This article is reprinted with permission from the
October 31, 2001
edition of
New York Law Journal.
2001 NLP IP Company.

Negotiating Options for New Executives

By Joseph E. Bachelder

NEGOTIATING STOCK options for senior-level executives moving to a new employer can be a difficult matter. It involves the valuation of options being left behind at the executive's prior employer. It involves debate over what it takes (and what the new employer is able and willing to do) to make the executive whole in this regard.1 This is in addition to negotiating what represents competitive option grants going forward.

In almost every case, an executive leaving an employer (Company A) voluntarily will forfeit his stock options. For those options not yet exercisable when the executive leaves his old employer, the executive will forfeit the spread (since he cannot yet exercise the options).

Even in the case of exercisable options (which the executive may exercise before leaving), the gain realized may be subject to a clawback if the executive leaves voluntarily and/or goes to work for a competitor. In the event of a clawback, the executive presumably will seek protection from his new employer (Company B) with the make-whole award being the same as for an option not exercisable at the time of departure.

As to both exercisable and not-yet-exercisable options, the executive will forfeit the opportunity for future growth over the remaining term of the option and will want to be made whole as to that future growth by the grant of replacement options by his new employer.

In addition to the foregoing, the executive will want to be assured that in the future he will have the opportunity for ongoing option grants at his new employer at least equal to (if not greater than) the ongoing option opportunity he would have had if he had remained at his prior employer.

The following discussion will cover, first, the make-whole issues and, second, the issues as to future awards.

Make-Whole Issues

1. Making the Executive Whole, Part One: Forfeited Spread.

(a) Determining the Amount Forfeited. Ordinarily this is a straightforward calculation of the excess of the current market value over the exercise price of those options not yet exercisable at the time the executive leaves Company A. For example, if the fair market value of the Company A stock subject to an unexercisable option is $50 and the exercise price is $20, the loss in spread for the departing executive is $30. If the executive had 100,000 Company A shares subject to an unexercisable option with an exercise price of $20, the aggregate spread forfeited would be $300,000. (As already noted, the executive also may forfeit gains realized on options exercised just before he leaves if these gains are subject to clawback).

(b) Form of Make-Whole Award. There are several forms that the make-whole award for forfeited spread may take. These include cash and sometimes stock in Company B (usually in the form of "restricted stock" as discussed below).

In recent years, make-whole awards in the form of forgivable loans have been viewed by some as a tax favorable way to give the new executive a make-whole award without incurring an immediate tax. The executive then realizes this value for tax purposes later as the loan is forgiven. However, the Internal Revenue Service has questioned the treatment of forgivable loans for Federal income tax purposes. See TAM 200040004, Oct. 6, 2000. TAM 200040004 was discussed in a column by the author in The New York Law Journal on March 21, 2001.

Occasionally, the make-whole award may take the form of a Company B stock option with an exercise price below the current market price so that the aggregate spread in the new option is equal to the aggregate spread in the options being forfeited. This is unusual, in part because many stock option plans provide that the options must be granted with an exercise price no less than the market price on the date of the grant. On very rare occasions, a new employer will propose granting a stock option with a "Black-Scholes" value equal to the forfeited spread. A new executive will resist this because it represents speculative future value replacing current realizable value (that is, realizable if the executive had not departed Company A). (As to the Black-Scholes valuation method, see discussion below under heading of "Making the Executive Whole, Part Two: Loss of Future Growth in the Options Left Behind at Company A.")

(c) Attaching Conditions to the Awards. Each of the forms of make-whole awards noted above may be granted subject to conditions that prevent the new executive leaving voluntarily for a specified period of time without forfeiting the award (or having the economic value clawed back). The executive, of course, will resist having the awards subject to forfeiture for any period of time beyond that applicable to the awards at Company A that are being replaced.

