Primer on Management Equity Incentive Programs

This memorandum describes the key features of stock plans for management employees. It does not purport to be exhaustive. The number of shares reserved for these kinds of plans usually represents 10% or less of the outstanding shares. Occasionally, companies with low market capitalizations exceed 10%, but this is the exception rather than the rule.

Stock plans for management employees are usually required to be submitted to shareholders for approval, and typically reserve a certain number of shares of stock for issuance to management employees pursuant to specified types of stock incentives. The types of stock incentives authorized usually are as follows:

a. Stock Options. A stock option entitles the employee to purchase a certain number of shares at any time during a specified period of time (usually, ten years) at the market price of the shares on the date the option is granted. For example, a typical option that is granted today would entitle the employee to purchase a certain number of shares of Company stock (let's say 100 shares) at any time during the next ten years at today's market price (let's say $6). Thus, if the market price increases above $6 at any time during the next ten years, the employee would be able to buy the shares at a discount. Thereafter, the employee could sell the shares or hold them, as s/he prefers (subject to any applicable securities law restrictions).

The employee is never obligated to exercise an option. Thus, if the market price does not increase during the life of the option, the employee would not exercise the option.

The right to exercise a stock option usually is phased in over a period of time after the grant of the option. For example, half of the option described above (i.e., 50 shares) might become exercisable on the first anniversary of the option grant date, and the other half might become exercisable on the second anniversary of the option grant date. The phase-in is intended to ensure that the company receives substantial additional service in exchange for granting the option, which is a valuable right. Typically, if employment terminates before the right to exercise the option has been fully phased in (e.g., after the first anniversary of the option grant date in our example but before the second anniversary), the portion of the option that has not been phased in is immediately forfeited. Option rights that have been phased in (i.e., options that have become exercisable) usually expire when the employee's employment terminates or within a limited period of time (e.g., three months) after employment terminates, depending on the circumstances of termination. For example, if employment terminates by retirement or disability, the employee might have the right to exercise the option for three months after termination, but if employment is terminated by the company for cause, the option might expire immediately.

Options can be granted to selected individuals and need not be granted to the whole organization. Furthermore, the specific terms and conditions of the options that are granted need not be the same for each participant. For example, the company may grant a 5 year option to one executive and a 10 year option to another. Also, the phase-in period can be longer for one executive than for another. These decisions are made by the plan administrator in its discretion, subject to the terms and conditions of the stock incentive plan approved by shareholders. Usually, the terms and conditions of stock incentive plans are quite flexible and allow the plan administrator wide latitude to determine who is to get options, and the terms and conditions of the options.

In the case of public companies, the plan administrator generally must be a compensation committee of the board of directors, consisting of outside (non-employee) directors who are ineligible to participate in the plan. In order to remove stock option gains from being counted towards the $1 million limitation on corporate tax deductions for any public company top executive's pay, the plan administrator should also consist exclusively of directors who have no substantial commercial relationships with the company and who are not former officers or employees of the company. The committee may consist of only two board members.

In publicly-traded companies, stock options are typically granted as a normal part of executive pay packages. The number of options granted is usually determined by competitive practices, among other factors. In addition, stock options are increasingly being used by progressive companies as a substitute for cash compensation -- a practice that is generally viewed favorably by the investor community, because it replaces fixed cash compensation with an incentive that provides compensation to the executive only if the stock price increases. It also demonstrates to the investor community management's confidence in the company when managers are willing to trade cash for options that pay off only if the stock price increases.

