By Leonard Q. Slap and Benjamin Ferrucci, Edwards Angell Palmer & Dodge
Dividend recaps are all the rage these days. Successful companies that are not yet ready to go public or be sold and whose investors nevertheless want to take some money off the table are incurring debt for the purpose of paying a one-time special dividend to their stockholders.
Dividend recaps are good news events for stockholders, as they will actually receive the cash. However, the company’s employee stock option holders actually lose value in the transaction. The new debt does nothing to increase the value of the business; indeed the very point of the exercise is to extract value out of the business and distribute it to the stockholders. After the new debt is incurred and the dividend paid, the company’s shares are actually worth less, and so too then are the options on those shares.
Option holders are not stockholders and so have no protection generally against such dilutive transactions under applicable corporation statutes or other laws. Save for the limitations imposed by capital surplus, insolvency and fraudulent conveyance laws, there is no legal impediment to a company effecting a dividend recap, notwithstanding the adverse impact on the option holders. Unless there are restrictions in the contractual terms of the stock options themselves—which is rare—the company is free to dilute the value of the options.
Of course, companies grant options in the first place as incentive to management to grow the business, so reducing the value of those options by incurring the recap debt can be counterproductive. Aware of this problem, companies are implementing a variety of strategies to preserve for option holders the value that is inherent in their options before giving effect to the recap. What follows is a description of several of these strategies and their tax impact on option holders.
1) Cash Bonus. A basic approach to compensating option holders for the dividend is to pay them a cash bonus equal to the dividend they would have received on the shares underlying the options if the options were exercised. From the company’s perspective, this represents an additional cash cost of the transaction (which may be partially mitigated by the tax deduction for the bonus paid). From the option holders’ perspective, receipt of such a bonus is additional compensation, taxable as ordinary income and subject to applicable withholding taxes. In contrast, a dividend on the outstanding common shares would, assuming the applicable holding period and other requirements are met, potentially qualify for the more favorable capital gains rate. As a result, a cash bonus payment would likely be subject to a higher tax rate for the option holders than would be applicable to the common stockholders receiving the special dividend.
The out-of-pocket cost and other consequences of exercising an option make it unlikely that an option holder would exercise the option simply to receive the special dividend. To defer tax burdens, most option holders hold their options until the company is sold and the options cashed out. The gain realized on those options when cashed out is generally taxed as ordinary income, and is not eligible for the more favorable capital gains rate. Since the resulting likely exit scenario for an option holder involves ordinary income, incurring ordinary income with respect to a bonus paid to mirror a common stock dividend is not, in practicality, a disadvantage that needs to be adjusted for.
Bonus programs do present some complexities however, including whether or not (and how) to compensate for options that are subject to future vesting requirements and whether or not (and how) to compensate option holders who are no longer employees. In addition, consideration must be given to Section 409A of the tax code to ensure that any such cash payments do not inadvertently taint the underlying options as non-conforming deferred compensation.
2) Adjustment to Options. A common method of neutralizing the dilutive effect of the recap is to adjust the terms of the option. By lowering the option strike price and increasing the number of shares subject to each option, the aggregate spread between the fair market value of the shares and the option strike price before the recap dividend is paid may be preserved.
Adjusting option terms can have adverse tax consequences to the option holders. To avoid these pitfalls, it is necessary to comply with Section 422 of the tax code governing “incentive stock options” (“ISOs”) and Section 409A of the tax code governing nonqualified deferred compensation arrangements. Specifically, an adjustment may only be made to options without causing a loss of ISO status under Section 422 and without the imposition of a 20 percent excise tax on the entire spread of vested options, whether ISOs or non-qualified options (“NSOs”), under Section 409A, if such adjustment is made by reason of a “corporate transaction.”
So what is a “corporate transaction”? The ISO regulations generally define a “corporate transaction” to include a distribution (excluding an ordinary dividend or a stock split or stock dividend) or change in the terms or number of outstanding shares. In the context of a special dividend, including one to be made in connection with a leveraged recapitalization, the issue then becomes whether or not a dividend recap transaction qualifies as other than an “ordinary” dividend.
