5 Frequent Modification Mishaps
Modifications of share-based payment awards are a natural part of life for companies that issue equity awards. In a dynamic talent market, they’re a critical tool for keeping compensation programs competitive. But that flexibility comes with a cost—the financial impact of the modifications isn’t always intuitive, meaning that it can be all too easy for costs to unintentionally outweigh benefits if modifications aren’t structured right.
In this article, we highlight some of the most common types of modifications we see in practice and reveal the pitfalls in the resulting financial statement and proxy implications. (For a more exhaustive discussion of modification accounting, plus more real-life modification cases, please see our modifications white paper.)
1. C-Suite Departure
The Case: Following many years of exemplary service to the company, a CEO decides to retire at the end of the year. Importantly, the equity award agreements contemplate no special treatment upon retirement and unvested shares will forfeit by default. In light of the CEO’s history and performance, the board allows all unvested shares to accelerate upon retirement. After all, the stock price has risen for many years in a row—although there’s been a slight dip since the most recent annual grant.
Potential Mishaps: Paying out shares that otherwise would have forfeited amounts to what ASC 718 refers to as a “Type III” modification. All previous expense is reversed on the modified shares, and the fair value of those shares as of the modification is recognized from modification date to the new service period end date.
This resetting of the expense to a new value basis has a few notable implications. First, because the CEO is working until the end of the year, this can lead to a net reversal of expense in the period of modification. Second, the ultimate expense will be very different than previously anticipated—it will be stepped up to the higher value for the older grants, and actually stepped down for the most recent annual grant because of the price decline since the grant date. This effect of decreasing expense is unique to a Type III modification. Finally, the total value of the modified shares will be added to the proxy in the modification year as if they were new awards. Some might see this as double-counting the shares, since their value was already disclosed in the year of grant, but this effect is present in the proxy because there is no concept of reversing prior value the way that one does for P&L expense.
2. Planning Ahead…But Not Far Enough
The Case: Let’s add a common twist to the first case. Instead of directly modifying the CEO’s awards, the company adds retirement eligibility features to the entire equity compensation plan for all employees. Seems easy enough—it’s natural for the population of award recipients to mature as the company matures. Rewarding service with retirement benefits is also natural as a total rewards strategy. But the timing is critical when we consider the accounting treatment of adding retirement eligibility provisions.
Potential Mishaps: ASC 718 and other standards have anti-abuse provisions to prevent companies from taking advantage of accounting loopholes. Retirement eligibility introduced right before an executive departure is a big red flag.
Why? According to the accounting guidance, if a change is made “in contemplation of” an event, the accounting must assume that the two events are linked. In this case, a retirement eligibility feature added to the plan right before the CEO’s departure would be accounted for with exactly the same Type III framework as in case #1 above.
Absent an executive retirement or any other coincidence that seems too good to be true, proactively adding the retirement eligibility provision would typically have no accounting impact. This is because it wouldn’t affect the vesting, fair values, or award classification of a particular award, which are the criteria that must change for there to be accounting implications. Instead, the modification would simply require disclosure in the footnotes.
3. Modifying In-the-Money Options
The Case: Let’s add one more stitch to our case of the outgoing executive. Now say that some of the unvested awards undergoing a Type III modification are stock options which will need to be revalued. Keep in mind that multiple grants are significantly in the money because of the stock price runup to the current year.
Potential Mishaps: The Black-Scholes-Merton (BSM) formula is perfectly acceptable for new, at-the-money stock option grants. However, the BSM formula breaks down in certain situations. One such case is in-the-money options where the company pays a dividend, like we have here. The BSM formula can actually return a fair value less than the intrinsic value,* which is almost certainly not a compliant fair value.
Instead of the BSM formula, a lattice model must be used to calculate the fair value of these options. (Deciding whether the BSM formula is an acceptable approach—and then deploying a lattice model if it isn’t—are difficult tasks even for a specialist, so we encourage you to reach out to our team with any stock option modification questions.) Fortunately, using a lattice model for modification cases doesn’t stop a company from using the BSM formula for any normal at-the-money grants later.
* Try it with your own BSM calculator: stock price = $25, strike price = $10, volatility = 40%, risk-free rate = 1%, dividend yield = 3%. The BSM value is $14.68, which is less than the $15 intrinsic value!
4. Resetting Performance Targets
The Case: In a blockbuster deal, ABC Corp. acquires XYZ Inc. ABC has performance-based equity awards with earnings before interest, taxes, depreciation and amortization (EBITDA) as the primary metric and the XYZ acquisition is expected to be immediately accretive. Prior to the announcement of the acquisition, the awards were tracking toward 100% payout. The additional earnings from XYZ are expected to increase the payout to the 200% maximum level. To avoid a large, near-automatic windfall for executives holding the performance awards, the board adjusts the EBITDA targets higher. Following the modification, the expected payout is back to 100%, keeping the recipients effectively whole compared to pre-acquisition.
Potential Mishaps: While some might argue that an increased performance payout is an appropriate reward for helping secure the strategic acquisition, many would rebut that the spirit of the EBITDA goals is business profitability and growth, not mere acquisitiveness. This brings us to the first potential mishap: If adjusting performance targets based on the expected impact of the acquisition is more palatable to shareholders, it could still upset participants who will see the modification as punitive.
From an accounting standpoint, the most important consideration for this type of modification is that expense must be recognized if the original terms are met. This requires tracking the original performance targets, which can be difficult once a large corporate transaction has fundamentally changed the firm. That’s the second potential mishap. Then again, if mutually understood terms providing for a certain adjustment to the performance goals were in place before the contemplation of any particular acquisition, there may be no accounting modification at all.
In general, modifying performance awards with scaled payout percentages—e.g. 0% for nonattainment up to 200% for maximum performance—deserve careful review.
(For more on how ABC Corp. should account for the unvested equity awards it assumed when acquiring XYZ, see our business combinations white paper.)
5. Modifying an Award after Service Has Been Provided
The Case: A handful of employees voluntarily terminated in late December. Per normal termination provisions, their unvested awards were forfeited and their vested options had a 90-day post-termination exercise window. They were unable to exercise immediately due to a blackout window that was scheduled to lift following the release of their annual earnings results. However, due to delayed filings, the blackout window was extended. As the 90-day exercise window was nearing completion with no ability to exercise, the company decided to modify their options to allow a longer exercise period.
Potential Mishaps: This scenario can give rise to two key issues. The first is that the awards may no longer even be accounted for under ASC 718, as the modification is no longer compensation for service being provided. Depending on facts and circumstances, this may trigger mark-to-market accounting or a more complex balance sheet presentation.
The second is the possibility of very high incremental cost. Even if the option is deep in the money, it has zero value if there’s no way to exercise it due to the blackout window. This means that the entire postmodification value is incremental cost, with no offset or reversal to counteract the step up in expense.
Between complex accounting guidance and creativity in structuring modifications to solve strategic HR needs, modification accounting is among the most misunderstood—and misapplied—areas of share-based compensation. The examples we just discussed are but a small part of we see on a regular basis (not to mention the ones we see on an irregular basis). Our recent webcast on modifications and our modification accounting white paper are must-have resources for anyone considering a change to equity awards—or tasked with implementing the change from an HR, stock plan administration, legal, or accounting standpoint. We’ve seen time and again that proper coordination among affected stakeholders can help to avoid countless headaches from modification mishaps.