i.e., 1,000 shares instead of merely 833. (Barring, of course, language in the plan that stipulates which FMV must be used to calculate the number of shares granted, which is unusual.)
Note, however, that doing so will increase the company’s cost for the grant. In my example, the company’s cost will be $12,000 (1,000 shares multiplied by the $12 per share FMV) instead of the $10,000 expense the company would have recognized if the grant had been approved when it should have been.
2. Tie Vesting to the Earlier Date: In most cases, it is also permissible for vesting in the award to commence based on when the award was originally to have been granted (again, barring language in the plan prohibiting this). Let’s say that the RSU in my example should have been granted on January 1, 2021, the error isn’t corrected until April 1, 2021, and the grant is to vest in three annual installments. It is permissible for the grant to vest on January 1 of 2022 through 2024, rather than on April 1 of those years.
Here again, this will affect the expense the company recognizes for the award. In this case, it is the timing of expense recognition that will change, rather than the amount of the expense.
In my example, the $4,000 of expense attributable to the first vesting tranche will be recognized over the nine months from April 1, 2021 through January 1, 2022. This will result in an expense of $444 per month ($4,000 divided by nine months). If the award had been granted as intended, only $278 of expense would have been recognized per month. (The aggregate expense of the award would have been only $10,000 and one-third of this amount, or $3,333, would have been attributable to the first year-long vesting tranche, resulting in an expense of $278 per month).
Where the company accrues expense on a straight-line basis, the expense for the second and third tranches will be recognized over 12-month periods, as would have been the case if the grant had been issued as intended. This will drop the expense per month to $333 ($4,000 divided by 12 months) but it is still higher than the $278 per month that would have been recorded absent the error.
Where the company uses the accelerated attribution method, expense for the second and third tranches is recorded over the period from the grant date until the tranche vesting date. This will be a shorter time period than would have been the case if the grant had been issued when originally intended.
I’ve ignored the impact of forfeitures in my example to keep the expense accrual calculations as simple as possible. If the company applies an estimated forfeiture rate to its expense accruals, the above amounts would be adjusted by that rate.
3. Increase Option Size or Other Compensation: In the case of full value awards, the above adjustments should be sufficient to restore the economic value the employee would have if the error hadn’t occurred. For stock options, however, the exercise price remains a concern. If the award in my example is a stock option, the exercise price will now be $12 per share, instead of the originally promised $10 per share.
Our only alternative here is to offer to compensate the employee for the increase in exercise price. The aggregate increase in price is $2,000 (1,000 shares multiplied by $2 per share). The most common solution would be to simply increase the grant by 200 shares, to make up for the higher price ($2,000 divided by $10 FMV). Alternatively, the $2,000 could be paid out in cash to the employee. (Payout of the $2,000 should not be tied to exercise of the option, as this could be viewed as a reduction of the exercise price.)
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