Some companies are rushing to let "underwater" stock options become exercisable now, before a new rule will force them to be recorded as an expense.
For many companies that passed out employee stock options like party favors during the go-go 1990s, the looming requirement that those options be treated as business expenses must look like a locomotive about to crash through their bottom lines.
Mandatory expensing of options, which starts later this year, likely will subtract millions of dollars from the reported profits of Northwest companies. So, it’s probably not surprising that some businesses are doing whatever they can to get out of that particular train’s way.
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In a maneuver that has caught the eye of the Securities and Exchange Commission, more than two dozen companies have quietly accelerated the vesting of “underwater” options — those whose exercise price exceeds the market price of the underlying stock.
By making the options exercisable immediately, before the expensing rule kicks in, the companies can tuck away the cost in a footnote now rather than recording it as an actual expense later and have it sap reported profits.
Take RadiSys, a maker of embedded computer systems based in Hillsboro, Ore. Last November, the company made 1.1 million unvested underwater options exercisable immediately. The move, RadiSys said, will keep $2.1 million in options-related expense off its books this year and $3.7 million next year.
That’s hardly small potatoes for RadiSys, which reported a $13 million profit last year. In its third-quarter SEC filing, the company estimated that had options expensing been in effect last year, its nine-month profit would have shrunk by 43 percent. (A full-year estimate won’t be available until the company files its 10-K report.)
Julia Harper, RadiSys’ chief financial officer, said accelerated vesting was a legitimate response to what she considers a flawed and unfair options-expensing rule.
“Options like these that are underwater and will never get exercised — our employees view them as having no value, we view them as having no value, yet (under the rule) you’re going to be running them through your income statement as if they had value,” she said.
RadiSys is among the companies — some large, some small, many in technology or health care — that have accelerated vesting on their underwater options. Other companies are considering the move, say corporate-finance watchdogs, who will be scanning the next few months’ worth of SEC filings to see if the trickle becomes a deluge.
“This is really just kind of a last-ditch effort” to avoid taking an earnings hit, said Todd Fernandez, senior research analyst with Glass Lewis, a San Francisco research firm that advises institutional investors on financial-reporting and corporate-governance issues.
In adopting the new rule in December, the Financial Accounting Standards Board (FASB) argued it would lead to profit-and-loss statements that more accurately reflect a company’s economic condition, and make it easier for investors to compare financials across companies and industries — contentions hotly disputed by Harper and other critics.
In the Northwest, two other companies — Wilsonville, Ore.-based InFocus and Portland-based Electro Scientific Industries — have accelerated vesting of large blocks of underwater options, according to a review of SEC filings by The Seattle Times.
Though legal, the accelerations have drawn the attention of SEC staff. In December, Chad Kokenge of the SEC chief accountant’s office told a meeting of accountants that their corporate clients must at least tell stockholders what they’re up to: “If you have engaged in this type of transaction or are planning to, be prepared to explain your actions to your investors in your SEC filings.”
A changing rule
Since 1972, companies have had to treat options as expenses only if the strike price is below the share price at the time the options were granted. As a result, virtually all employee stock options are issued with strike prices at the then–current market price.
In 1995, FASB issued a new rule requiring companies to estimate the “fair value” of options and encouraging them to record them as expenses. But, bowing to industry and congressional pressure, FASB allowed companies the option of stating what the expense would be in footnotes to their financial statements. Nearly all companies chose the footnote approach, even as option grants soared in size and popularity during the 1990s tech boom.
After years of debate, more than one false start and heated controversy — much of the latter stemming from the technology industry, which more than any other business relies on stock options to compensate workers — FASB last month approved a rule requiring companies to count options as expenses. The new rule takes effect for fiscal periods that start after June 15 (Dec. 15 for certain small businesses).
For companies that haven’t made wide use of options, recognizing them as a compensation expense won’t change the bottom line very much. But heavy options users can expect to get hammered: According to InFocus’ third-quarter report, for example, expensing options would have deepened its nine-month loss to $7.5 million, from $2.3 million.
On Dec. 20, InFocus accelerated vesting of 585,727 underwater options. In its SEC filing, the company estimated the move would save it $1.2 million in options expense this year and $500,000 next year.
Accelerated vesting offers companies a way to cushion the blow to their bottom lines. Right now, the expense of an option is reported gradually over its vesting period, typically three to five years. For companies that have chosen the footnote approach, the expense isn’t counted against income (though that will change when the new rule kicks in).
But if the options are vested immediately, the expense can be recognized all at once — before the footnote option goes away, said Scott Olsen, a New York-based principal in PricewaterhouseCoopers’ human resource services practice.
The idea is simple, Olsen said: “Let’s accelerate as much of the expense as possible so we can get it into the footnote and keep it off the income statements.”
Accelerated vesting probably won’t lead to a flood of new shares, since holders of underwater options aren’t likely to exercise them right away, if ever.
Companies adopting this tactic typically don’t accelerate “in the money” options because, under accounting rules, they would have to be revalued and expensed right away, defeating the purpose.
Some companies argue accelerated vesting does more than reduce exposure to the options-expensing rule — companies such as Linear Technology of Milpitas, Calif., which avoided some $75 million of options expense when it accelerated 4.5 million options last month.
“Because these options have exercise prices in excess of current market values of our stock, we believe they are not fully achieving their original objective of incentive compensation and employee retention,” Linear CEO Lothar Maier said in a statement. “Thus the acceleration may have a positive effect on employee morale, retention and perception of option value.”
Fernandez, of Glass Lewis, scoffed at that rationale: “It’s such backward, Jedi-mind thinking that only a tech CEO would love it.”
The reason options vest over several years, he noted, is to encourage employees to stay at the company (since they typically forfeit their unvested options when they leave) and to align their interests with those of shareholders.
But employees holding options that vested years early are positioned to benefit from short-term upticks in the stock price rather than the company’s long-range success, Fernandez said: “By stripping away the vesting terms, you put shareholders and employees on completely different planes.”
That may have happened last summer with Electro Scientific.
On June 28, the company accelerated vesting of 1.2 million options with strike prices greater than that day’s closing price of $23.38. The next day, after the markets closed, Electro Scientific reported much higher than expected fourth-quarter sales and profits. On June 30, its shares soared to $28.31; they topped out at $29.40 on July 2 before falling back.
Some of the newly accelerated options, to be sure, remained far underwater: Electro Scientific’s options carried strike prices as high as $61.63.
But as of May 29, the end of Electro Scientific’s 2004 fiscal year, nearly 1.4 million unvested options had strike prices between $24.03 and $27. Anyone holding those options when they were accelerated on June 28 would have been in position to profit handsomely during Electro Scientific’s brief run-up. (The company did not respond to calls seeking comment.)
To guard against such a situation, InFocus accelerated vesting only on options that were significantly underwater — those with strike prices above $11.21, $2.50 more than the stock’s closing price on Dec. 20.
“We wanted to maximize the potential impact, but we didn’t feel it would be fair to our current shareholders to give our executives and employees an immediate windfall if the (share) price appreciated in the short term,” said Roger Rowe, InFocus’ vice president and controller. “We wanted to be reasonable.”
Even if acceleration becomes widespread, Olsen said, savvy investors — especially those already concerned about over-reliance on options — will know to check the footnotes to see what companies are scrambling to keep out of their financials.
“I don’t think anybody is going to be fooled by this,” he said. “These numbers are coming out, one way or another. The bigger issue is, are you as a company going to look for more efficient ways to manage compensation costs? That’s what investors are going to be looking at.”
Drew DeSilver: 206-464-3145 or email@example.com