Is Your Stock-Based Compensation Program about to Cause a Second Wave of Expense?
The first quarter of 2020 was one of the worst quarters for the stock market since the Great Recession, with the S&P 500 Index dropping over 20%. Many companies are preparing for reduced revenue and earnings with shelter in place orders slowing the economy. As companies contemplate a new and uncertain future, an unanticipated drag on earnings may come from an unexpected source: existing stock-based compensation awards.
For most time-vested and performance-vested restricted stock units (“RSUs” and “PSUs”), a drop in stock price between the grant date and the vest date will result in the recognition of additional expense. Because the company will receive a tax deduction when the employee recognizes income for a stock-based compensation award, the company also records a tax benefit for book purposes. However, there is a mismatch in timing between when the value of the award is measured for book and tax purposes:
- Book purposes: Grant Date
- Tax purposes:
- RSUs: Vest Date
- Stock Options: Exercise Date (gain realized by employee)
As a result, if the stock price declines between the grant date and the vest date, the expected benefit booked by the company based on the grant date stock price will be larger than the tax benefit that is realized by the company. The difference between the two – the tax benefit shortfall – must be recorded for financial accounting purposes as additional income tax expense.
- Assume Company A grants 120,000 RSUs at $50 per share and the tax rate equals 25%.
- Company A books an expected tax benefit of $1.5 million (120,000 * $50 * 25%). However, if the RSUs vest during a market downturn, at $20 per share, Company A would realize a tax benefit of only $600,000 (120,000 * $20 * 25%).
- As a result, the $900,000 tax benefit shortfall would be booked as additional income tax expense on the day the RSUs vest.
The incremental tax expense can be even more pronounced with stock options during a market downturn or recession. The expected tax benefit for employee stock options is based on the grant date fair value, which is often estimated using the Black-Scholes option pricing model. But if the stock options expire underwater (i.e., the exercise price exceeds the stock price) without being exercised, the entire expected tax benefit must be recognized as additional income tax expense. Companies should review upcoming option expirations and moneyness levels to determine to what extent they will be impacted. The problem can be exacerbated by corporate restructurings or layoffs that occur in response to the economic downturn because vested stock options typically expire 30 to 90 days following the termination of the participant’s employment. As a result, the impact on tax expense of the expiration of underwater stock options could be like expense timebombs going off 30 to 90 days following a layoff.
- Assume Company A completes a reduction in force in late 2020. The terminated employees hold 1.5 million vested stock options that were granted between 2011 and 2020. The average grant date Black Scholes value equaled $16, the tax rate equaled 25%, and Company A booked an expected tax benefit of $6.0 million (1,500,000 * $16 * 25%).
- If the stock options expire underwater in early 2021, following the end of the 90-day post-termination exercise window, the entire $6.0 million would have to be booked as additional income tax expense on the day the stock options expire.
To adequately prepare for potential expense that could result from stock-based compensation during a market downturn, managers in a company’s accounting, finance, and tax groups need to understand the impact and timing of future RSU/PSU vesting, as well as the expected attrition (both voluntary and involuntary) among option holders. While companies can’t control the outcome, they can prepare by modeling various stock prices that will trigger options to expire in or out of the money over at least the rest of the year. This may involve sensitivity analyses under a range of stock prices and attrition rates. Most third party stock plan administration software platforms will not have the functionality to perform the analysis; therefore it’s likely that the analysis will need to be performed outside of the stock administration platform. The use of a third party specialist may be required, particularly if the dataset is very large and/or sophisticated predictive models, such as a Monte Carlo simulation, will be applied.
The world has changed. COVID-19 is anticipated to cause a drop in GDP in 2020 and beyond. As a result, companies are examining their earnings projections and may be preparing revised guidance for market analysts. Examining the magnitude of the potential variance between (i) the tax benefit that was booked based on the grant date value and (ii) the current and projected future stock price is essential in understanding the impact of stock-based compensation on future earnings. Without performing analysis, it would be very difficult to assure company leadership that there won’t be any unexpected consequence on earnings.
Infinite Equity has the experience and skill-set to assist companies of all sizes in assessing the potential impact of a market downturn on all types of stock-based compensation. Please reach out for additional information.