Compensation & Benefits Alert

March 2017

Reduce Employee Stock Option Expense by Introducing Different Entry Levels and Forfeiture Techniques


Companies have adjusted over the years since the days of APB 25 to account for the expense of its employee stock options. And ever since, companies have adjusted the different variables within the traditional Black-Scholes-Merton pricing model to reduce the expense (e.g., reducing the once standard 10-year term to 7-years or less, premium pricing the strike/grant price above the underlying asset price, or using an annual risk of forfeiture rate to discount the option valuation). These minor measures do little to reduce the stock expense to a company's books and do little to further support its overall rewards programs.

There are, however, three other techniques that can significantly reduce the total stock option expense which accounts for stock option grant practices already in place, or practices that are philosophically practiced but are not accounted for in the current pricing of a company's stock options. The three techniques in this three-part article series are: Down and Out, Up and In, and Forward Start. Each one of the techniques, when applied to employee stock options, will have their own discounts, features, and drawbacks. Each one of these techniques uses a pricing model that is compliant with today's ASC 718 requirements (formerly FAS 123R), so we'll cover the necessary base calculations for each one of these before we discuss each of the different techniques. This article will focus on Down and Out options.