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The Employee Ownership Update

Corey Rosen

June 1, 2005

(Corey Rosen)

Cisco Proposes Market Test for Options Value

Cisco Systems has proposed issuing a special security that would mimic employee stock options as a way to create a market-based valuation of the awards. Cisco has presented the idea to the Securities and Exchange Commission. SEC Chair William Donaldson has expressed interest in the idea. Cisco has said it will not issue the security unless the SEC indicates that it would approve using a market price for the new investment as a way to value employee options.

Under the proposal, Cisco would create a new derivative security whose terms would be the same as its employee options. Derivative securities are investments whose values is derived from their relationship to an underlying security, in this case Cisco common shares. Like employee options, the securities would have a fixed term, would have an exercise price equal to the price of common stock when the derivative security is bought, and could not be exercised until a defined period of time has elapsed. Moreover, investors could not hedge their investments against the options, effectively limiting their potential loss or gain. These options would thus be considerably more restrictive than conventional traded options and therefore would sell for a greater discount to common shares. Cisco would issue a limited number of these options and would make them available only to certain institutional investors.

Cisco argues that the price the market sets for these options would be the value it should use when it accounts for the cost of employee options. The security creates an interesting dilemma for the company in that it would generate more equity investment if the price it obtained for the options were high, but that would then mean it would take a higher charge against earnings for its employee options.

Analysts had mixed reactions. On the one hand, some were intrigued by the idea of creating a true market value for employee options rather than a guess based on arcane formulas with multiple assumptions. On the other hand, some argued that because of their restrictions, the options would not be very appealing to investors and would carry a relatively low price. Supporters of the proposal contend that if the restrictions make the options less valuable to investors, they should be equally less valuable to employees and should be accounted for as such. Opponents respond that this is just another way the tech sector is trying to play down options value.

If the proposal does get approval, it is unlikely to be imitated by all but the largest companies. However, the data generated from these markets could provide a model for valuing all options. Over time, smaller companies might also find ways to issue the securities under some kind of underwriting umbrella that would make the costs lower.

IRS Drops New Attribution Rules for S ESOP Anti-Abuse Test

One of the most confusing and controversial aspects of the proposed rules for anti-abuse testing on S corporation ESOPs (Temporary and Proposed Treasury Regulation Section 1.409(p)-1 T) concerned the combination of the family attribution rules under existing tax law with the specific tests for family ownership in the S ESOP rules (essentially that family members were limited to 20% of the synthetic equity plus ESOP allocations to avoid testing under the disqualified person rules). The combination could make the 20% test meaningless because individuals are limited to 10% of the synthetic equity plus ESOP allocations, and if the attribution rules applied, family members' ownership could bring an individual above this individual 10% limit, even if it were below the 20% family limit.

In response to concerns expressed by practitioners and Employee-Owned S Corporations of America (an organization of S corporations with ESOPs), among others, the IRS has agreed to simply drop this paragraph.

New NCEO Survey Shows ESPPs Will Persist, But Often with Modifications

As reported in this column on May 10, a new NCEO survey shows that most companies are not, as has been widely predicted, about to terminate their employee stock purchase plans (ESPPs). Of 117 respondents, 26 companies will or might modify their plans. Of these 26, 15 plan to or might change the look-back period, while 12 will or may discontinue it. Twelve will or might change the discount, and 8 more will or might reduce it. Finally, 12 said they will or might modify the offering period. Other changes were less common.

The findings are based on a new NCEO survey on ESPPs, available at $25 for members and $35 for non-members.

Harvard Business Review Publishes Article on Broad-Based Employee Ownership Plans

The June issue of the Harvard Business Review (HBR) contains an article titled "Every Employee an Owner. Really" by Corey Rosen of the NCEO, business writer John Case, and Martin Staubus of the Beyster Institute. The article is focused primarily on employee ownership in public companies but discusses all of the manifestations of the idea. It draws on, but has a somewhat different focus, than the book the three authors just published from Harvard, Equity: Why Employee Ownership is Good for Business (available in many bookstores, online, and through the NCEO). Reprints of the HBR article are available from the publisher.

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