December 3, 2008
Volume 1, No. 5
In this Issue:
Vote for SOS Excellence Award Candidates
SOS Focus: Net Exercise
Free Webinar: Option Exchanges
SOS Webinar Summary: A Good Year… End
To Schedule D or Not To Schedule D…
Data & Technology Solutions
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SOS Xtra: Volume 1 No. 5
SOS has received nominations for 17 worthy candidates for the SOS Excellence Award for 2008
which is designed to recognize an equity compensation professional who has contributed to
the stock plan profession above and beyond the call of duty. Nominees include personnel
from service providers, industry organizations, and issuing firms.
Please submit your vote today for one of these deserving individuals and help them get
the recognition they deserve. Votes will be accepted until December 22nd. Our winner
for 2008 will be announced on New Year’s Eve.
Cast Your Vote Today!
(Thanks to all those who submitted nominations for SOS personnel, however SOS team members
are not eligible for the award.)
*Please feel free to forward this newsletter on to others who might be interested in the content.
You can join the SOS Xtra mailing list by clicking here.
SOS Focus: Net Exercise
As we mentioned in October in our SOS Perspective
article, net exercise is getting a lot of attention these days. With the implementation of FAS 123(R)
as the US accounting standard for share-based payments, the negative accounting treatment of
net exercise was eliminated. In addition, many companies are looking for ways to reduce the
dilutive impact of equity grants. So some companies are now considering implementing “net exercises”
as a choice (or in some cases a mandate) for their participants. We have gotten a number of
questions on implementing this practice over the last few months, and are speaking about it twice
in December alone. So let’s dive in and discuss the details.
What is a “net exercise”?
A net exercise is the practice of “tendering back to the company” some of the exercised
shares to cover the exercise price of the option. In some cases, shares will be tendered
to cover taxes as well. Many people find this more understandable when we call it “withholding
shares” since the participant never actually holds the shares, the company just issues the “net
shares” to the participant, hence the term “net exercise”.
Let’s talk through an example: Let’s say you have a non-qualified option with 100 shares.
The price is $10 per share and the current market value is $25. To exercise the 100 shares,
the participant must pay the $1,000 of the option price (100 shares * $10 price per share).
In a net exercise, you would simply divide the amount due by the market value and withhold
that many shares: $1,000 / $25 = 40 shares to withhold. 60 shares are issued to the participant.
Now let’s add in taxes. If you assume a 40% tax rate, the participant would owe $600 for
taxes ($1,500 gain * 40% tax rate), divide that by the $25 market value, and you withhold
another 24 shares for taxes. The participant receives 36 shares.
Please note that the end result of the transaction is shares, not cash. Some companies
are exploring net exercise as an alternative to same-day sales, where the end result of
the transaction is cash to the participant. In its current form, net exercise does
not produce the same results as a same-day sale.
Some Advantages of Net Exercise:
- Same result for the participant, with no cash outlay
In a cash exercise, where the participant must fund the exercise out-of-pocket, the
participant will end up with more shares, but the initial economic result is the same.
They hold shares worth $2,500, but they had to pay $1,600 to receive those shares. The end
result is a $900 “gain”. When you issue only 36 shares after withholding shares for price and
tax, again the participant ends up with a value of $900 (36 shares * $25 market value), but
the participant didn’t submit any cash to initiate the exercise.
- Reduces plan dilution
Since only 36 shares are issued into the market, not 100, the impact to your earnings
per share is much, much less. In many cases those 64 withheld shares are retired and
thereby lose their ability to contribute to dilution in the future. In some cases,
those shares are added back to the plan pool and can be granted as options or other
vehicles in the future. That practice, however, comes with its own considerations,
which we’ll discuss further later.
- Encourage share ownership without out-of-pocket investment
Since the participant is not required to invest their own funds in the exercise,
some companies are using this as an easy way to encourage actual share ownership
without the risk of a cash exercise.
- Not reported as a sale on Form 4 and does not require a Form 144
Yes, the exercise is form 4 reportable, but not as a sale; the shares are “disposed”
back to the company instead. In addition, since no sale occurs as part of the exercise,
no form 144 is required either.
