Memorandum by Jeremy Goldstein - A discussion on stock options for employees. There are a number of advantages of stock options as a form of equity compensation.

1. Goldstein and Associates explain the
“Knockout” Option: A New Form of
Stock Option
By Jeremy L. Goldstein April 7, 2015
1 Comment
The popularity of stock options as a compensatory tool has been waning at public companies for
years. While there have been a number of factors that have contributed to their decline over the
past decade or so, three chief concerns about compensatory options have been: (1) the
accounting expense associated with stock options often exceeds their perceived value from the
perspective of employees, (2) if a company’s stock price falls dramatically and the options have
little chance of being in-the-money, the company must still recognize an expense and still incur
the overhang of options with no way of getting rid of them and (3) stock options provide a
“heads I win; tails I don’t lose” form of compensation.
Despite these concerns, there are a number of advantages of stock options as a form of equity
compensation. First, recipients only benefit from options if the stock price appreciates and,
accordingly, stock options create great incentives for employees to increase stock price,
particularly in high-growth industries. Second, they are easy to explain to recipients. Third, they
are far easier to administer than other forms of equity compensation under Section 162(m) of the
Internal Revenue Code (the $1 million cap on compensation deductions for non-performance
based compensation for a public company’s most senior executives) and Section 409A of the
Internal Revenue Code (tax on non-compliant deferred compensation). The trick for companies
that are partial to stock options is to find a way to use them while reducing the upfront
compensation expense associated with their grant and to find a way to avoid continuing expense
and overhang if the options become significantly underwater.
A relatively simple fix to these problems exists: the “knockout” stock option. The knockout
option provides that the option has its normal vesting features and term, except that the option
will automatically be forfeited or expire if the price of the stock subject to the option decreases
below a certain threshold. For example, a ten-year option to purchase 10,000 shares at $100 per
share would automatically be forfeited or expire, whether or not other vesting conditions are met,
if the price of the underlying shares falls below $50 per share. To avoid the automatic forfeiture
of options if the stock falls below the threshold for only a short period (e.g., a scenario like the
“flash crash” of 2010), we recommend that knockout options only be forfeited if the stock price
falls below the specified threshold for a certain period (e.g., 5 or 10 consecutive trading days).

2. For companies with higher volatility stock, the knockout option should result in a lower upfront
accounting expense than a typical stock option because the expected life of the option would be
shorter than a typical option. In addition, if the accounting charge is lower, the numbers in the
summary compensation table of the annual proxy will be lower. Moreover, the company will not
have to continue to suffer potential overhang at a time that the option is, or is viewed by the
recipient as, worthless. Finally, by including an additional forfeiture condition that plain vanilla
stock options do not, the knockout option creates downside disincentives. While the knockout
option is not a panacea to all of the perceived shortcomings of stock options, it should help
mitigate some of the more problematic aspects of options for companies wishing to grant them.
Companies should discuss with their auditors the likely accounting benefits to be derived from
these structures and be sure to understand in advance of the grant whether the auditors would
view the cancellation of an knockout option followed by the grant of a new option within a
specified period will be considered a repricing.
This post is based on a memorandum by Jeremy L. Goldstein & Associates, LLC dated as of
April 8, 2015.