There is scant guidance in the ISO regulations or elsewhere regarding when a dividend qualifies as other than an “ordinary” dividend for ISO and 409A purposes. In the absence of definitive authority, companies rely on a facts and circumstances test to determine when a dividend is an “extraordinary” dividend and hence a “corporate transaction.” The critical factors to be considered are (1) whether or not the dividend is a non-recurring distribution and (2) the amount of the dividend as a percentage of the fair market value of the underlying stock, with a percentage of 10 percent or more generally of sufficient size as to make the dividend “extraordinary.” The basis for the 10 percent threshold comes by analogy from Section 1059(c)’s definition of “extraordinary dividend” that, in part, defines an extraordinary dividend on common stock as one in excess of 10 percent of the common stock’s fair market value. Certain statements of the Emerging Issues Task Force, a committee of the Financial Accounting Standards Board, suggest that an “extraordinary dividend,” at least for financial accounting purposes, could be in an amount as low as 5 percent of the stock’s fair market value.
Adjustments to the option strike price and number of shares may be implemented through a simple amendment to the option agreements. Well-crafted stock option plans permit the issuing company to make such adjustments unilaterally so long as such adjustments do not adversely affect the rights of holders. To assure that such an amendment complies with the strictures of the ISO regulations and Section 409A, the resulting adjustment must not create additional pre-adjustment aggregate spread between the fair market value of the shares and the options’ strike price (the “Aggregate Spread Test”). In the case of ISOs, the adjustment must also preserve the pre-adjustment ratio of exercise price to fair market value (the “Ratio Test”). (For nonqualified options that are not subject to the ISO rules, Section 409A guidance apparently eliminates the Ratio Test, thus allowing a simple strike price reduction equal to the special dividend.) Generally, these tests are satisfied by development of an adjustment factor based on the company’s stock price at the “ex-dividend date” divided by company’s stock price at the “ex-dividend date” minus the dollar amount of the dividend.
As a simple illustration, assume an option to acquire 1,000 shares at $1.00 per share, and that the company pays a $4.00 cash dividend on its common shares when the pre-dividend fair market value per share is $10.00 (and the resulting post-dividend value is $10 – $4, or $6.00).
In this case, to preserve the $9 spread the options may be adjusted as follows:
o Adjustment Factor: $10/$10-$4 = 1.6667
o The strike price of $1.00 is divided by 1.6667 (to $0.60) and the number of shares subject to the option is multiplied by 1.6667 (rounded down to nearest whole share). (See Table 1 below.)
Table 1: Pre- and Post-adjusted Options
Number of Options Strike Price Fair Market Value of Stock Option Spread
Pre-Adjustment 1,000 $1.00 $10.00 $9,000
Post-Adjustment 1,667 $0.60 $6.00 $9,000
3) Cash Bonus and Option Adjustment. Often, companies will adopt both approaches. By allowing option holders to participate in the dividend partially through the payment of a bonus, and adjust the options to make up the remaining value gap. For instance, in the above example where the company pays a $4.00 dividend on its shares, it might pay a cash bonus to the holder of an option on 1,000 shares in an amount equal to $1.00 for each such optioned share. With a cash bonus equivalent to $1.00 per share, the remaining value gap to be filled for the option holder would be $3.00 per share. This gap then is filled by adjusting the option terms so as to preserve $3.00 of value lost through the dividend.
Here, the adjustments would be as follows:
o Adjustment Factor: $10/($10-$4) = 1.6667
o The option strike price of $1.00 is divided by the 1.6667 Adjustment Factor to $0.60
o Solve for the adjusted number of shares subject to the option that will fill the remaining $3.00 value gap given the new $0.60 option strike price, i.e., 1,482 shares (see Table 2 below).
Table 2: Pre- and Post-adjusted Values
Number of Options Strike Price Fair Market Value of Stock Option Spread Bonus Total Value
Pre-Adjustment 1,000 $1.00 $10.00 $9,000 $0.00 $9,000
Post-Adjustment 1,482 $0.60 $6.00 $8,000 $1,000 $9,000
Thus, through a combination of a cash bonus and the adjustment to the option strike price and the number of underlying option shares, the option holders can generally be made whole. Moreover, absent specific contractual mandates in the option award or governing plan documents, these components, if chosen by the company, may be weighted in any manner, subject to meeting the tax code parameters.
Companies issue options to align the economic interests of management with the success of the business. Such alignment is all the more important given the added management challenges presented by the debt incurred to fund a special dividend. A transaction that benefits only a company’s investors and affirmatively devalues management’s options is sure to destroy that alliance. There are effective ways to make a recap good news for management as well as for the investors, and it is in the investors business interest to assure management’s continued focus on the growth of the business. After all, who else is going to manage under all of that new debt?
Leonard Q. Slap is a partner in the venture capital practice group of the 520-attorney national law firm of Edwards Angell Palmer & Dodge. He may be reached at email@example.com. Benjamin Ferrucci is also a partner also in the venture capital practice group. He may be reached at firstname.lastname@example.org.