8 - Long-Term Incentives— Part I

Question 1

The essential difference between long-term and short-term incentives is the length of the __________. While short-term incentives are typically one year, long-term incentives are multiyear in nature.

Answer 1

performance period

Question 2

The type of company definitely affects the importance of long-term incentives. While very important in for-profit companies, they are virtually nonexistent in not-for-profits. In the for- profit sector, companies with publicly traded stock are at an advantage over privately held companies due mainly to the more restricted market for the latter’s securities. Publicly traded for-profit companies place high emphasis on long-term incentives in the ____ and _____ stages. Plans use either a form of ____ and/or ____. Stock plans may consist of publicly traded, privately traded or not traded stock. Each can consist of full value or appreciation only. The full value may or may not require an investment or purchase by the executive. Long-term plans typically require some form of ______ to give them a present value and thereby permit valuation vs. salary and short-term incentives.

Answer 2

threshold and growth

stock

cash

discounting

Question 3

As with short-term incentive plans, eligibility may be determined using key position, salary, job grade, title, reporting relationship or some combination of these methods. Typically, the degree of _________ penetration from the chief executive of cer (CEO) down is not as extensive as with short-term incentive plans if the eligibility basis is tied to those who have an impact on the long-term success of the organization. This criterion would relate to a time span measurement of decisions and actions. Namely, what is the length or span of time that must pass before measuring the appropriateness of the decision/action? Typically, this correlates rather well with organizational level since the longer term, larger risk decisions are handled at the top of the organization.

Answer 3

organization

Question 4

The accounting rules for long-term incentive plans are not as _______ as with short-term incentives. All compensation is a charge to the ________ statement. Under FAS ______R, it is either measured at date of grant or on date of _______. The first applies to stock-settled awards; the second applies to those settled in _____. The first accrues the fixed expense over the vesting period, and the second is a variable accrual “trued up” at time of settlement.

As for taxation, the basic rule still applies. Namely, compensation is taxed as ______ when received, and the company has a like-amount tax deduction in that year. However, there are two exceptions. The first of these is that exercise gain on statutory stock options and long-term capital gains when stock has been held for the required period of time. There is neither income recognition nor a company tax deduction on the difference between grant price and fair market value at time of the exercise of a statutory stock option. Secondly, companies receive no tax deduction on income gains to the executive taxed as long-term capital gains.

In addition, SEC defines _____ (those with information not available to the public that could affect the price of the stock), conditions under which they may buy and sell company stock, and what reports they must make regarding purchases, sales and holdings.

Answer 4

• simple
• earnings
• 123
• settlement
• cash
• ordinary income
• insiders

Question 5

Long-term incentives are either dependent upon stock price (_______ based) or independent of stock price (______ based).

Answer 5

market

nonmarket

Question 6

________ plans typically use common stock, which is traded on one or more stock exchanges. plans either offer an option to buy or an outright grant of stock requiring no financing by the executive. the stock may be received either in the form of actual stock certificates or credited electronically to an account in the executive’s name. this is sometimes called a book entry form

Answer 6

Market-based

Question 7

A _______ is the right given to a person (optionee) by a company (grantor or optioner) to purchase a stipulated quantity of shares of the company’s stock at a stated cost over a prescribed period of time in accordance with stated eligibility periods. Five key dates are contained in one. These are date of _____, date to exercise or purchase, date option expires, date of actual _____ and date of ____.

Answer 7

stock option

grant

exercise

sale

Question 8

Stock options are either statutory (_______) or nonstatutory, referring to the Internal Revenue Code (IRC). Those options that comply with Section ____ of the IRC are said to be statutory options and, therefore, qualified for favorable tax treatment. Namely, optionees are not taxed at time of grant or at time of exercise but only at time of _____. If the optionee does not meet the required holding period before the sale of a statutory option, the difference between purchase cost and selling price will be considered ordinary income. This is called a disqualifying _______.

