Goldstein and Associates explain the “Knockout” Option: A New Form of Stock Option

The popularity of stock options as a compensatory tool has been waning at public companies for years. While there have been a number of factors that have contributed to their decline over the past decade or so, three chief concerns about compensatory options have been: (1) the accounting expense associated with stock options often exceeds their perceived value from the perspective of employees, (2) if a company’s stock price falls dramatically and the options have little chance of being in-the-money, the company must still recognize an expense and still incur the overhang of options with no way of getting rid of them and (3) stock options provide a “heads I win; tails I don’t lose” form of compensation.

Despite these concerns, there are a number of advantages of stock options as a form of equity compensation. First, recipients only benefit from options if the stock price appreciates and, accordingly, stock options create great incentives for employees to increase stock price, particularly in high-growth industries. Second, they are easy to explain to recipients. Third, they are far easier to administer than other forms of equity compensation under Section 162(m) of the Internal Revenue Code (the $1 million cap on compensation deductions for non-performance based compensation for a public company’s most senior executives) and Section 409A of the Internal Revenue Code (tax on non-compliant deferred compensation). The trick for companies that are partial to stock options is to find a way to use them while reducing the upfront compensation expense associated with their grant and to find a way to avoid continuing expense and overhang if the options become significantly underwater.

A relatively simple fix to these problems exists: the “knockout” stock option. The knockout option provides that the option has its normal vesting features and term, except that the option will automatically be forfeited or expire if the price of the stock subject to the option decreases below a certain threshold. For example, a ten-year option to purchase 10,000 shares at $100 per share would automatically be forfeited or expire, whether or not other vesting conditions are met, if the price of the underlying shares falls below $50 per share. To avoid the automatic forfeiture of options if the stock falls below the threshold for only a short period (e.g., a scenario like the “flash crash” of 2010), we recommend that knockout options only be forfeited if the stock price falls below the specified threshold for a certain period (e.g., 5 or 10 consecutive trading days).

For companies with higher volatility stock, the knockout option should result in a lower upfront accounting expense than a typical stock option because the expected life of the option would be shorter than a typical option. In addition, if the accounting charge is lower, the numbers in the summary compensation table of the annual proxy will be lower. Moreover, the company will not have to continue to suffer potential overhang at a time that the option is, or is viewed by the recipient as, worthless. Finally, by including an additional forfeiture condition that plain vanilla stock options do not, the knockout option creates downside disincentives. While the knockout option is not a panacea to all of the perceived shortcomings of stock options, it should help mitigate some of the more problematic aspects of options for companies wishing to grant them.

Companies should discuss with their auditors the likely accounting benefits to be derived from these structures and be sure to understand in advance of the grant whether the auditors would view the cancellation of an knockout option followed by the grant of a new option within a specified period will be considered a repricing.

This post is based on a memorandum by Jeremy L. Goldstein & Associates, LLC dated as of April 8, 2015.

1 Comment

  1. Michael Halloran

    I substantial comments on this in memo form
    Please give me an email address to which to forward
    Mike Halloran

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