Selected Issues in Equity Compensation, 21st Ed.

Excerpts

From Chapter 1, "Administering an Employee Stock Option Plan"

Under an employee stock plan, the number of shares of stock to be granted pursuant to an equity award is typically determined by the board of directors or appropriate board committee that has been designated as the plan administrator. Companies use a wide variety of approaches to determine grant sizes. Typically, a company establishes guidelines for determining the number of shares of stock to be subject to each grant. Often, these guidelines are set as a range of shares based on job classification or length of service. The number of shares of stock may be determined on an employee-by-employee basis (often based on individual performance), by job classification, or based on the company’s overall performance over a specified period of time. The number of shares of stock also may be determined as a percentage of the employee’s annual salary or based on a desired overall dollar value for the award. Typically, a company will establish an annual budget for the number of shares to be granted over the course of the year, with the allocation among employees determined on the basis of guidelines such as those described in the preceding sentences.

With performance-based equity awards becoming more common, a question may arise as to the number of shares of stock to be credited against the plan’s share reserve for a performance-based grant. This issue is relevant where the award provides for variations in the number of shares earned (or available to exercise, in the case of options) based on the actual level of performance achieved. These awards provide for a target performance level and often set forth a threshold performance level below which no shares will be earned and a maximum performance level at which the number of shares that may be earned is capped. These are typically expressed as a percentage of the target (e.g., the maximum payout may be 150% of the payout at target). In this instance, even though the performance outcome will not be known at the time of grant, it is customary for the company to assume that the actual performance will be at the maximum performance level to ensure that an adequate number of shares has been reserved for the award and, perhaps more importantly, to guard against inadvertently exceeding the limit of the plan share reserve.

When the stock price significantly declines, many companies need to grant more shares than they anticipated to deliver the targeted values to employees. This increases the company’s annual share usage and may exhaust the share reserves available for grants under the stock plan more quickly than anticipated. To the extent the share reserves are exhausted and the burn rate exceeds the norm, companies may have difficulty seeking shareholder approval for additional shares. To address the impact of stock price volatility on the number of shares granted, companies may use an average stock price over a short period (e.g., a 20-trading day average) rather than the price on the grant date to determine the number of shares to grant. If the company’s stock price experiences significant volatility over a sustained period, a longer averaging period (e.g., six months or one year) may be used to better reflect prices once the market stabilizes. Alternatively, the company may conserve shares by limiting participation in equity grants, shifting grants from options that require more shares to full-value awards like RSUs that require fewer shares (for companies with equity plans based on a fungible pool that does not treat options and full-value shares the same), or using cash awards instead of equity awards (for companies that are not cash-strapped).

Public companies that wish to grant equity awards to new hires to induce their recruitment but anticipate depleting their share pool before the next annual meeting when shareholders will vote to approve adding more shares to the plan or adopting a new plan may consider granting “inducement awards” under a separate plan that does not require shareholder approval. However, inducement awards may be granted only to prospective employees (not a director or consultant) and cannot be ISOs since shareholder approval was not obtained for the plan. The company must notify the applicable stock exchange at least 15 days before adopting the inducement plan and when inducement awards are granted. Promptly following the grant of an inducement award, the company must also issue a press release disclosing the material terms of the award, including the recipients and number of shares involved. If the inducement award is made to an executive officer or individually negotiated, then the press release must identify the recipient. Otherwise, the disclosure may be aggregated without having to provide individualized award details. Filing a Form 8-K with the SEC does not satisfy the press release requirement. As a drawback to this approach, inducement awards could receive scrutiny from shareholder advisory firms.

Alternatively, public companies may grant contingent awards under the existing stock plan. The company’s board of directors would propose the number of shares by which to increase the share pool and grant awards contingent upon shareholder approval of the increased share pool. The company’s proxy statement will need to detail any contingent awards that have been made.