Options are _________ plans; that is, the company does not prescribe certain goals that must be achieved in order to receive payment.

Many believe the stock market to be a good indicator of a coming recession or recovery, namely, that the market will drop prior to a recession. As the recession continues, stock prices increase in anticipation of a recovery. The consideration of downside risk is also important in stock option plans. The executive is placed in a precarious position when having to borrow to exercise the stock option if the intent is to hold it for some time.

If one company acquires or merges with another in a stock transaction, it is appropriate to restate the option price for purchase of the acquiring company in relation to their respective prices. This is called a rollover or redenominated-type stock option.

Dividends are payable only on shares of issued stock. Therefore, shares under option do not receive dividends (of course, they could receive dividend equivalents). The receipt of a stock option grant is not a taxable event. However, the exercise or purchase of stock under an option does have tax consequences.

Answer 8

qualified

422

sale

disposition

non-goal-oriented

Question 9

FAS 123R, “_________,” requires that all employee equity awards be expensed at “fair value.” Fair value is considered to be the price that would be paid or received in exchange for an asset based on terms and conditions of the sale. Stock options are valued using: _____(3)

Answer 9

“share-Based payment”

• (a) the Black-scholes model,
• (b) the binomial model and
• (c) the minimum option value method.

Question 10

The __________ is the most widely used model for estimating the present value of stock options granted by a company to its employees. This model includes option price, price of an underlying security, stock price volatility, risk-free rate of return, dividend yield and expected term of the option grant. Other things being equal, the model will place a greater value on a higher priced stock option.

Answer 10

Black-Scholes Model

Question 11

The _______ model is quite similar to the Black-Scholes Model since it includes the market price of the stock on the date of grant, the exercise price of the option, the expiration date of the option, the dividend yield of the stock, the volatility of the stock and the risk-free interest rate. The model is not as easy to use as the Black-Scholes Model but may be more accurate by offering a more detailed, multi-period valuation.

Answer 11

binomial

Question 12

The _______ method calculates the present value as being equal to the current fair market value of the stock price discounted by a risk-free rate of return for the period of the option term as well as the expected dividends over the same period. Essentially, it is the Black-Scholes Model with zero _______.

Answer 12

minimum option value

volatility

Question 13

Typically, options are given to the CEO and other highly positioned executives. Beyond that, as with short-term incentive plans, candidates may be determined by base salary, job title, job grade, organizational level, a banding of comparable level positions or on a job-by-job selection basis. The degree of organization penetration from the CEO down is normally not as deep as with short-term incentives. Rather broad coverage is consistent with a desire to place a large number of executives and managers at risk with stock price and thus more closely associated with other shareholders.

If the company has a broad-based stock option plan, it must determine whether or not those executives selected for _______ should be included. The argument for inclusion of executives is that a broad-based plan is by definition an all-______ program. The argument for exclusion is that executives have their own plan and therefore should not be greedy.

Additionally, companies might make a grant to new hires as a hiring incentive, perhaps to offset in part forfeited future compensation from previous employment. Stock option grants may also be made to an employee for an outstanding contribution and/or future potential.

In addition to employees, companies can make grants to nonemployees. However, these can be only ______-type grants. The most common group included is non-management members of the board of directors, although this practice has dramatically ______ in recent years.

Answer 13

• key grants
• employee
• non-statutory
• declined

Question 14

It used to be common practice to grant options every three to five years. ______ grants are now by far the most common action. Fewer shares on a more frequent basis minimizes the impact of rising __________ and swings in the price of the stock, as well as the visibility of large grants to ______. If options are not granted on an annual basis, the company will need a mechanism for interim, that is off-year, grants to new hires and the recently promoted.

When interim or catch-up grants are made between normal grant dates, the regular stock option grant guidelines are adjusted by:

• (1) the estimated future market value,
• (2) the previous grant (number of shares and option price),
• (3) the extent of lapsed time since the regular grant and
• (4) the current option price.