Some Disadvantages of Net Exercise:
- Limited automation
Software and platform support are still evolving for net exercise because it is just
beginning to be requested by issuing firms. Many firms that are currently offering
net exercises have manual processes around it. Some vendors have recently updated their
platforms to support net exercise and there are workarounds for some other platforms,
but you should be aware that most processes are still more manual than for other types
- Same considerations as RS/RSU with share withholding
All the same issues encountered in withholding shares for taxes on restricted stock
or units also apply to net exercises. Cash inflow is reduced since you are no longer
receiving the exercise price from the participant. If you choose to withhold shares
to cover taxes, cash outflow will increase, since the funds due to the IRS no longer
come from the exercise. And the funds are due nearly immediately if/when your company’s
cumulative liability exceeds $100,000 (the exception that allows more time to remit
funds applies only to same-day sale exercises of non-qualified options). And determining
tax rates for international participants is a challenge since there are generally no
“one-size-fits-all” tax rates in non-US tax jurisdictions.
- IFRS 2 & Liability Accounting for Shares Withheld for Taxes
As you’ve probably heard, the adoption of IFRS by US companies may be required by 2014.
IFRS 2, the international accounting standard for share-based payment, requires liability
accounting for grants where the number of shares to be delivered may vary (as they would
if shares are withheld to cover taxes). So, if an award allows a participant to pay taxes
via share withholding, liability accounting is likely to be required for that grant.
However, please note that this is not an issue if you are withholding shares to cover
the option price (since that is a fixed amount), only shares withheld to cover taxes.
Other Things to Consider
Just as with share withholding for taxes on restricted stock, to round up, or round down,
that is the question. And the issues are the same too. If you round up, you are
“over-withholding” taxes, and some audit firms have recently begun to assert that
rounding up may trigger liability accounting. If you round down, you are under-withholding
and need to collect the small remainder in cash in some manner. Some companies collect
via check (generally because their plans will not allow other methods), but most seem to
collect the remainder through payroll. (Note that collecting the amount through payroll
for your insiders might be problematic due to the prohibition on “loans” to insiders.)
In addition, we believe that if you are withholding shares for both price and taxes, it
is a best practice to compute the number of shares due for price and tax separately and
apply the rounding separately so that the number of shares withheld for tax vs. price
can be determined for accounting purposes.
- Which Market Value to Use
Since you must have a determinable market value to know how many shares to withhold,
which market value will your company use? Some companies use the market value from the
prior trading day’s close since that allows the number of shares to be issued to be
determined immediately. Some of our clients have rejected that because of the
possibility of the participants’ “playing the market” since the prior day’s closing
value is known. However, if you use the closing value from the current trading day,
the results of the transaction cannot be known until after the market closes. Some
clients have insisted that a “spot price” be used – the price at which the shares are
currently trading at the moment the exercise is initiated. However, since there is no
market transaction from which to determine price, at least one industry expert has
asserted that this practice would likely be risk-prone due to the possibilities of
manipulation and fraud.
- Returning Withheld Shares to the Plan
As alluded to above, some plans do allow companies to return shares withheld to the
plan so that they can be “reused” for other grants. However, under more recent guidelines,
some proxy advisory firms, such as Riskmetrics, consider this practice “liberal share
counting” and will count shares in plans with these provisions as “full-value shares”
(like restricted stock) when performing their calculations on Shareholder Value Transfer
(SVT). This does not preclude the use of the provision, but it may mean that the proxy
firm will approve fewer shares for your plan. If your primary goal is the reduction of
dilution, a best practice is to retire these shares instead of returning them to the plan.
That may not extend the life of your plan, but since they cannot be reissued, they will
never become dilutive.
Other Sources of Information on Net Exercise:
SOS Net Exercise Survey Results
E*TRADE Corporate Services White Paper
NASPP Website (requires membership to access)
Benefits of Net Exercises Over Cashless/Same-Day-Sale Exercises
Net Exercise Comparison Chart
These are just a few of the things to think about when considering implementation of net
exercises. If you have questions please e-mail us at:
Free Webinar on Option Exchanges: The Good, the Bad, and the Ugly – December 17th
Please join us for our next free webinar on Wednesday, December 17th at 11am Pacific Time.
