Do you understand the options backdating “scandal”? What is it exactly? Why are so many companies in trouble?
Let’s start at the bottom. What are employee stock options? Employee stock options are the right (but not the obligation) to purchase shares in the company’s stock for a specified price and for a specified period of time. Do not confuse employee options with options on equities, indexes and futures like those traded on open markets. Generally, employee options are a benefit that companies offer to their employees, officers or directors in addition to their normal compensation, and are not transferrable. (unless you work for Google) The price is usually determined by the closing price in the market on the day the option is granted. Options will often have a 5-10 year period during which the employee is required to “exercise” the option, or purchase the underlying share. During this time, if the employee decides to exercise his or her options the employee will always pay the “exercise price”, or the share price determined on the day the option was granted, even if the shares have increased or decreased in value. If the employee does not exercise the option in the time permitted, the option will expire.
Now, let’s explain more of the terminology. Options which have an exercise price below the current market price of the company’s shares are said to be “in the money.” Take an easy example: you were granted 100 options two years ago at an exercise price of $10 and the stock is currently trading at $20. If you were to exercise your 100 options today, at a cost to you of $1,000, you would immediately own 100 shares worth $2,000. On the other hand, if you were granted 100 options at an exercise price of $10 and the stock is currently trading at $5, your options are said to be “underwater.” They are of essentially no value to you. (unless, again, you work for Google)
Most companies also structure option grants so that the options “vest” to the employee over the course of many years. When an option “vests” to the employee, the employee then owns the right to exercise and purchase the underlying share. For example, a company may decide to grant 10,000 options on a given date with only 2,000 of those shares vesting immediately. 2,000 options may vest 1 year from the grant date, 2,000 more 2 years from the grant date, and so on. Option agreements usually provide that the options expire when the employee is terminated or leaves the company. However, agreements could also allow for “acceleration”, or the speeding-up of the vesting schedule. Executives often have accelerated vesting provisions in their contracts which allow them to exercise all of their options within 60-90 days of their termination.
Why have so many companies, especially technology companies, made liberal use of options to compensate employees? There are a number of reasons. First, and most important, under applicable accounting standards options are generally not recognized as a compensation expense if the option price is set at the closing price on the day of the grant. Growing companies can therefore make use of options to compensate employees without taking a major hit against their earnings. You may be thinking: wait, it can’t be that much money, can it? Well, consider that many techonology companies were using options to compensate employees at all levels of the company, from CEO to secretary. Option grants at some companies may run into the millions of shares per year. You can see that this starts to add up very quickly.
Second, an option grant can be highly lucrative for an employee in the right situation. Most employees do not exercise options; however, for those that do, it can be rewarding if the employer is a young, growth-oriented company. Take an obvious example: Google. Employees of Google who received options with an exercise price in the $100 - $200 dollar range are now sitting on small fortunes with the stock trading near $450 - $500.
Third, like any grant of company securities to an employee, the employee’s interests are aligned with shareholders, at least in the short term. In other words, the employee has a personal stake in driving the share price higher that is not limited to the normal salary and bonus structure.
So what is backdating? Why is it a problem? Where is the illegal conduct?
Stay tuned…
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