Regardless of the formula or the approach used, the basic logic is to give options to recent hires and those promoted that equate to the major grant optionees only for the remaining time until the next grant.

Answer 14

Annual

compensation

insiders

Question 15

The stock option grant specifies a beginning date. Typically, this date is the date of the grant. It also has an ending date, which is when the right to purchase the shares expires. Within this period, typically ____ years, there is a date when first eligible to purchase, which is called the ______, before any shares may be exercised. The grant will also specify the maximum number of shares that may be exercised on or after that date.

While most plans have a fixed exercise period, some use a failure to meet stated financial targets or stock prices at prescribed dates during the exercise period to automatically cancel the option.

This is one way to minimize, if not completely avoid, underwater stock options (i.e., the option price is above the market price). Some refer to this as a _______ stock option for its shortened period of exercisability.

Answer 15

ten

waiting period

truncated

Question 16

Many plans have a one-year waiting period after which all shares granted might be exercised. Others have additional eligibility requirements typically called a vesting period. One form is the ___ vest, which sets a waiting period before which no shares are exercisable and after which all shares are exercisable. A typical example would be five years on a ten-year option. Another version is the ______ vest. A typical approach would be to vest 20% of the shares after one year, 40% after two years, 60% after three years, 80% after four years and 100% after ve years. Such vesting schedules are designed to _____ optionees who leave shortly after receiving a stock option since they will have to forfeit the unvested portion.

If the option is intended as a form of “golden ______,” then a long vesting period is appropriate. It could also be combined with an additional forfeiture clause such as the requirement that the optionee sell the stock back to the company at exercise price if the individual leaves before a stated period after exercising the option. This is sometimes called a _______ option.

Answer 16

cliff

installment

penalize

handcuff

clawback

Question 17

A variation of the cliff or installment-vesting schedule is a _______ vest. It prescribes the conditions under which an option will vest. When the option is not exercisable unless the performance criteria have been met, it is sometimes identified as a performance requirement vest or an earn-it or lose-it option.

Another variation is the ______ vest, where a stock option vests 100% on the earlier of a prescribed vesting date, or when the company stock trades at or above a specified dollar amount on average for a prescribed period of time. This is called a performance-accelerated stock option plan (_____). The performance feature could be expressed in multiple terms. The enhanced performance-vesting schedule rewards the optionee for a signi cant increase in stock price sooner. It is typically called performance-accelerated vesting.

Answer 17

performance

backward

PAYSOP

Question 18

Should the individual terminate employment, many plans provide a very limited exercise window. In cases where the individual is quitting or being terminated for cause, the option may logically cease on date of termination. Periods of six months to one year, on the other hand, are not uncommon after termination due to _____ or _____. On the other hand, many nonqualified plans simply use the IRS rules for quali ed plans, namely, ____ days from date of termination except for disability (one year) or death where it runs the term of the option.

If disability status does not constitute termination of employment, eligibility continues until service ends, at which time the exercise eligibility will continue for one year unless the individual has retired. In this case, retirement provisions apply.

As for death, some plans distinguish between death while an active employee or as a retiree. With both, the grant may be fully vested, but the ______ exercise period may only extend for a year whereas the ______ would extend for the full term of the grant.

Answer 18

disability or death

90

while-active

while-retired

Question 19

If the terms of the option are met, the optionee has a unilateral right (but not a _________) to buy the stock at the price stipulated. The exercise or purchase may be accomplished in one of several ways, as long as they are permitted by the plan. These include paying _____, tendering company stock and/or simultaneously buying and selling the stock—called a ______ exercise.

Answer 19

commitment

cash

cashless

Question 20

Rather than selling company stock and having to pay taxes, it is more advantageous to ______, that is, turn over the company shares of company stock owned, or ______, that is, confirm in writing the number of shares owned whose value without reduction for taxes is sufficient to exercise the stock option. This is called a stock-for-stock exchange or stock _____, enabling the optionee to defer tax on the value of shares tendered until they are actually sold. This form of payment may also be used to exercise a statutory option; however, both the shares tendered and new shares must meet the one-year and two-year requirements of statutory options to avoid a disqualifying disposition. A stock-for-stock exchange allows a company to help the executive avoid ______ problems. Specifically, it permits the optionee to use stock already owned to meet a portion of the exercise cost.

