• Shedding Light on the Benefits of Net Share Settlement
  • December 7, 2006 | Author: David M. Kaplan
  • Law Firm: Pepper Hamilton LLP - Philadelphia Office
  • For many years, the most common way to exercise compensatory public company stock options without the outlay of cash by the optionee, has been by means of a broker-assisted “cashless” exercise. In such a transaction, a broker would advance briefly enough money to the optionee to pay the exercise price of his or her option (and often, the tax withholding liability triggered by the exercise of that option). Following the exercise, a portion of the acquired stock would be sold promptly, and the proceeds would be used to repay the broker and to cover any associated broker’s fees.

    An alternative to traditional broker-assisted cashless exercise known as “net share settlement” or “immaculate” cashless exercise is gaining popularity. In the next few years, it is foreseeable that net share settlement will displace broker-assisted cashless exercise as the predominant method of option exercise for public company stock options.

    A net share settlement feature allows a company to deliver only gain shares (i.e., shares with a fair market value equal to the option spread upon exercise, net of required tax withholding) directly to the optionee without the need for the optionee to liquidate shares or borrow cash in order to exercise his or her options. The net economic result to the optionee is the same as a broker-assisted cashless exercise or even slightly better, since no brokerage fees are incurred in connection with the net share settlement. However, for the company, net share settlement has the important benefit of reducing the number of shares that must be issued in connection with an option exercise (i.e., reduces shareholder dilution).

    Consider the following example:

    Assume an optionee holds an option to purchase 100 shares at $15 per share at a time when the fair market value of the stock is $25 per share. Assume further that the total required tax withholding rate is 30 percent.

    In a broker-assisted cashless exercise, the company would issue 100 shares. The broker would sell 60 shares to finance the exercise price and 12 shares to finance the tax withholding obligation and deliver the remaining 28 shares to the optionee. The company would receive $1500 in cash, plus another $300 that it would forward on to the tax authorities. In the end, however, the company's total outstanding shares would increase by 100, even though all 100 shares do not end up in the hands of the optionee.

    If net share settlement was used to exercise the same option, the company would simply issue 28 shares directly to the optionee. This amount is determined as follows: {[100 * (25 - 15)] * (1-30%)}/25 (i.e., the aggregate after-tax option spread divided by the current fair market value/share). The portion of the option that applied to the remaining 72 shares would be cancelled in satisfaction of the exercise price and tax withholding. While the company would pay $300 of its own cash to the taxing authorities and would not receive any cash in payment of the exercise price, the total number of outstanding shares would increase by only 28. In essence, it's as though the company redeemed the 72 shares that otherwise would have been sold into the market.

    For a company with adequate cash, this is an attractive opportunity to limit the growth in its outstanding shares. However, for an issuer short on cash or that believes its shares are valued incorrectly by the market, such an approach may be less attractive. Net share settlement may be used for only the exercise price, or both the exercise price and tax withholding amounts, depending on the company's willingness to send its own cash to the IRS.

    Another valuable benefit of net share settlement is that, if the plan documents contemplate it, the number of shares subject to that portion of the option deemed cancelled in satisfaction of the exercise price and tax withholding can be returned to the pool of shares reserved for grant under the plan. In the illustration above, 72 shares would be recycled back to the plan and the plan's "burn rate" would be reduced. Issuers with plan documents that do not contemplate net share settlement will be interested to learn that amendments authorizing the feature are not generally considered “material amendments” requiring shareholder approval under NYSE or Nasdaq rules.

    Historically, net share settlement rarely was utilized (or even provided for) under most equity plans because it gave rise to adverse accounting treatment. However, this is no longer the case under newly applicable accounting standards (i.e., FAS 123(R)).

    Companies considering implementing a net share settlement feature may need to amend their existing plan, change in-house and/or third-party administrative procedures and educate optionees on this new feature. For many, however, the benefits exceed the costs.