The value of the stock options that are granted as a substitute for cash compensation is generally intended to be equal to the cash being given up, so in theory the transaction is an equal exchange. The value of the stock options is calculated for this purpose, not by the paper profit on the date of grant (which is zero, since the purchase price of the shares under the options is almost always equal to the market price on that date), but by mathematical models that attempt to determine the option's market value at grant based on the key characteristics of the option and the stock. Usually (but not always), the value of an option using these models falls within a range of one-third to one-half of the market value of the stock that is subject to the option on the option grant date. For example, the value of our option to buy 100 shares at $6 per share would typically fall within a range of $200 to $300 (1/3 to ½ of $600). In this case, an executive who gives up $600 of cash compensation could expect to receive between 2 and 3 options at $6 per share, depending on whether the option value was determined to be $300 or $200. Of course, if the mathematical models indicate that the value of an option exceeds this range (perhaps amounting in some cases to 70% of the market value of the stock subject to the option on the option grant date), the number of options the executive would receive would be lower.

For tax purposes, stock options are classified as either "incentive stock options" ("ISOs") or "non-qualified stock options" ("NQSOs"). When NQSOs are exercised (i.e., when the employee purchases shares at the option price under the option), the discount at which the employee is purchasing the shares is taxed to the employee at ordinary income rates (now as high as 39.6%), and the company is entitled to deduct the same amount as compensation on its tax return. For example, if the option in our example is classified as a NQSO for tax purposes and the employee buys stock under the option at $6 when it is selling on the market at $8, the $2 discount is taxed to the employee as ordinary income when s/he purchases the stock and is deductible by the company on its tax return. Also, the $2 discount is subject to Social Security taxes at a rate equal to at least 2.9%, half of which is payable by the employee and half by the company.

ISOs offer 3 advantages over NQSOs--

1. The discount is not taxed when the employee purchases the shares. Instead, the tax on the discount is generally deferred until the employee sells the shares. This creates a tax incentive to hold rather than sell the shares, since selling them accelerates the employee's tax liability.

2. When the discount is taxed, it is taxed at capital gains rates, rather than ordinary income rates, if the shares have been held by the employee for at least one year and the shares are sold more than two years after the option was granted. Today, ordinary income rates can be as much as 100 percent higher than capital gains rates -- 39.6% versus 20%-- so this can offer a substantial advantage to the employee.

The potential tax advantages of ISOs to executives may be partially offset, however, by the fact that the discount is treated as "alternative minimum taxable income" which may be subject to alternative minimum tax liability in the year in which ISOs are exercised.

The tax advantages of ISOs for executives come at the expense of the company which grants them: if the employee exercises an ISO and holds the shares long enough to be taxed on the discount at capital gains rates rather than ordinary income rates, the company ceases to be entitled to deduct the discount on its tax return as compensation. As a result, the company will pay more tax under these circumstances. (This assumes, of course, that the company is in a tax paying position. If the company is not, e.g., if it has tax losses or tax loss carryovers which shelter it from taxes, the company's tax liability may be largely unaffected by granting ISOs as opposed to NQSOs).

ISOs entail additional restrictions in the case of employees who own more than ten percent of the voting power of all classes of stock of the employer corporation or its parent or subsidiary corporations. In the case of such individuals, an option will qualify for ISO tax treatment only if the option is priced at 110% of the fair market value of the stock on the date of grant of the option (as opposed to 100%, which is the rule applicable to other employees), and only if the option will expire within five years of its date of grant (rather than ten years, which is the rule applicable to other employees).

Options granted to employees of publicly traded companies generally do not give rise to compensation expense for accounting purposes, so reported earnings are not reduced as a result of the grant or exercise of options. However, granting options reduces earnings per share, because shares subject to options are considered outstanding when EPS is calculated (i.e., the number of shares in the EPS denominator is increased but the earnings in the EPS numerator do not change). In 1996 and later financial statements, the hypothetical "fair value" of options granted in 1995 and later years must be disclosed in a footnote to the financial statements, along with the pro forma effect on net earnings and EPS which would result if the reported earnings had been reduced by the "fair value" of the options in accordance with new accounting rules. However, reported earnings in the financial statement will not in fact be reduced.

