This article is reprinted with permission from the
June 29, 1998
edition of
New York Law Journal.
1998 NLP IP Company.

 


Premium-Priced, Hurdle and Indexed Options

By Joseph E. Bachelder

 

EXECUTIVE STOCK options are being granted with more "bells and whistles" than ever before. This column will examine three ways in which an option price may be set: (i) at a premium (or premiums), (ii) subject to a hurdle (or hurdles) or (iii) based on an index. We also note an interesting variant recently introduced at Monsanto Co.: a premium-priced option that the executive may purchase.

Premium-Priced Options

A premium-priced option has an exercise price above the market price of the common stock on the date of grant. If the market price on date of grant is $40, an option with a 50 percent premium would be granted at an exercise price of $60. A variation would be to grant the option with two or more levels of premium: for example, half at $60 (50 percent premium) and half at $80 (100 percent premium).

A number of major U.S. corporations have granted premium-priced options to their executives in the last several years. For example, Transamerica Corp., in 1998, granted its chief executive officer an option with an exercise price 43 percent above the market price on date of grant. Coopers Cos., in 1996, granted an option in several tranches to its chief executive officer with different premium prices for each tranche, ranging from 38 percent to 193 percent above the market price of the stock on the date of option grant. (In fact, one of the tranches was a hurdle grant of the sort discussed in the second part of the column.)

A new premium-priced option program at Monsanto is especially interesting. 1 Under that program, about 30 Monsanto executives are to be given the opportunity to invest in options that would be granted at a premium price above the market price on the date of option grant. The premium is 50 percent above the market price. Thus, if the Monsanto market price were $60 on the date of grant, the exercise price would be $90. The options have terms of eight years, and a market price at or above the premium price must be maintained for 10 or more consecutive trading days during the first five years of the option term in order for the option to be exercisable; unless the market price maintains the premium price for the 10 trading days, the options expire at the end of the five-year period.

The executives must pay for the grant of the premium-priced options. The purchase price is half the Black-Scholes value of the option. Under the Black-Scholes formula, the historical performance of the stock (volatility) is combined with such other factors as interest rates and the period covered by the option to establish an estimated value of the option at the date of grant.

For example, if the price of Monsanto stock were $60 on the date of grant, the estimated Black-Scholes value of the eight-year stock option on this stock, without a premium (that is, with an exercise price equal to $60) would be about $24.73. With a premium price of $90, the estimated Black-Scholes value reduces to about $15.20. Half of that, $7.60, would be the purchase price of the premium-priced option under the assumptions just made. 2

The executive electing to participate in the premium option program may pay in cash (after-tax dollars) or arrange for payment through withholding from other compensation due him (such as salary). Monsanto has designed the withholding program to allow the executive to purchase the option out of pretax dollars, thus adding an income-deferral feature to the program.

At this point, one might ask why an executive would be willing to pay for an option that carries with it a premium price when executives typically receive options with an exercise price at market (or even below in some cases) for which they pay nothing. There are two reasons. First, in the Monsanto program there is a special inducement for an eligible executive to purchase the premium-priced option. By investing at least 10 percent of salary in the premium-priced option, as just described, the executive is able to participate in a second option program (also premium-priced but without a purchase of the option being required).

The second reason for an eligible executive to purchase a premium-priced option in the Monsanto program is that it represents an outstanding investment opportunity. Following is an illustration.

Benefits of Premium-Priced Options

Assumptions:

1. Market price of stock on date of grant: $60

2. Premium price for stock option: $90

3. Estimated Black-Scholes value of option on a per-share basis (after taking into account the premium of 50 percent over market value on date of grant): $15.20

4. Number of shares subject to option: 10,000

5. Executive pays $76,000 (half of Black-Scholes value) by payroll deduction for an option on 10,000 shares

6. Stock doubles in value within five years to $120.

On this basis the executive will, after five years, have an option to acquire 10,000 shares of stock valued at $1.2 million. The premium price to acquire these shares will be $900,000 leaving a pretax gain of $300,000. His payroll investment (pretax) in purchasing the option was $76,000. This represents a gain of 295 percent on the $76,000 investment in the options. This is equivalent to an annual compound rate of growth of about 31 percent on that investment.