Follow this link to register:
This panel of experts will provide an overview of:
• the mechanics of option exchanges,
• the myriad issues to consider during the analysis and design phase,
• the accounting for exchanges, including incremental expense, accrual, and
• securities law (including compliance with tender offer rules and proxy disclosure
• tax law (including the impact on incentive stock options),
• labor and employment law and other legal issues, and
• shareholder voting requirements and other shareholder concerns
We will also review statistics from research studies and surveys by SOS, Cooley Godward Kronish,
and Equity Methods to give you a real sense of what other issuing firms are doing and what they have (and haven’t) gotten approved by shareholders. The session will also provide best practices based on panel members’ personal experience with issuing firms going through exchanges.
• Elizabeth Dodge, VP Product Management, Stock & Option Solutions, Inc.
• Takis Makridis, VP Professional Services, Equity Methods LLC
• Thomas Welk, Partner, Cooley Godward Kronish LLP
(One hour of Certified Equity Professional continuing education credit is available for attending. See the CEPI website
for more information on continuing education requirements.)
…tender tidbits about people and players in our industry…
Danielle Benderly, president of the Portland Chapter of the NASPP, (and a partner with
delivered Alexandra Benderly on September 28… Jana Vretenar of Morgan Stanley has gotten engaged and is
planning a wedding in 2009… Wendy Davis, at Cooley Godward Kronish LLP, has just been elected to the
partnership, effective January 1st!
The Certified Equity Professional Institute (CEPI) has just announced the CEP Volunteer Excellence Awards
for 2008; the awards recognize CEP volunteers that provided exceptional service, exceeding expectations,
to the CEPI over the past year. Pam Ellis & Glas Blas, of Stock & Option Solutions, were among the winners!
On the Move!...
Caron Stempek and Kimberly Lekse have joined E*TRADE Corporate Services as account managers...
Renee Demming has joined Cooley Godward Kronish LLP as a partner in the Compensation & Benefits Group...
Joanne Norgart has taken the role of Sr. Mgr of Stock Administration at Data Domain, Inc.
Equity Methods is holding a design and compliance forum in San Jose on December 4th.
The NASPP is putting on its 2nd Annual Year-end Tax Reporting webcast
on December 9th… E*TRADE Corporate
Services is hosting two webcasts with Baker & McKenzie on Net Exercises on December 5th and 8th (for E*TRADE
Mission Mpower is pleased to announce the release of its new
equity compensation administration software: Equity Central… E*TRADE Corporate Services
is launching Equity Edge 8 this month, with full
support for performance awards, fungible share tracking, and enhanced mobility tracking... Schwab
has recently enhanced EquiView, its web-based administration platform, with dividend and equivalent
(cash and stock) tracking and reporting, as well as robust mobility tracking for geographic moves and/or
moves within your organization.
Have something to Xpose? Email me! (But keep it clean, people!)
(All of the content included in SOS Xposé has been approved by the firms/people discussed.)
SOS Webinar Summary: A Good Year…End
In case you missed last month’s webcast on improving year-end practices and procedures, we’ve summarized
just a few of the highlights:
It’s a Project… Manage It!
Year-end is a big project from any perspective, so to succeed you really need to employ true
“project management” practices and procedures (and if you can, even get a professional project
manager involved –see if there’s any chance you can leverage your company’s project management
personnel or just expertise). Compile a Master List / Schedule: Include deliverables,
due dates, owners. Update the list throughout the year. Hold a cross-functional kick-off meeting
(and do it as early as you can!): At the meeting, review the master schedule for the year-end project.
Meet with vendors too. Calendar Important Events: Use your calendar. Keep important events on your
(and others’) schedule. Proxy filing dates, annual meetings, 10Q dates, 10K date, large vesting events,
etc. Regular Meetings to Review: As you approach year-end, hold review meetings more often to keep people
on track. But don’t waste people’s time; have an agenda and stick to it. Lessons Learned: Once it’s
mostly over (is it ever really “over”?) hold a “lessons learned” session with the whole team to figure out
solutions to problems you encountered this time while the issues are still fresh in your mind.
The Advance Advantage
Do everything you can in advance. Year-end is crazy enough without having to do “your regular job” too,
so get as much of it out of the way early as you can.
File Form 4s for transactions that could wait for a Form 5 as they occur (better perception by shareholders
too!). Do data audits and reconciliations throughout the year. Increase their frequency as you get closer
to year-end so you only have a little data to audit and reconcile at the very end. Survey for and record
dispositions for ISOs and ESPPs throughout the year. Also keep an “aud log” – a record of all unusual
transactions as they occur - so you don’t have to track them down at year-end.