The accounting treatment of options granted by privately held companies is complex and currently under review. Generally speaking, such options give rise to compensation expense for accounting purposes, if the company is likely to settle the option for cash shortly after issuance of the shares (generally defined to mean within a period of less than six months). If the company is likely to settle the option for cash, but not shortly after issuance of the shares, the appreciation in value between the date of grant of the option and the date of exercise of the option may be treated as compensation expense that reduces reported earnings, but subsequent appreciation should not be so treated if the purchase price constitutes a "substantive" investment in the shares.

b. Stock Awards. To save cash, the shares reserved for use under a management stock plan usually may be issued to employees outright in lieu of cash compensation such as salaries and bonuses. Thus, the Company could use the shares to pay the salaries it owes for past services, as well as a portion of salaries for future services. Unlike options, however, the shares when issued would have immediate value, so the value of the stock awards to the employees would not be contingent on future appreciation.

The market value of the shares when they are issued would be treated as compensation expense for accounting purposes, which would reduce reported earnings. However, the compensation expense is treated as a tax deductible item, so the amount of expense is reduced by the value of the tax deduction. This is essentially the same accounting treatment as a cash payment.

c. Restricted Stock Awards. The shares reserved for use under the plan could also be issued to employees as restricted stock awards. Restricted stock awards are stock bonuses that are issued before the employees earn them. Because they have not yet been earned, the employee's rights in the shares are restricted -- restricted in the sense that the employee cannot sell the shares until they are earned and must forfeit them back to the Company if his or her employment terminates before they are earned. Restricted shares are usually earned simply by remaining in the company's employ until a specified future date, so restricted shares are usually considered to be a "golden handcuff". Although restricted shares are restricted until they are earned, the employee usually has full dividend and voting rights in the shares as soon as they are issued. In a sense, restricted shares are an advance of future compensation. However, they do not necessarily represent an increase in the total compensation the employee would otherwise receive.

For example, if the market value of a share is $6 the Company could issue 20,000 restricted shares to an employee and reduce the employee's future salary by $60,000 per year for two years. As soon as the shares are issued, the employee would be entitled to vote the shares and keep any dividends paid on the shares. However, until the restrictions are lifted the employee would be unable to sell the shares and would forfeit them back to the Company if his employment terminates for any reason. The restrictions would be lifted on 10,000 of the shares after one year, and on the other 10,000 shares after two years, if there has been no termination of employment. However, if there is a change of control of the Company during the two year restriction period, the restrictions would be lifted immediately.

Employees are taxed on restricted shares when the restrictions are lifted, and the amount of income is measured by the market value of the shares at that time. For example, the employee in the example above would be taxed on 10,000 of the shares after one year, and the other 10,000 shares after two years. The amount of income which the employee would recognize would be equal to the market value of the shares after one year (for half of the shares) and after two years (for the other half of the shares).

Within 30 days after restricted shares are issued to an employee, the employee can make a special election under section 83(b) of the Internal Revenue Code to be taxed on the shares when they are issued, rather than when the restrictions are lifted. If the employee makes this special election in accordance with applicable Treasury regulations, the amount of income subject to tax will be measured by the market value of the shares when they are issued, which may be much lower than their market value when the restrictions on the shares are later lifted. If the employee makes this special election, the employee will not have any tax liability when the restrictions are lifted, and all gain on the shares after the date they are issued to the employee will be taxed as capital gain rather than ordinary income. However, if the employee forfeits the shares because his or her employment terminates before the restrictions are lifted, the employee will not be entitled to deduct the amount which the employee elected to be taxed on when the shares were issued.

For accounting purposes, the Company must treat the market value of the restricted shares when they are issued as compensation expense that reduces reported earnings. The amount of expense does not fluctuate if the market price of the stock moves up or down during the restriction period. The expense is generally treated as a tax deductible item for accounting purposes, so the amount of the expense is reduced by the amount of the tax benefit anticipated at the date of grant of the shares.

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