Accounting for Extending a Post-Termination Exercise Period

It’s time to return to my ongoing series on how to account for award modifications. Today’s topic is modifications to extend the time to exercise options when employees terminate employment. This one is kind of a doozy.

This modification is similar to a repricing in that it doesn’t impact the vesting conditions of the award and, thus, doesn’t change the vesting probability of the award. In this case, however, the award will be vested—you wouldn’t extend the exercise period for an award that is going to be forfeited. [If the award isn’t vested and you are also accelerating vesting, that is accounted for as an acceleration of vesting—more info below.)

Can you explain the accounting treatment in 75 words or less?

Barely. This is a probable-to-probable (Type I) modification:

1. None of the previously recognized expense will be reversed (and because we are only dealing with the vested portion of the award, there shouldn’t be any remaining unrecognized expense).
2. The company will recognize incremental cost equal to the excess of the option fair value immediately after the modification over its fair value immediately beforehand. This cost will be recognized in full in the period the modification occurs.

What will change in the before and after valuations?

The primary difference between the two values will be the expected life of the option. Before the modification, the expected life will usually be close to zero (maybe a few months) because the option is about to expire. After the modification, the valuation will be the new period in which the option can be exercised. That increases the time value of the option and results in a higher valuation.

How about an example?

Say that an employee terminates while holding an option to purchase 10,000 shares that is fully vested. The option is scheduled to expire three months after the employee’s termination, but the board approves an extension to allow exercise for three years.

Let’s assume that the original grant date fair value of the option was $10 per share, so the company has recognized expense of $100,000 for the option. None of this expense is reversed.

In addition, the company will recognize incremental cost for the modification. When calculating the value of the option before the modification, the company will assume an expected term of three months, since that’s how long the former employee has in which to exercise. After the modification, the expected term will increase to three years, which could in turn affect the interest rate, expected dividend yield, and expected volatility. I came up with a before valuation of $15 and an after valuation of $19.* This results in incremental cost of $4 per share, or $40,000 in aggregate, which will be recognized immediately in the period in which the board approved the modification.

What if the modification isn’t in connection with a termination of employment?

Just like with acceleration of vesting, this will be a facts and circumstances determination. If the post-termination exercise period is modified at a time when there isn’t an expectation that the option holder will terminate, the modification would likely have no impact on the expected term of the option and would not result in any incremental cost.

What about modifying the contractual term of the option (rather than the post-termination period)?

In most cases, this question is a non-starter. Under Section 409A, if an in-the-money option is modified to allow exercise beyond its original contractual term (or longer than ten years after the grant date, if earlier), this is considered to be the addition of a prohibited deferral feature. It causes the option to become subject to Section 409A retroactive to the date of grant. That’s going to be a lot of years of 409A penalties that suddenly apply to the option. The accounting consequences would be the least of your worries.

Section 409A allows an exception, however, for options that are underwater or at-the-money. The accounting consequences are the same as described above: no expense is reversed, incremental cost equal to the excess of the “after” value over the “before” value, and the incremental cost is recognized immediately.  

This is something to keep in mind when extending the post-exercise termination period; if the option is in-the-money, you don’t want to extend that period beyond the earlier of (i) the original contractual term of the option or (ii) ten years after the grant date.

What if the board accelerates vesting and extends the exercise period at the same time?

For this modification, you have to look at the vested and unvested portions of the option separately.

The vested portion is accounted for exactly as I have described above (Type I, probable-to-probable modification). If none of the option is vested (or if the vested portion of the option has already been fully exercised), there’s nothing to account for here.

For the unvested portion, the acceleration of vesting drives the accounting treatment. This will be an improbable-to-probable (Type III) modification:

• Any expense already recognized in connection with the unvested portion of the option is reversed and the expense originally computed for this portion is no longer recognized.
• The new fair value of the modified portion of the award is recognized as expense in the period the acceleration occurs. When computing the new fair value, the company should increase the expected term for the extended exercise period.

Are there any other considerations to worry about?

You bet! To learn about the securities law, tax, and other considerations that apply to award modifications, check out my blog entry “5 Things to Know About Award Modifications” and this handy table summarizing the considerations for various types of modifications.

- Barbara

Thanks to Dan Kapinos of Aon Rewards Solutions for helping me understand how to account for a combined acceleration of vesting and option term extension.

* Want to try this at home? I used this valuation model and assumed the following:

• Option price/grant date FMV of $25 per share.
• Expected term of 5 years at time of grant.
• Stock price of $40 per share at time of modification.
• Expected term of .25 years (3 months) before modification and 3 years after.
• Interest rate of .5, volatility of 45%, and dividend yield of 0%. I kept these variables constant in all three valuations so that I could focus on the impact of the change in the expected term. In real life, these variables could also change.