Expiring Options? The Case for Automatic Exercise

You hate to see it: an employee with a vested in-the-money option that is about to expire unexercised. Even more heartbreaking is the desperate email just days after the option has expired. At that point, there is no easy solution to make the employee whole.

But there is a solution that can potentially prevent the above scenarios: automatically exercising in-the-money options just before they expire. In this blog entry, I cover some of the key considerations for this program.

The Cost of Option Expirations

Expired in-the-money options can have unfortunate ramifications for the company, as well as for the employees who allowed the options to expire:

• Compensation Expense: Any expense for vested options that expire is fully recognized; because the expiration isn’t a forfeiture, there’s no reversal of expense. This is compensation at its most inefficient: the company records an expense but no value is delivered to the employee.
• Additional Tax Expense. In addition to not being able to reverse the compensation expense recorded for the option, for NQSOs, the company will have to record additional tax expense in the period when the option expires. As compensation expense is recorded for NQSOs, the company also reduces current tax expense in anticipation of the tax deduction that will be realized when the options are exercised. When NQSOs expire unexercised, the company never realizes a tax deduction for the option and the previously assumed tax benefit must be written off as additional tax expense.
• Potential for Litigation. Option expirations are a common source of litigation with stock plan participants. Even where the company has a defensible position (e.g., the option expiration date was clearly stated, the optionee acknowledged acceptance of the terms and conditions of the option, and there were no administrative errors, such as a failure to follow the company’s customary procedures with respect to providing notice of the option expiration), lawsuits like this can be very costly.

How Do Automatic Exercises Work?

An automatic exercise is exactly what it sounds like: the company automatically exercises the option on behalf of the employee. The transaction is typically accomplished via a net exercise, with sufficient shares withheld to cover both the exercise price and any taxes due upon exercise. The exercise is processed after the market closes on the last day that the option is exercisable, so that the FMV is known (and the employee has until market close to initiate an exercise). The remaining shares not needed to cover the cost of the exercise are deposited into the employee’s brokerage account.

Using a net exercise, rather than a same-day sale, offers a number of advantages:

• A net exercise can be fairly easily unwound or rescinded prior to the end of the calendar year, should an employee raise an objection to it.
• A net exercise can be processed without the assistance of a broker. The stock plan administration team could manage this entire process independently—merely depositing the shares into employees’ brokerage accounts after the transactions have been completed.
• Brokers may be reluctant to execute a sale without express direction from the employee (even though this is done routinely for exchange-traded options and sell-to-cover transactions for RSUs); net exercise overcomes this concern.
• Because a net exercise doesn’t involve an open market sale, the automatic exercise could still be executed during a closed trading window.

One drawback to be aware of is that a net exercise likely disqualifies ISOs from preferential tax treatment—not just the shares withheld to cover the cost of the exercise but all the shares exercised. The tax code is unclear on this point, but most practitioners believe that it’s best to treat the exercise as an NQSO (which means withholding taxes and reporting W-2 income).

So long as the only circumstance in which net exercise is permissible is upon expiration, the option retains its ISO status right up until the point of the auto-exercise. Thus, if the employee voluntarily initiates an exercise, the option can still qualify for ISO treatment.

Does Automatic Exercise Make Sense for Your Company?

When evaluating whether auto-exercise at expiration is right for your company, one obvious key consideration is the number of in-the-money stock options that currently expire unexercised. The higher this number is, the more beneficial the program will be.

Another key consideration is the amount of time the stock plan administration team must spend warning employees that their options are about to expire. Most companies with stock options have some form of outreach process targeted to optionees with upcoming option expirations. These efforts can involve phone calls, emails, letters and more. A successful notification program may prevent most options from expiring but may also consume a significant amount of administrative bandwidth.

Updating the Plan

Before implementing this program, the plan should be updated to include language providing for the automatic exercise upon expiration. The language should also give the company the right to discontinue the program.

Companies should also evaluate whether agreements for existing options must be amended to provide for automatic exercise and whether this modification adds a benefit that could disqualify ISOs from being eligible for preferential treatment.

Modification Accounting Likely Isn’t a Concern

In most cases, adding an automatic exercise feature to existing grants is unlikely to change the fair value of the grants. Amendments that do not change the grant fair value, affect vesting, or cause the option to be treated as a liability are not considered modifications for purposes of ASC 718.

Notice of Impending Exercise May Still Be Necessary

I expect that automatic exercise won’t fully eliminate notices of impending option expirations—it would be prudent to notify employees that they have an option that is due to expire that will be automatically exercised on the expiration date unless they take action before then. But hopefully one notice, not the two or more that many companies provide now, would be sufficient.