(i) Cash. Cash may be awarded in the form of deferred cash vesting and paying out over a period of time, subject to forfeiture in all or in part if the executive leaves voluntarily during that period of time. Even a payment of cash up front may be subject to clawback. The problem with a clawback for the executive leaving prematurely is that he will have paid tax on the cash and, if it is clawed back, there may be a question of whether he will be eligible for a full, offsetting tax benefit for the clawback deduction (which he will need in order to come out whole on an after-tax basis).

(ii) Stock. If the award is made in stock, the employer can condition its vesting on the same continued employment over a period of time as noted above in the case of a cash award.2 Even if the stock is not subject to forfeiture (thus preventing its being sold), it is unlikely that the new executive could sell or convert it immediately. Assuming it is registered stock without restrictions on resale, it is, nonetheless, unlikely that the executive, newly arrived at Company B, will want to report its sale on Form 4 (assuming he is an officer with reporting requirements pursuant to @ 16(a) of the Securities Exchange Act of 1934) and thus put on the public record that he is selling Company B stock shortly after moving to Company B. Accordingly, the new executive may prefer to get cash (even on a deferred payment basis) in order to be free to reinvest in something other than Company B stock (in which stock he already will have a large stake due to option grants).

Forgivable Loans

(iii) Forgivable Loans. Assuming, notwithstanding TAM 200040004, that the award is in the form of a forgivable loan, the forgiveness schedule likely will be for the same period of time noted above in connection with cash and stock awards. If the executive voluntarily leaves during that period, the loan will not be forgiven (or will have been forgiven only in part) and may become payable immediately.

(iv) Options. Assuming the make-whole award takes the form of an option (again, an unusual occurrence), it would be subject to the same conditions noted above. The conditions would presumably be gradual vesting and exercisability over the same period noted above in connection with the other forms of award.

Future Awards

2. Making the Executive Whole, Part Two: Loss of Future Growth in the Options Left Behind at Company A.

The executive has had the opportunity, through his stock options at Company A, to realize future growth in the value of Company A stock. In order for the executive to be made whole going forward (not just made whole for the spread left behind) he must be awarded stock options at Company B that offer equivalent value in future growth opportunity to that which he had in the options left behind at Company A. (Note that this sign-on option grant is in addition to the on-going awards the executive will receive under the stock option program at Company B, as discussed further below.) This is a much more complex issue than replacing forfeited option spread.

(a) Determining "True" Value of Options. This determination must take into account the "true" value of an option at Company A versus one at Company B. What is the best way to make this comparison? Among approaches taken to making this comparison are the following:

(i) Black-Scholes Option Valuation Method. Black-Scholes is a method of stock option valuation frequently used to fix a value on an executive stock option. Basic to the Black-Scholes valuation is the "volatility" of the stock. This reflects the variability in the price of the stock over a period of time. A stock with a history of significant price variation will have a higher volatility "value" than a stock that has had a more stable price and, accordingly, such volatility will impute a greater value to an option to acquire that stock than would be imputed if the stock had a lower volatility.

In addition to the volatility factor, Black-Scholes takes into account the following:
* Length of the option period (e.g., ten years for the typical executive stock option). The longer the option period, the more valuable the option.
* An interest rate (risk-free) reflecting, in part, the fact that the owner of the option does not have to pay the exercise price until he chooses to exercise the option. Generally speaking, the period of the risk-free rate should be the same as the length of the option period.
* Exercise price. The lower the exercise price, the higher the opportunity to be "in the money" and the more valuable the option. (Most executive stock options are granted with an exercise price equal to the market price of the stock on the date of grant.)
* Dividends paid on the stock (significant dividends over the applicable historic period reduce option value).

In addition to the basic factors making up the Black-Scholes valuation method, further adjustments frequently are made for employment-related factors such as the period over which the option vests and the likelihood of the executive remaining employed for the full option period (thus adjusting the length assigned to the option period as noted above).

Determining the forfeited value of the executive's stock option at Company A over and above the spread at the time he departs is somewhat more complicated than valuing a stock option at the time of grant -- when the exercise price generally is equal to the market value at the time of grant.

