In the span of a few months, the COVID-19 health crisis and the resultant adverse economic impact, which, for certain industries, such as travel and hospitality, retail, automotive, and energy, has been acute, has significantly altered the way we operate, both personally and professionally. According to a COVID-19 disclosure post by Equilar on May 7, 2020, in light of these developments, several companies have elected to make changes to their executive compensation and incentive plans as a means to ease the burden that their employees are facing during this unprecedented time.
These changes have been wide-ranging, from the elimination of executive incentive programs and bonuses and salary deferrals to the acceleration of year-end bonuses or special one-time payments to non-executives to ease the hardships that many are facing. A few companies have also begun to disclose adjustments to existing employee stock-based compensation awards. This trend is expected to gain momentum as reporting entities seek to balance supporting employees in the short term while continuing to incentivize long-term performance.
Award modifications were last popular during the Great Recession. Modifications can take the form of repricings, where the exercise price is reduced, or more complex exchange programs, whereby companies modify more than just the exercise price. Most commonly, this involves amending the performance and market conditions upon which awards vest.
Accounting Standards Codification Topic 718, Compensation – Stock Compensation (ASC 718), defines a modification as “a change in the terms or conditions of a share-based payment award.” This definition is applied broadly and typically includes situations in which awards are canceled and replacement awards are issued. Modification accounting is not required if all of the following are unchanged immediately pre- and post-modification:
Examples of changes to employee equity that we have seen classified as a modification under this guidance include:
First, as a refresher, “performance conditions” generally include the attainment of specified financial performance targets (e.g., earnings before interest, taxes, depreciation, and amortization (EBITDA) or revenue), operating metrics, or other specified actions under the control of the company (e.g., a liquidity event). Awards with performance conditions are recognized as compensation expense only when it is probable that the performance condition will be satisfied. If the performance condition subsequently becomes improbable, the previously recognized compensation cost is reversed in the period in which the change occurs.
“Market conditions” typically include the achievement of a specified price of the company’s stock or a specified return on/increase in the company’s stock relative to an index or another benchmark. In contrast to performance conditions, awards with market conditions are recognized as compensation expense whether or not they are probable, with the market condition being factored into the fair value of the award.
Accounting for award modifications depends on both (a) the way in which the award is modified, and (b) the type of award that is modified. ASC 718 classifies award modifications into the following four categories, based on the probability that the award will vest immediately pre- and post-modification:
Of these, Types I and III are the most common. Type I modifications typically occur when a company amends an award to reduce the exercise price, extend the exercise period, or adjust the market conditions (e.g., reduce the share price targets). In these cases, the total compensation expense recognized for the award is the sum of the grant-date fair value and any incremental value created by the modification. In order to derive the incremental value created by the modification, the fair value of both the pre- and post-modification options must be measured. As illustrated in Figure 1, the difference in the total fair value between the pre- and post-modification options represents the incremental compensation expense associated with the modification.
Incremental compensation expense is recognized immediately for the portion of the award for which service has already been completed (i.e., the award is vested). Total compensation expense recognized for Type I modifications cannot be less than the original grant-date fair value of the award.
Type III modifications are typically the result of adjustments to performance conditions, such as reductions to EBITDA or revenue targets. When an improbable performance condition is adjusted such that it becomes probable, the total compensation expense recognized for the award is based on the post-modification fair value of the award. As a result, expense is immediately recognized for the portion of the post-modification fair value for which service has already been completed. While expense is not typically recognized for awards with improbable performance conditions, any previously recognized expense would be reversed.
Type II and IV modifications are less common. Generally, the accounting for Type II modifications is in line with Type I modifications, and the accounting for Type IV modifications is in line with Type III modifications. This means that total compensation expense recognized in Type II modifications is equal to the grant-date fair value plus the incremental value created by the modification, while total compensation expense recognized in Type IV modifications is equal to the post-modification fair value (assuming, in both cases, that any performance conditions ultimately become probable).
“Plain-vanilla” employee stock options typically have the following basic economic structure at grant, where the primary variance among companies tends to relate to the length and structure of the time-vesting conditions:
Because of its ease of use and verifiability, the Black-Scholes Option Pricing Model (BSOPM) is generally employed to value plain vanilla employee stock options. A lattice model or Monte Carlo simulation is occasionally required in the case of more complex structures that have market vesting conditions (TSR awards tied to relative peer group performance, options that vest once certain stock price thresholds are achieved, etc.). For the purpose of this example, however, we will focus on a simple BSOPM calculation.
The BSOPM is an arbitrage-pricing model that was developed using the premise that if two assets have identical payoffs, they must have identical prices to prevent arbitrage. The BSOPM relies on six variables: (i) asset price, (ii) strike price, (iii) term, (iv) risk-free rate, (v) volatility, and (vi) dividend yield. Figure 2 presents the directional impact to value of each input to the model as well as typical sources for each input.
In the following example calculations for a Type I modification, and as depicted in Figure 3, we show the expense impact of a modification to the strike price of an option. We can think about this representative scenario as follows:
The Figure 3 calculations give us the incremental value resulting from the modification. We next present a representative discussion of income statement expense implications based on the following example, and as shown in Figure 4:
Resetting outstanding options may become more prevalent as companies attempt to modify the terms of options to incentivize employees. Because of the earnings impact, it is critical that key assumptions are supported with robust analysis when determining the fair value of pre- and post-modification options.