Answer 20

tender

attest

swap

financing

Question 21

Tendering stock to exercise an outstanding stock option and then immediately retendering the shares received, continuing this virtual simultaneous exchange of shares received in ever-increasing amounts to exercise remaining shares, is called _______. It would be possible to exercise the option by tendering one share and then engage in the rapid-fire pyramid until the entire option was exercised. Since the tendered stock has not been owned for at least six months, the company is subject to recognize a charge to earnings on appreciation. Furthermore, such an action would be precluded for 16(b) executives. (Section 16(b) of the Securities and Exchange Act stipulates that any profit made by an officer or director of a company by purchasing shares of the company within six months of selling similar shares must be ________.

Answer 21

pyramiding

returned to the company

Question 22

If the optionee wishes simply to receive the after-tax appreciation in stock price over option price, the _________ is the most efficient method. As the words imply, the optionee does not have to put up the cash to exercise the option but instead borrows the needed monies from a broker to exercise the options and then has the broker sell those shares. If the company covers the cost of the loan, it would seem to be barred by Sarbanes-Oxley for officers and directors. Merely arranging for the loan might also be a violation.

If the executive chooses not to borrow from a broker to exercise the option but merely receives the appreciation in cash or shares of stock, the transaction is sometimes called an ______ exercise.

Answer 22

cashless exercise

immaculate

Question 23

The exercise of a nonstatutory or nonqualified stock option triggers a _____ event regardless of whether the cost obligation is satis ed by cash or with stock. However, tax liability deferral is possible only if elected at least ____ months prior to the exercise of the option and in conformance with Section 409A of the Internal Revenue Code. Key points to remember in designing this feature include:

(a) Keep in mind that FAS 123R considers a reload a new ____.
(b) Use ______ share units rather than actual shares to avoid current taxation issues.
(c) Be certain that exercise action is set for a date more than ___ months in the future while an active employee and that it is in compliance with Section 409A.

Permission to elect a deferral could be accomplished by permitting the action in the stock plan and/or by establishing an unfunded, executive deferral plan that permits the deferral of stock option exercise gains. While it may be best to do both, certainly the appropriate deferred compensation plan should be in place.

Answer 23

taxable

• six
• grant
• unfunded

six

Question 24

Options that lapse, that is, the period of exercisability is exceeded, are considered voluntary ________. the typical reason is that the option price is underwater or the option price is greater than the fair market value at the time the option expires. typically, these unexercised options are returned to the pool available for grant.

the other type of forfeiture is the involuntary forfeiture. the most common type relate to a ______ clause in stock options or stock award plans. it would require that all profits received by the executive within a stated period of time be returned to the company if during that period, the individual violated a ______ clause or engaged in acts deemed to be _____ to the company.

Answer 24

forfeitures

clawback

noncompete

injurious

Question 25

Describe the sale of a stock

Stock received may be held, passing from generation to generation, or more likely, the optionee will sell at some point in time. This sale is a disposition and, if the acquired stock was under a _______ grant, the sale is either a qualifying or disqualifying disposition.

A qualifying disposition means the stock has been held the prescribed period of time. If this time period is equal to or greater than the ________ holding period, the favorable spread will be taxed to the individual at the favorable long-term rate, but the company has no tax deduction. However, if the statutory holding period has not been met, the sale is a __________. The gain is taxed as ordinary income and the company has a tax deduction of like amount. Companies wanting the executive to retain stock acquired may either motivate them to hold on to the stock or put restrictions in place that must be met before the stock could be sold.