Black-Scholes Value

Assume the Company A stock option has a positive spread in it at the time the executive leaves Company A to join Company B. The spread in the Company A stock option may be realized by the executive (by the executive's exercising the option before he departs if the option is exercisable) or forfeited (if the option is not yet exercisable). The forfeited spread may be made up to the executive by Company B (as noted above it may be paid to the executive by Company B in cash or in some other form of award (e.g., restricted stock)). For purposes of determining the make whole to be paid to the executive by Company B for the forfeited value of the Company A option over and above the spread, the calculation of the Black-Scholes value of the Company A stock option when the executive departs, as just described, involves a three-step process:

(A) The Black-Scholes value of the Company A option is determined taking into account the several factors noted based on the original exercise price and the market price of the stock at the time the executive leaves Company A.

(B) The spread at the time the executive terminates his employment at Company A is determined (as just noted, it is assumed that the executive will get cash or a restricted stock award of equivalent economic value to keep him whole as to the forfeited spread at the time of his termination).

(C) From the value established in (A) is subtracted the value in (B). This net amount represents the "net" Black-Scholes value of the option -- as just explained, that is its value over and above the spread in it at the time of valuation. The amount obtained in (C) assumes, of course, that Company B is also making the executive whole as to the forfeited spread in the Company A option.

Valued in Same Manner

It is the amount determined in (C) that should be represented by a stock option of equivalent value in Company B stock in order to keep the executive whole as to the going forward opportunity in the Company A options he is leaving behind. Assuming the Black-Scholes method was used in valuing Company A stock, presumably the stock option to Company B stock will be valued in the same manner.3

(ii) An Alternative Theory to Black-Scholes: Projecting Stock Growth at Company A Versus Stock Growth at Company B Over the Next Several Years. Assume that Company B, once a strong stock performer with a high historic volatility and therefore a high Black-Scholes valuation, is currently in a lull in its stock price. If Company A has a low historic volatility but the executive believes its stock price is about to take off, the executive may object to the use of the Black-Scholes method for determining the comparative values of the stock options of Company A and Company B. He might suggest, instead, a comparison of the projected growth in value of the two stocks over the next 5 years. Company B and the executive, of course, may have different views on those projections.

(b) Providing Comparability in Key Terms of Options. As noted in connection with make whole of forfeited option spread, in paragraph 1(c) above, the executive will want vesting arrangements in his new options at Company B that are no less favorable than those he had at Company A. For example, he might have had 50,000 option shares at Company A that were fully vested with four years left to run. Another 50,000 may have been scheduled to vest in another two years and have eight years thereafter to run. He will probably try to get the options at Company B to mirror those at Company A with regard to these particular terms. Another key provision will be the post-termination exercise entitlements accompanying the options. These will vary depending on the type of termination: death, disability, termination without cause, termination for cause, voluntary termination, etc. (Presumably a termination for cause or voluntary termination will have a limited, if any, post-termination exercise period.) Finally, what happens to Company A options in the event of a change-in-control? For example, do they immediately vest in that case? Again, the executive will seek comparability in the terms of the options granted to him by Company B.

In some cases, Company B may be reluctant to grant requested provisions as a matter of policy or because it cannot do it under the terms of its stock option plan. If, under its stock option plan, Company B is unable to deliver an option substantially like that held by the executive at Company A, or is not able to deliver at all (if for example, there are not enough shares available under the plan), consideration may be given to granting the option outside of the stock option plan. For these considerations see discussion in footnote 1.

(c) Tax Cost of Early Exercise. Not taken into account in paragraph (a) or (b) above is the tax cost to the executive of exercising his exercisable stock options immediately before leaving Company A (to avoid forfeiture). Instead of having the benefit of future growth on the shares subject to the option, the executive is limited to growth on the after-tax value of the spread realized on the premature exercise.

