Why Net Exercise?

Net exercises can be a great alternative to traditional broker-assisted cashless/same-day-sale exercises, more efficiently using the company’s share reserves and resulting in less overall plan dilution. In this blog entry, I explain how net exercises work and discuss some considerations for implementing them.

What Exactly Is a Net Exercise?

The concept of a net exercise isn't unfamiliar. Many companies already employ share withholding on restricted stock units or even have a stock-settled SAR program. Like share withholding on restricted stock units, a net exercise means that the employee tenders shares back to the company to cover his or her financial obligations for the exercise. Like a stock-settled SAR, the participant realizes the appreciation in stock price without an output of cash for the exercise price and without a sale of shares.

In a net exercise, when a participant wants to exercise an in-the-money option, the company holds onto enough shares from the exercise to cover the exercise price and delivers the net amount remaining to the employee. For example, if an employee exercises 1,000 shares of an NQSO with an exercise price of $15 per share at a time when the current FMV is $40 per share, the company retains 375 shares ($15,000 exercise price divided by $40 per share FMV) and delivers 625 shares to the employee (1,000 shares exercised less 375 shares tendered to cover the exercise price).

Depending on the plan parameters, the shares tendered to the company may return to the stock plan or may be retired. Either way, the exercise does not result in a market sale.

What About Tax Withholding for Net Exercises?

The company may also set up the net exercise program to include share withholding to cover employees’ tax obligations. If this is the case in our example above, the company would hold back another 186 shares to cover the employee’s federal tax withholding obligation (tax withholding of about $7,400 divided by the $40 per share FMV) and the employee would receive only 439 shares.

When Is Net Exercise a Good Fit?

There are many advantages to implementing a net exercise program. If those advantages are important to your company, net exercise may be a good fit. If your company is concerned about dilution or wants to promote share ownership (especially if your executives are subject to holding or ownership requirements), net exercise may be particularly appealing. For additional information, check out our article:  “10 Reasons to Implement Net Exercise.“

Net exercise is particularly useful for executives and Section 16 insiders. Because net exercises do not involve a market sale of shares, they do not trigger a Form 144 filing. Additionally, unlike same-day sales, the net exercise method provides Section 16 insiders with a way to fund their exercise that doesn’t risk triggering short-swing profits recovery. The tender of shares to the company is reported on Form 4 as an exempt disposition of stock to the company, rather than as a non-exempt sale.

Net exercises also help executives comply with company share ownership and retention requirements.

Making the Switch to Net Exercise

One truly great aspect of net exercise is that it doesn't require the company to grant new equity vehicles. It is common for equity plans to allow for a variety of exercise financing methods, even methods the company doesn’t anticipate offering when the plan is adopted. Thus, your equity plan may already allow for net exercise; implementing a net exercise program may be as simple as promoting this financing method to employees.  

If your plan doesn't already include net exercises, amending the plan to allow net exercise should be straightforward and typically would not require shareholder approval. Amending existing grants to permit net exercise generally would not be treated as a modification under ASC 718 unless the availability of this exercise method is expected to change employee exercise behavior. Because net exercise provides the same economic benefit to employees as cashless/same-day-sale exercises, it may be reasonable to assume that employees will continue to exercise over the same time period as in the past.

Eliminating Cashless/Same-Day-Sale Exercises

Companies that want to fully benefit from the advantages of net exercises may want to consider eliminating their cashless/same-day-sale exercise program. Otherwise, employees are likely to simply continue to exercise their options in the manner they are familiar with because this is what they are most comfortable with.

(Auto) Net Exercise for Expiring Options

Another effective use of net exercise is to implement a policy that allows for auto execution of a net exercise on in-the-money options that are about to expire. This allows the company to obtain the tax deduction on options that have already been expensed and prevents the participant from losing out on option shares they have earned. For more information on this strategy, see the blog "Expiring Options? The Case for Auto Exercise."

Considerations in Deciding on Net Exercise

If you are contemplating whether net exercise is right for your company, there are several important issues to consider. Most significantly, take a good look at the goals of your equity compensation program to evaluate whether the benefits of net exercise facilitate those goals. For a full comparison of the tax, financial reporting, and proxy disclosure considerations of various option exercise methods, including net exercises, see our Option Exercise Comparison Table.

Then, conduct a careful review of your plan document and grant agreements. In your plan document, verify which exercise methods are permitted, any requirements around modifications to the plan, and if you have any pesky outdated language regarding the use of "immature" shares that will need to be eliminated.[1] You'll also want to know if any of your grant agreements limit the methods of exercise that may be used.

Although the tax code is not entirely clear, most practitioners believe that allowing net exercise disqualifies options from ISO tax treatment. If your company currently grants ISOs, net exercise may not be a fit for you or may be a fit only for your NQSO grants. See our discussion of ISOs in  “10 Reasons to Implement Net Exercise” for more information.

Finally, your international employee population must also be considered. There may be jurisdictions in which net exercise is either prohibited or where the challenges outweigh the benefits. Before implementing net exercise outside the United States, consult with your advisors.

Additional Resources on Net Exercise

The following resources were mentioned in this blog:

• 10 Reasons to Implement Net Exercise
• Option Exercise Comparison Table
• Expiring Options? The Case for Auto Exercise

------------------------------------------ 

[1] The US accounting standard that preceded ASC 718 imposed unfavorable accounting when immature shares (i.e., shares held for less than six months) were tendered in payment of option exercises. Although ASC 718 eliminated this treatment, plans sometimes still include language prohibiting use of immature shares to exercise options.