It was great to meet so many of you at the IAAP Summit in Florida last month! Not a lot of you have direct responsibility for stock plan administration—but all of you love a good scary story, right? In June I promised to share some of my favorite stock plan horror stories from my book “If I’d Only Known That!” Here’s the first one…
Once upon a time, there was…
A company with a strong egalitarian ownership philosophy provided stock option grants to every employee, even part-time store workers—a highly unusual practice in the industry. The minimum option grant size was 50 options subject to the company’s standard vesting schedule: 25 percent annually for four years (ignore the resulting rounding problems).
The company decided to change to restricted stock unit (RSU) grants to deal with dilution and stock price volatility issues. It began exchanging the 50 options for 12 RSUs with the same four-year vesting schedule. They thought this 4:1 conversion ratio was a good idea—there was no exercise price for the new awards, just a cash payout when the awards vested. How can that be bad?
But… the company’s stock price continued to decline due to changes in the industry and economic weakness.
Then a year later…
When the first tranche of three RSUs vested (remember 12 RSUs, vesting at 3 RSUs per year for 4 years), with a current stock price of $14 each these employees vested in $42 worth of RSUs. After withholding they netted less than $30 for the year’s vested shares. It seemed like a joke, and the employees laughed about their newfound riches.
Until the next year when the affected employees began their annual tax reporting preparations.
Rather than simply withhold from the affected employees’ paychecks or have them write small checks to the company for the taxes due on the $42 gain, the company simply reduced the number of shares issued to the employees. In the eyes of the Internal Revenue Service, this was a “sale” of the withheld shares to the company. This interpretation resulted in a small short-term capital gain of $12, the difference between the price at the vest event and the price on the date the shares were “sold” to cover tax withholding, and that small gain eliminated the employees’ ability to use the Form 1040EZ when they filed their income taxes.
The affected employees had to instead file full Form 1040s, with many of them requiring the assistance of a tax preparer—which cost far more than the $30 they realized from the cash settlement.
To “rescue” this situation…
The company accelerated vesting on the three remaining tranches of RSUs, the remaining 9 shares, delivering another $108 in value—and one final year of tax impact for the plan participants.
In the end, each employee ended up paying an average of $200 in tax preparer fees for a net gain of less than $100.
Moral of the story
I’ve always wanted a good excuse to quote this Scottish poem in its entirety. Here is the English translation:
The best laid schemes of Mice and Men
oft go awry,
And leave us nothing but grief and pain,
For promised joy!
—Robert Burns, “To a Mouse” (November 1785)
Even assuming that a qualified equity compensation professional was involved in the decision to move from option grants to RSUs, the plan went off track because no one bothered to do the math. Setting all good intentions aside, the key really is simply taking a specific look at what is planned and what the possible results could be. I recently attended an equity compensation conference session where one of the panelists recommended a three-prong analysis: the good, the neutral, and the ugly… uh, bad. If that analysis had been performed before the board authorized the 4:1 RSU exchange, this frustrating situation would have been brought to light and the company could have structured a reward program for its hourly employees that didn’t cost the employees more than they received in the bargain.
Well, forewarned is fore-armed. In next month’s Admin Super Powers blog we’ll continue with real life examples of what happens when stock plan administration goes awry! If you’ve got any similar stories you’d like to share, of good intentions gone bad, I’d love to hear them. Have a great summer!