Granting Future Options

3. Going Forward: Granting Future Options on an Ongoing Basis.

The new executive at Company B will want to participate in the ongoing stock option program at a level no less (or perhaps greater) than that at which he was participating at Company A. In addition, if he is being promoted to a higher position (e.g., CEO of Company B after being in a lesser position at Company A) he will want awards that are competitive for his new position based on awards at comparable levels at companies in the same or similar industries and of comparable size to Company B. Not only will the size of the award be a consideration, but also, as noted in paragraph 2(b) above, attention will need to be given to the new executive's entitlements under the option program (e.g., vesting and post-termination exercise rights). Company B may be more flexible in the terms of options granted as make-whole option awards (as described in paragraph 2 above) than it is in modifying such arrangements in the ongoing option grants to be made to the new executive under its regular option program in the future.

Stock Option Grants

4. Sign-on Stock Option Grants in Addition to Make-Whole Awards.

An executive in a strong negotiating position may be able to negotiate a sign-on stock option grant (or other form of award) over and above the make-whole grant awards described in paragraphs 1 and 2 above. Such an award is a "premium" award, similar to the sign-on bonuses to athletes when they join a professional athletic team, to induce the executive to join Company B.


1 An important consideration will be whether the new employer currently has enough shares authorized under its applicable plans to grant an option for a number of shares equal to the proposed award. Due to the magnitude of some sign-on equity awards (especially stock options), it is not uncommon to discover there is a deficiency in shares authorized under the existing plan or plans. In such case, alternatives may include:
(a) Make the stock option grant (or other equity award) outside any plan. This may avoid the need for shareholder approval depending on a number of things, including: (i) stock exchange requirements for shareholder approval of such plans (but an exemption may apply, such as Rule 312.03 of the NYSE Listed Company Manual applicable to a newly-employed officer); (ii) language of the existing stock option plan (e.g., does it indicate that shareholder approval will be sought before any more stock options are granted under or outside the plan?); (iii) the willingness of the new employer to risk loss of a tax deduction under section 162(m) of the Internal Revenue Code of 1986 (the Code ); (iv) the certificate of incorporation and by-laws of the new employer; (v) applicable state corporation law; and (vi) if the new employer is in a regulated industry, applicable regulatory requirements.
(b) Make the stock option grant subject to shareholder approval. Ordinarily this means delay in the effective date of the stock option grant until the next annual shareholders meeting. It also may result in an accounting charge for any increase in stock price between the date of grant (when, presumably, the exercise price is determined) and the date of the shareholders meeting when the necessary shares are authorized. It also jeopardizes the exempt status of the grant under Code section 162(m).
(c) Make the award in some form other than a stock option grant (e.g., a stock unit grant which may not require shareholder approval but will be less attractive to the new employer due to the accounting charge and probable loss of exemption under Code @ 162(m)).

2 In general, under @ 83(a) of the Code, property that is transferred to an employee in connection with the performance of services and is subject to a substantial risk of forfeiture is not taxed until the risk of forfeiture has lapsed. (Pursuant to Code section 83(b), the executive may elect to be taxed sooner.) A substantial risk of forfeiture exists when an individual's rights to property are conditioned upon the future performance of substantial services. Treas. Reg. @ 1.83-3(c)(1). Whether the services to be performed are substantial depends on the facts and circumstances, including the time spent in performing such services. Treas. Reg. @ 1.83-3(c)(2). An example contained in the regulations under section 83 indicates that a requirement that an employee continue in employment for two years causes the employee's rights to be subject to a substantial risk of forfeiture. Treas. Reg. @ 1.83-3(c)(4), Example (1). In another example, of shares transferred, a portion that vests on the first anniversary of transfer is considered subject to a substantial risk of forfeiture. Treas. Reg. @ 1.83-3(c)(4), Example (3).

3 The discussion in paragraph 2 of the text, concerning the make whole for loss of future growth in options left behind at Company A, assumes the replacement award will be in the form of a stock option. Occasionally, a new employer will offer some other form of award to replace this lost value. Such replacement value will, presumably, be based on the Black-Scholes value of the Company A options (less any spread recovered prior to departure or replaced by Company B as discussed in paragraph 1) and may be in the form of cash, stock or a loan (but see discussion of forgivable loans as a form of make-whole award in paragraph 1(c)(iii) of the text).