Are TSOs a New Trend?

When Microsoft adopted third-party option transferability in 2003, the program made waves as an unorthodox way to incent and retain employees. The software giant’s one-time offer for employees to get value for below-market options by selling them to JPMorgan Chase had Wall Street speculating about a potential secondary market for vested options. Four years later, Google is making headlines for a more permanent transferable stock option (TSO) program that will allow employees to sell their vested options to preapproved financial institutions in an online auction managed by Morgan Stanley. This time, because the advantages are many, the prospect of a TSO trend looks promising.

Inside Google’s TSO Plan

Participants in the plan may exercise their vested options under a traditional option program or sell them at auction. Employees will use a company Web tool to review prices offered by competing financial institutions. From their perspective, the right to sell options adds considerable value to each grant. The financial institutions, meanwhile, will seek a spread-namely, the difference between the fair market value and the exercise price-at which they can hope to make a profit.

Because the company does not want to encourage key management to sell options, only employees below Google’s executive management group will be eligible to participate. Indeed, some companies require CEOs to hold stock equal to 500 percent of their annual compensation. Others allow CEOs to exercise options and sell shares to pay taxes, although they often put a restriction on the sale of stock. MCI, for example, precludes executives from selling more than 25 percent of their stock until they reach early retirement age. Citicorp has a similar rule, and such restrictions may become common over time.

Only options granted on or after the date of Google’s initial public offering will be eligible for sale. Options granted prior to the IPO made many employees millionaires and billionaires. The option prices were as low as $10, and the stock now trades close to $500. To complete the sale, the usual restriction prohibiting transferability except to family members must be amended.

By the Numbers

Options currently have a 10-year term. However, once sold to a third party, the option expires two years from the date of transfer or on the original expiration date of the option, if earlier. So the buyer has no more than two years in which to make its gain. Options with a remaining term of less than six months are not eligible for sale under the program due partly to SEC concerns. To avoid being considered a public offering, no further transfers to the public will be permitted after employees sell their options to a financial institution.

There will be an increased compensation charge relative to the traditional option for currently outstanding options. The increase will equal the difference between the value of the modified stock option and the value immediately prior to modification, as measured using the Black-Scholes-Merton option-pricing model. The right to sell increases the charge because the option is more valuable. The charge will be taken on the date the program is initiated for all vested options and will be spread over the remaining vesting periods for unvested options. New grants will also have a higher value because Google, in valuing the option, will anticipate the exercise period to be six years rather than the present four years.

Benefits of TSOs

The principal benefit of the Google TSO is that compensation expense will be more closely aligned with pay delivery. In addition, if options are granted “underwater,” the TSO eliminates the need to take corrective measures, such as making additional grants like Microsoft has done, or repricing the options as Apple did. These grants still have incentive and retention value.

The change makes TSOs quite similar to restricted stock, which is used more frequently now that there is an accounting charge on the grant of options. (Remember, the accounting advantages of options have been eliminated.) In the case of a TSO, participants will have the ability to time their taxable income since they choose when to sell or exercise the option, unlike restricted stock, which is taxable at a fixed period-namely, the date it vests. Employees perceive a higher value for both restricted stock and TSOs. Traditional options only have value if they go up in price.

The company and shareholders also benefit. The company will be able to grant a lower number of option shares to deliver the same compensation value since value of a TSO option will be greater than that of a traditional option. This is a key advantage to employers and shareholders because the number of shares outstanding is reduced, thus reducing dilution. The sale feature also should allow companies to make stock grants more often because shareholders are generally more likely to approve new share authorizations when the number of outstanding options held by employees, i.e., overhang, is lower.

The company still receives a tax deduction for the amounts realized by the participants on the sale to financial institutions. Thus, it could receive a deduction for underwater options that are sold. These options will not be exercised and ordinarily the deduction would be lost. For employees, competitive bidding by several financial institutions will help ensure receiving a fair price for options.

Caveats for Companies

Some advisers suggest that institutional investors and related advisory services may not distinguish between options held by employees and those transferred to financial institutions in calculating overhang. However, analysts will generally recognize the key value of selling underwater options in reducing overhang. Institutional holders are more likely to object to the right of participants to realize compensation even when the exercise price exceeds fair market value. This same objection is made to restricted stock that vests upon a period of service, dubbed “pay for pulse.”

Initially, compensation expense will increase for new options and previously outstanding options affected by the program because they are more valuable, but that is unlikely to generate a lot of criticism.

Backdating Backlash?

This is not a good time for changing the nature of option grants (see “The Truth Behind the Backdating Brouhaha,” December 2006). So far, at least 66 top officers, including approximately 20 CEOs, have been terminated as a result of backdating scandals. It is estimated that 150 companies are under investigation, and the number continues to grow. In the midst of the resulting turmoil, compensation committees and boards may be reluctant to change any options until this is accomplished.

Compensation experts foresee more widespread adoption of these programs. TSOs may not be appropriate for smaller firms due to their higher administrative costs, but for larger firms the benefits to employers and employees outweigh the additional costs. The transition, however, will take time. TSOs constitute a major change, and compensation committees will need time to adjust, especially in light of the backdating issue.

Arthur H. Kroll is CEO of Hartsdale, N.Y.-based KST Consulting Group, and author of Compensating Executives.