Or it may decide to issue both types. In some cases, the company allows the executive or employees to choose between the two. The decision to be made as to which to use must be done with the following in mind:. Benefits to the grantees and to the company. In the case of ISOs, there is no deduction by the company, assuming no disqualifying dispositions are made. Restricted Stock and RSU: No taxes are assessed to the grantee at grant. Taxes are assessed when the Restricted Sock vests as they are now transferable or not subject to risk of forfeiture, Section 83 b IRC.
The values depend on such factors as the exercise price relative to the current market price, the expected volatility, the expected time to expiration, the expected risk free interest rates, and the expected dividends. The value of the grants perceived by the grantee, especially with regard to ESOs or SARs may be far different than the value allocated to theoretical costs to the company.
This is so because companies tend to under-value the ESOs at grant day, and the expected time to expiration of the ESOs may vary considerably in the estimation of each individual.
There is always the risk that the grantee will not achieve that vesting and therefore never own the granted equity value and lose it all. Another risk, in the case of ESOs and SARs, is that the stock is lower or unchanged from its exercise price on expiration day and the grantee will receive nothing. On the other hand, with RSs or RSUs, if the stock in lower or unchanged years after the grant, the grantee will probably get a large part of the grant day value.
A consideration that companies make when granting equity compensation is the possibly future cash flows to the company, although it is seldom mentioned by the company executives at the time of the grants.
When ESOs are exercised, the exercise price is paid to the company by the grantee and the company issues new shares. These two cash flows are often a large percentage of the total company cash flows. A good article on this point can be found here. These credits are partly the reason of why the companies and wealth managers encourage early exercises of ESOs and discourage hedging which delays the cash flows. When RSs vest, the only flow to the company is the credit of the tax deduction, but it comes sooner than with ESOs.
It comes when the RSs vest, whereas the tax credit from ESOs comes when they are later exercised after the vesting. In the case of SARs and RSUs, the companies can choose to avoid dilution and forfeit the cash flow credits by settling the exercise or vesting by a cash payment without issuing new stock. The grants of RSs have a quite large probability of causing dilution of earnings, because no matter where the stock is trading, the RSs will be owned by the grantee after vesting and the number of shares increase, whereas, there is a good chance that the ESOs or SARs are never exercised because there is a chance that the stock will be trading below the exercise price near expiration.
There is also a chance that the grantee never becomes vested for the ESOs. However, if the stock advances a reasonable amount, the dilution will be grater with ESOs because more ESOs are granted relative to the number of RSs that are granted, if equal valued grants are sought.
But that reduces the cash flow and cash positions. Which type of grant best preserves the alignment of interests between the grantee and the shareholders? After all, that is the major purpose of the compensation plan. In the case of RSs, most grantees generally sell their unrestricted shares immediately after vesting to pay the tax liability and lock in their profits on the remaining shares, although some plans require that a part of the stock be held for years after vesting.
Of course, the sale of the shares eliminate any alignment that may exist from holding those shares. So with RSs, there is usually an early termination of the alignment of interests as the shares are sold immediately after vesting. There are many considerations to make when deciding on which type of grants to make. Today we see some very sophisticated companies issuing combination of grants trying to grant the highest value both real and perceived to the grantees for the lowest costs to the grantor company.
With the above in mind, I have created a new type of ESOs, which is designed to increase the positive benefits to the grantee while at the same time enhancing the objectives of the grants and keeping the costs to the grantor modest.
Click here for more information or to register. Grants of Employee Stock Options vs. Photo by Bill Selak.More...