6 Considerations Before Modifying Equity Awards

It is sometimes necessary to modify the terms of equity awards, often to address events or circumstances that weren’t foreseen at the time the awards were granted. But changes to the terms of awards can have accounting, legal, or other consequences.

In this blog, I discuss six ramifications to consider carefully before modifying an equity award.

Consideration #1: The Company Will Incur a Cost for Most Modifications

Under ASC 718, changes to the terms of an award that meet any of the following conditions must be accounted for as modifications and will likely result in additional expense that must be recognized in the company’s financial statements:

• The fair value of the award just after the modification differs from the award’s fair value just before the modification.
• The vesting conditions of the award are changed.
• The accounting treatment of the awards is changed from equity to liability or vice versa.

The accounting treatment of modifications varies based on whether the awards were probable of vesting before the modification and are probable of vesting after the modification. Under ASC 718, there are four types of modifications:

• Type I (Probable-to-Probable)
• Type II (Probable-to-Improbable)
• Type III (Improbable-to-Probable)
• Type IV (Improbable-to-Improbable)

Each of these four types of modifications is accounted for differently. Most modifications are classified as either Type I (Probable-to-Probable) or Type III (Improbable-to-Probable), so let’s focus on those.

Type I (Probable-to-Probable) Modifications

In this type of modification, the grant is considered likely to vest both before and after the modification. Probable-to-probable modifications can include the following:

• Repricing
• Acceleration of vesting that is not in connection with termination of employment
• Extension of the post-termination exercise period for stock options

The following principles govern the accounting treatment of probable-to-probable modifications:

1. None of the expense already recorded for the repriced option is reversed.
2. The company must recognize any remaining unamortized expense over the remaining service period.
3. The company will recognize incremental cost equal to the amount by which the fair value of the option immediately following the repricing exceeds its fair value immediately before the repricing.

It’s like trading your old car to buy a new car. You don’t get any of the money you paid for the old car back and, if you haven’t yet finished paying off the loan on the old car, you still have to pay it off. But the amount you pay for the new car will be reduced by the value of your old car at the time you trade it in (except that with stock option repricing, the old and new options aren’t being valued by a car dealer who is trying to rip you off).

Type III (Improbable-to-Probable) Modifications

In this type of modification, the grant is not expected to vest before the modification but is likely to vest afterward. One example of an improbable-to-probable modification is acceleration of vesting upon termination.

The following principles govern the accounting treatment of improbable-to-probable modifications:

1. The expense originally computed for the modified portion of the award will no longer be recognized. Any expense that has already been recognized for this portion of the award is reversed.
2. The new fair value of the modified portion of the award is recognized as expense in the period the acceleration occurs.

Consideration #2: Shareholder Approval May Be Required

Proxy advisors and investors often view repricings and similar option exchanges unfavorably and will vote against equity plans that allow companies unfettered authority to implement these programs. As a result, most equity plans stipulate that shareholder approval is required for any option repricings or similar exchanges.

Most other modifications, such as acceleration of vesting or modifying performance targets, generally do not require shareholder approval. This can vary by plan, however. Review the terms of your plan documents.

Consideration #3: Award Holders May Need to Consent to the Modification

Modifications that require award holders to give up existing rights under their awards generally require consent from the holders. For example, if award holders must accept extended vesting or a reduced number of shares to participate in a repricing, they’ll need to consent to that.

Likewise, if a modification could result in loss of preferential tax treatment, consent may be necessary. Acceleration of vesting might seem like a benefit to an award holder, but if it will cause an ISO to exceed the $100,000 limit, the option holder might not be so keen on it.

Consideration #4: The Modification Could Be Considered a Tender Offer

If it is necessary to obtain award holders’ consent for the modification, it is also likely that the SEC will view the modification as a tender offer. Unless only a handful of awards are modified, the SEC generally requires modifications to comply with the requirements for tender offers when award holders are asked to give up some of their rights in exchange for the modification (for example, the award holders must agree to forfeit some of the shares in their award, accept additional or extended vesting conditions, or give up rights to preferential tax treatment).

Tender offer compliance generally entails preparing and filing specified documents with the SEC, including Schedule TO, and providing award holders with at least 20 days in which to decide whether to accept the offered modification.

Consideration #5: Many Modifications Trigger Disclosure Requirements

Many modifications are subject to disclosure, especially if named executive officers or Section 16 insiders are involved.

• Under ASC 718, all material modifications that occurred during any year presented in the P&L must be discussed in the notes to the company’s financial statements.
• Repricings are reportable on Form 4 for Section 16 insiders, as are extensions of the contractual term of stock options.
• Most modifications made to grants held by named executive officers will need to be discussed in the CD&A and may require additional disclosure in the proxy statement.
• Material grants issued to named executive officers are reported on Form 8-K. Where modifications to these grants are material and are not consistent with the previously disclosed terms of the awards, the modifications must also be reported on Form 8‑K.
• All grants issued to named executive officers (NEOs) and material grants issued to executive officers other than NEOs are filed with either Form 10-Q or 10-K. Amendments to previously filed grants should also be filed with Form 10-Q or 10-K.

Consideration #6: Modifications Can Affect the Tax Treatment of Awards

There are several tax traps to be wary of when modifying equity awards:

• Modification of ISOs is considered a cancellation of the original option and grant of a new ISO. At the time of the modification, the new grant must meet all the requirements of Section 422 for the option to retain its ISO status.
• Modified ISOs will have a new grant date for purposes of the statutory ISO holding period.
• Although not considered a modification for purposes of Section 422, accelerating vesting can cause an employee’s ISOs to exceed the $100,000 limit.
• Extending the expiration date of an NQSO when the option is in-the-money will cause a Section 409A violation that will be retroactive to the date the option was originally granted. This will subject the option holder to a 20% penalty tax plus interest at 1% higher than the penalty rate.

Learn More About Equity Award Modifications

The NASPP article “Accounting for Equity Compensation in the United States” covers the accounting treatment of different types of modifications in more detail, including examples of eight common modifications to equity awards. You can also check out the NASPP webinar “The Truth about Modifications - Equity Awards & ASC 718” to learn more about how modifications are accounted for.

For a reference guide to other possible pitfalls, check out this handy table summarizing the considerations for various types of modifications.