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Performance Stock Options in Broad-Based Plans

[Editor's note: You can find many more articles on employee ownership and corporate performance in the articles section title Ownership Concepts and Research on our home page.]

Almost all stock options issued under broad-based stock options plans are either nonqualified stock options (NSOs) or incentive stock options (ISOs). These plans qualify for fixed price accounting, so they do not show up on the company's income statement at the time they are granted. Some executive plans, however, use performance-based options. These plans provide that the option holder will not realize any value from the option unless specified conditions are met, such as the share price exceeding a certain value above the grant price or the company outperforming the industry. Performance-based plans can require variable plan accounting, which requires companies to show on their income statement a value determined by calculating the difference between the grant price of the options and the stock's current fair market value, multiplied by the percentage of options vested, adjusted for the cumulative prior expense recorded. Any performance-based plan in which the measurement date (the first date on which the number of shares and the exercise price are known) occurs after the date of the grant triggers variable plan accounting.

This "hit to earnings" discourages most companies from using at least some kinds of performance options in a broad-based plan, even though an argument can be made that shareholders should be much happier with this approach. As long as shareholders remain in blissful accounting ignorance, however, the fixed approach appears better. Companies may also be concerned, however, that attaching a performance criterion to options may be inappropriate for non-executives because they have too little control over helping companies meet the targets. Of course, they have no more control over whether the company's stock price increases above the grant price, but the layering on of conditions may make the options seem too uncertain.

Advocates for performance-based plans counter that providing specific targets can help focus employee interest on company-specific goals, whereas employees can often benefit from options simply because the industry or broad market does well. The plans may also be easier to sell to at least some shareholders, especially if they qualify for fixed plan accounting. If these or other arguments are persuasive, several types of performance options might be considered. The plans described here are not the only choices; companies can impose all sorts of performance criteria and option terms. Whatever choice is made, however, care should be taken that it can be readily understood by employees, that it has a real chance of delivering meaningful value, that it fits with the company's culture, and that it will not cause recruitment or retention problems.

Plans That Allow Fixed Plan Accounting

Performance Grants

In the simplest of plans, the company grants options only on the achievement of certain specified targets, such as stock price or profits. Boeing announced such a plan a few years ago.

Performance-Accelerated Vesting

These plans grant options as usual, and have a normal vesting schedule. However, if specified targets are met, vesting accelerates. For instance, a 25% per year vesting schedule would result in 75% vesting after three years, but vesting could be accelerated to 100% if revenue targets are met. These plans normally get fixed plan accounting as long as the base vesting schedule does not exceed the company's normal option vesting schedule or, if it is the only kind of plan, what would be arguably normal in the industry.

Premium-Priced Options

These options are granted at a strike price (the price at which the shares can be exercised) that exceeds the current price, so for them to have a value, the stock must increase to at least this higher target price. Companies must, however, give option holders to right to exercise their vested options even if the price is below the target price. For instance, the current price at grant might be $10, and the strike price might be $15. If the shares go to $14 when fully vested, the option holder would have to be able to exercise the option to buy the $14 shares for $15.

Plans That Require Variable Plan Accounting

Price-Vested Options

With these plans, options are granted at the current price, but the holder only vests when the shares reach a designated higher price. A plan might provide that some of the options will vest at one price, while others will vest at a higher price.

Performance-Vested Options

These options are tied to specific individual, group, or corporate goals. Like price-vested options, they vest upon the attainment of an objective, except that some other measurement than stock price provides the trigger, such as revenues, profits, or return on investment.

Indexed Options

Because options can have value even in a company that underpreforms its industry, indexed options provide that the target price at which shares can be exercised is indexed by the performance of peers or the market in general. For instance, for options granted at $30, if the index of peer stock prices rises 50%, the shares could be exercised at $45. So only company performance of above $45 would provide value. Alternatively, however, if the share price goes down by less than the index, holders could get value even though the stock price has declined.

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