Play Well with Others
From payroll to HR to legal to tax to accounting, you need everyone to work together to get the year
closed. Form relationships and start talking to them early on about what they need from you for year-end
and when they need it by… And don’t forget your vendors (and if you changed vendors during the year,
coordinate with your old vendor too – avoid duplicate or missed reporting mishaps!) For payroll, make sure
you get that last payroll run scheduled early and determine your process for W-2Cs, if any. For HR, talk to
them about new policies and procedures or grant practices they’re thinking about. For tax and accounting,
give them copies of the reports you’re planning to produce for them, have them sign off early that the reports
do have the data they need.
Get Your Financial Reporting Ducks in a Row
Review your FAS 123(R) valuation inputs and forfeiture rates, run and audit your FAS 123(R) expense reports and
EPS reports. Be familiar with all the areas equity plans are disclosed in your 10-K/Annual Report and Proxy
Audits, Controls, and SOX, Oh My!
Get ready for your SOS Audit: Request an early copy of your vendor’s SAS 70 certification; Ensure all yellow-
or red-flagged controls are remediated. Avoid introducing new processes / procedures / system updates in Q4.
Budget some time and money to spend developing your skills, whether related to equity compensation or
just your own professional development. Make a commitment to do it and stick to it. You and your company
will reap the rewards of your investment.
Questions? Other year-end tips you want to share? Please e-mail us at: firstname.lastname@example.org.
To Schedule D or Not To Schedule D…
A little-known IRS revenue procedure has caused some discussion around the SOS office of late. We thought
we’d get the word out about the revenue procedure and what it MIGHT mean to your stock plans and participants.
Revenue Procedure 2002-50 (see page 61 of the PDF) exempts your brokerage firm from sending out 1099-B forms to your participants for
same-day sale exercises if the gain of the transaction is calculated based on the sales price of the shares.
To rely on this exemption, your brokerage firm must:
1) receive from your company written certification that any compensation income
generated by the exercise will be reported on a W-2 form and
2) furnish to the participant a written statement that includes
a. the gross sales price
b. fees charged by the broker on the sale; and
c. a description of how gain or loss is calculated and how to report the gain or loss
on a federal income tax return.
Why might your company care about this obscure revenue procedure?
In some cases, it may spare your participants the pain of completing a 1040 long form instead of the 1040EZ,
just because of an option exercise. If the participant does complete a Schedule D for the exercise, they are
reporting only the small capital loss that results from the fees charged by the brokerage firm. The rest of the
income is reported on the W-2 form. (If given a choice many participants might “pass” on completing a 1040 long
and a Schedule D to recoup only a small amount of tax.)
We have had some clients assert that because the income from the exercise is reported on the W-2, the participant
is no longer “required” to complete the Schedule D, and thereby can avoid using the longer 1040 form. The
underlying logic is that the IRS publications that seem to require the completion of the schedule D are not
law and while income and gains must be reported, participants do not have to report deductions and losses if
they don’t wish to use them. Other practitioners have asserted that the Schedule D reporting is still required,
but that since the transaction is not reported to the IRS on a 1099-B, there is no penalty assessed for failure
to complete the form. (It’s required, but you won’t be penalized if you don’t do it?)
Some clients have also reported that, since participants do receive a 1099-B and a W-2, in some cases that
income gets reported to the IRS twice, and subsequently taxed twice since some tax professionals do not
understand that the income from the same-day sale is already included in the W-2 income. No longer sending
a 1099-B to the participant should help to reduce this confusion as well.
In any case, if your brokerage firm can support it, you might want to discuss the possibility of the exemption and what it means for your participants with your legal counsel. It might save your participants a lot of pain every April.
||Information provided in this newsletter is designed for educational and entertainment purposes only and is not provided as
professional service or advice. Moreover, this newsletter should not be relied on as legal, accounting,
auditing, or tax advice. Anyone reading this newsletter should not act upon this information without seeking
professional counsel and/or input from their advisors. The preceding information does not necessarily represent
the official views of Stock & Option Solutions, Inc. with respect to any of the issues addressed.|