A premium-priced option is interesting in some other respects as well.

1. An option that is subject to a grant price equal to the market price at date of grant typically vests over several years. Since a premium-priced option will not be exercised until the price set by the premium is reached, an employer may be willing to vest the option at date of grant. This is significant for federal gift and estate tax purposes. In PLR 9350016 the Internal Revenue Service held that the transfer of a premium-priced option that was not conditioned on continued performance of services was a transfer subject to gift tax at the time of transfer. The IRS did not state, in that ruling, what the consequences would be if the vesting of the option at the time of transfer was conditioned on continued performance of services.

In Revenue Ruling 98-21, 1998-18 Int. Rev. Bull. 7 (May 4, 1998), the IRS held that an option subject to a requirement of continued performance of services by the transferor was not subject to gift tax at the time of transfer. It held this because, in its view, so long as the exercisability of the option was conditioned on continued performance of services, the transfer was not complete for gift tax purposes. In the author's thinking, for gift tax purposes, vesting conditioned on continuing services should have the same consequence as exercisability conditioned on continuing services.

In either case, the transfer, under the reasoning of Revenue Ruling 98-21, should not result in a gift tax at the time of transfer (although the holding of Revenue Ruling 98-21 refers only to the "right to exercise"). In such circumstances, the value of the option on the date it no longer is subject to the condition of continued performance of services is subject to the gift tax as a transfer by the executive (or subject to the estate tax if this occurs after the transferor's death).

The attractiveness of transferring unvested options to family members (discussed in this column of the New York Law Journal, Aug. 31, 1994) is substantially diminished by Revenue Ruling 98-21. Premium-priced options, on the other hand, provide an option vehicle in respect of which an employer may be willing to vest the option on date of grant, thus enabling the executive to obtain the benefit of treatment as a transfer for gift tax purposes at the time of actual transfer.

It also is noted that the value of a premium-priced option for gift tax purposes obviously is reduced from that of an option granted at the market price at the date of grant. Thus, the executive would be incurring significantly less gift tax as a result of the premium (assuming the same number of shares subject to each of these alternatives).

2. From a corporate governance standpoint, a premium-priced option purchased by an executive affords the employer and its shareholders an equity program with two advantages. First, it requires a substantial improvement in stock value before it will provide the executive any gain. Second, with a required investment in the option it means the executive must "put something on the line." It is an answer to the complaint of some critics of options that executives receive a "free ride" with options without having any of their own money at risk.

Hurdle Options

A hurdle option, in contrast to a premium-priced option, permits exercise at the original market price on date of grant if the target price is reached. For example, if the Monsanto options had been hurdle options, once the $90-a-share price was achieved the options would be exercisable at $60, the assumed market price on date of grant. Thus, once the hurdle is achieved, the hurdle option gives the executive the same economic benefit as if there had been no hurdle. Generally this would mean the spread between the price on the date of grant ($60 in this example) and the price on date the option is exercised.

An accounting rule requires that, in order to avoid a charge against earnings, a hurdle option must be fully vested at some point during the option term. Otherwise, there is a charge against earnings for growth in value from the date of option grant to the date of option exercise. Put another way, if the hurdle is a condition to vesting, there is a charge against earnings but if achievement of the hurdle simply accelerates vesting and exercisability, which would occur in any event after continued employment for a specified term, there is no charge against earnings. 3

As a result of the accounting rule, employers granting hurdle options frequently have provided for vesting of a hurdle option shortly before the end of the option term (typically a 10-year term). If the hurdle price is achieved, the vesting and exercisability accelerate. As just explained, acceleration does not cause a charge against earnings.

Premium-priced vs. hurdle options: values equated. A company considering a premium vs. a hurdle option program may provide for equivalent value in the original grant. Obviously the premium-priced option will require more shares assuming the same targets as the hurdle option.