Answer 25

statutory

long-term capital gains tax

disqualifying disposition

Question 26

Fixed value option plans are stock option plans in which an executive receives options of a ______ value every year over a certain plan period. For instance, a board of directors may decide to award a $1 million grant annually for the next three years to an executive. If the stock’s price is ascending, the executive will receive fewer options to keep the dollar value at $1 million in the second year. If the stock price is declining, the executive will receive more options to retain the value at the $1 million mark. Alternatively, the board could adjust the $1 million figure higher in the second and third years.

Fixed value option plans are popular because they allow companies using ______ compensation studies to make comparisons to other industry executives and adjust an executive’s pay package in amount and form to avoid losing the executive to a competing firm. However, since most of these plans determine a fixed value of future grants in advance, the link between pay and performance is ______. In fact, under the example described, an executive will receive a larger percentage of the company if the stock price is ______.

Answer 26

predetermined

consultant

weakened

deteriorating

Question 27

_Fixed *number* option plans_ are stock option plans in which an executive receives a fixed number of options every year over a certain plan period. For instance, a board could award 28,000 at-the-money options in each of the next three years to an executive. While the company would not lock in a dollar value amount that the executive receives in the form of stock option compensation, a fixed amount of options awarded is set. Fixed number option plans maintain a stronger link between pay and performance since the executive will become wealthier if stock price ______ and will be penalized if stock price _______. These plans have more _______ for the executive than do the xed value option plans described in Question 21.

Answer 27

escalates

decreases

upside potential

Question 28

the lump-sum mega-grant plan fixes the number of options in advance as well as the exercise price. These plans provide a strong incentive at inception because they offer the most ______. However, if the stock price dramatically falls, these plans can be problematic since the executive does not receive any new at-the-money options to make up for the worthless ones that are “underwater.” If the fall in stock price was due to poor performance by the executive, the decline in value of the options is probably _______.

However, if the fall in stock value is related to overall market _____, the lump-sum mega- grant plan may actually provide an incentive to leave the company, join another company, and receive new at-the-money options providing this leveraged upside potential.

Answer 28

leverage

warranted

volatility

Question 29

A company that has a lump-sum mega-grant stock option program that is seriously “underwater” is in a very difficult position. If the company reprices its stock options, the ______ of its future stock option plans may be undermined. Also, _______ generally do not look favorably on the repricing of stock options. However, if the company fails to reprice the options, the consequences may even be more devastating. Key executives, who see little upside potential from the “underwater” options, may decide to leave the company to receive at-the-money options from competing rms. In this latter case, talented human resources leave the company.

Answer 29

integrity

shareholders

Question 30

High-technology start-up companies often use lump-sum mega-grant stock options. Before an initial public offering (IPO), these companies find such plans extremely attractive. Historically, accounting and tax rules have permitted these companies to issue options at significantly discounted exercise prices. When issued as “______ options,” these plans have little chance of falling “underwater.” Therefore, these plans possess significant upside potential without the downside of options on publicly traded stock.

Following the initial public offering, many companies continue their use of mega-grant programs both because of a sense of “_____” and because other alternatives have not been examined.

The issuance of at-the-money options on publicly traded stock represents a much different risk profile for the option holder as compared with the pre-IPO “_____ options.” If the program were switched from the lump-sum mega-grant variety to a xed number grant of comparable value, an equal upside potential could be maintained while decreasing the risk to the option holder. By setting the exercise prices for portions of the grant at different ______, the value of the package becomes more resilient to drops in the stock price.

Answer 30

penny

“inertia”

penny

intervals

Question 31

Large, stable, well-established companies have historically chosen ______ stock option plans because these companies depend upon consultants’ compensation surveys and seek the highly predictable payouts that are offered by these types of plans.

A case can be made that the lump-sum mega-grant type of plan may be more appropriate for these companies to combat complacency and the threat of losing a few top executives is not such a company’s primary risk. The lump-sum mega-grant plan may cause these companies to think more creatively about new opportunities and generate greater shareholder value.

Answer 31

fixed value