For example, if a market-priced option, a premium-priced option and a hurdle option were granted on a share of Monsanto stock with a current market price of $60 and if the premium price and the hurdle were each $90, the approximate Black-Scholes value per share of each option (assumed in each case to be an eight-year option) would be as follows:

________________________________________________________________________________

    Type of Option

Estimated
Black-Scholes
Value

    Market-priced option
Premium-priced option
4
Hurdle option
4

  $ 24.73
$ 15.20
$ 24.08

________________________________________________________________________________

Translated into a number of shares to be granted under each type of option, assuming a 10,000 share market-priced option, for equivalent value as to each option (using the Black-Scholes method as applied above), the number of option shares for each would be as follows:

________________________________________________________________________________

        Market-priced option   10,000
        Premium-priced option   16,270
        Hurdle option   10,270

________________________________________________________________________________

 

Indexed Options

Yet another form of option grant is a so-called "indexed option." The option price is set at the market price on date of grant just as in a normal form of option grant. However, the option price is indexed to an external measure like the S&P 500. As the index changes, the exercise price changes proportionately. For example, if an indexed option is granted today with a $60 exercise price, equal to the market price on date of grant, and the index rises, say, by 25 percent by the date the option is exercised, the exercise price of the option will rise from $60 to $75.

The indexed option as just described raises both accounting and tax issues. As the index rises and falls, the exercise price will be adjusted accordingly.

Accounting Principles Board Opinion No. 25 (APB Opinion No. 25) (1972) provides, in paragraph 10(b), that the measurement date for determining the cost of a stock option does not occur until both the number of shares and the exercise price are known. For an indexed option, under APB Opinion No. 25, the correct accounting treatment would appear to be treatment on the same basis as other variably priced awards. Thus, an increase in the spread of market price over exercise price during a particular accounting period would be a charge against earnings (and decreases, to the extent prior increases have been charged, become credits).

A second consideration in the use of an indexed option is that it might fail to meet the test for an option to be exempt from the $1 million compensation cap under 162(m) of the Internal Revenue Code of 1986, as amended. Section 162(m) imposes limits on the deductibility of certain kinds of compensation paid to top officers of publicly traded corporations.

For a stock option plan to be exempt from the $1 million compensation cap (assuming it meets other requirements such as stockholder approval), the exercise price ordinarily must be no less than the market price on the date of option grant. See Treas. Reg. 1.162-27(e)(2)(vi)(A). In the event a plan provides that the exercise price of an indexed option can go below the market price on date of grant, it would risk loss of exemption from the deduction limitations under 162(m). (A stock option that has performance targets independent of the growth in value of the stock may qualify for the exemption without regard to meeting the date-of-grant market-price test).


FOOTNOTES:

1 As recently announced, Monsanto Co. and American Home Products Corp. have reached an agreement to merge. It is not known how the Monsanto options will be treated in the merger.

2 The Black-Scholes values represented here and elsewhere in this column do not take into account certain discounts that might be applicable, including discounts on account of (i) a lack of transferability, (ii) a requirement that the underlying stock of a premium-priced option satisfy certain hurdles before becoming exercisable and (iii) a requirement of continuing employment.

3 For purposes of this column, the Monsanto option has been classified as a premium-priced option. As noted, however, in the discussion of the Monsanto option, the premium price must be maintained for 10 consecutive trading days during the first five years following the date of grant or else the option is forfeited. This would appear to cause the option to be treated as a hurdle option for purposes of the accounting rule being discussed in the text. If that is the case, there would appear to be a charge against earnings unless the option vests in any event after the period of continuing employment (which does not appear to be the case under the Monsanto premium-priced option).

4 For the purpose of determining the Black-Scholes value of the premium-priced option and the hurdle option, no assumption has been made as to the number of consecutive trading days over which the stock must maintain the premium price or hurdle price in order to be exercisable. (The Monsanto premium-priced option requires that the premium price level be maintained by the stock for at least 10 consecutive trading days during the first five years in order for the option to become exercisable.) Some premium-priced option plans and most hurdle option plans require that the target price be maintained for a number of consecutive trading days (typically, within the range of 10 to 30 consecutive trading days). As a further qualifier on the estimated Black-Scholes value, see Footnote 2 above.