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Stock options are a frequently mentioned, but often misunderstood, part of the new economy. While the news media had focused on twenty-somethings joining start-ups and becoming multi-millionaires — whether in cash or “on paper” — more recent attention has been paid to their tales of woe. With the unmistakable easing of the capital markets’ appetite for new economy stocks, and the resulting rush to industry consolidation, many stock option sagas have less than happy endings. As investors, companies and employees all scrutinize the benefits and burdens of employee stock options, it behooves the principal, and the practitioner, to consider carefully the legal, business and tax consequences of stock options. STOCK OPTIONS IN A VOLATILE MARKET Stock options have traditionally been a significant component of the compensation offered to employees, particularly by new companies having little to offer in the way of a salary, but who expect their company’s valuation or stock price to grow quickly and dramatically. It is unlikely that the lure of such capital gains either has or will entirely dissipate, even when taken at the expense of current income. Nevertheless, employees can become disgruntled when the market tumbles and their options go “under water” (i.e., the price of the company’s shares falls below the exercise price of their options). This also produces a chilling effect for employees of privately held companies, particularly when it becomes common knowledge that such companies are seeking successive rounds of private equity financing at lower valuations than originally anticipated. Companies willing and able to stand alone may find it necessary to take some positive action both to sustain employee morale and to position themselves to attract the most qualified personnel. This can be especially critical for a company seeking to acquire the stock of another company whose value has fallen. If the acquirer is to realize maximum value from the acquisition, it will likely need the enthusiasm and commitment of the acquired company’s employees, who may have become dispirited. To address this challenge, some companies are re-examining their stock option plans, hoping to find a solution that is both beneficial to employees and has little or no cost to the company. One strategy is to grant new options at a lower exercise price. Indeed, it has been reported that Amazon.com, Microsoft and Novell have granted new stock options to their employees at more favorable prices, after their stock prices plummeted last spring. One unfavorable consequence of this approach, however, is the dilutive effect of such a grant on all stockholders. Moreover, for privately held companies, it is often the case that the company’s charter or bylaws will require the consent of certain equity holders before such grants may be made. Another strategy is a “repricing” of the existing options, i.e., modifying the options already granted by lowering their exercise price. While this would not have an unpleasant dilutive effect, the consequences to the company from an accounting point of view could be devastating. This is due to the recent change in the accounting rules described below. Caution in this regard is strongly recommended, because the employees will be worse off if the company is unable to recover from the resulting accounting treatment. In March, the Financial Accounting Standards Board (FASB) issued Interpretation No. 44, titled “Accounting for Certain Transactions Involving Stock Compensation.” Among other things, the interpretation changed the accounting treatment of stock options when they are repriced (either directly or indirectly) to reflect a lower exercise price. As a result of the interpretation, from the date of the award’s modification to the date the award is exercised, forfeited or otherwise expires, the award must be treated according to the rules of “variable accounting,” i.e., “marked to market.” Simply put, an option that had previously not been subject to a charge against the company’s earnings will now become subject to such a charge, equal to the increase in its “intrinsic value” or “spread” during each post-modification accounting period The negative impact on a company’s reported earnings is essentially unquantifiable, which among other things, makes the company less appealing to investors or potential acquirers. In an acquisition context, similar caution is warranted. If the stock options of an acquiree are exchanged for the stock options of an acquirer in a transaction treated as a “pooling of interests,” there will be no accounting effect if (1) the aggregate intrinsic value of the stock options is not increased and (2) the ratio of the exercise price per share to the market value per share is not reduced. If the transaction is treated as a purchase business combination, the fair value of the acquirer’s vested and unvested stock options issued in exchange for the acquiree’s stock options will be treated as part of the purchase price to the acquiree; however, this will exclude the intrinsic value of the unvested stock options attributable to the remaining vesting period thereof. The amount to be excluded is calculated by multiplying the intrinsic value of the replacement options as of the consummation date by a fraction, the numerator of which is the remaining vesting period of the options, and the denominator of which is the total pre- and post-consummation vesting period of the options. The excluded amount is then allocated instead to unearned compensation and recognized as compensation cost over the remaining vesting period of the option. TAX CONSIDERATIONS Companies are also well advised to take into consideration the tax consequences faced by option holders after such a repricing. From a federal income tax perspective, the repricing of options to a price that is not less than the fair market value of the stock at the time of the repricing — whether in the context of a corporate acquisition — generally does not have a negative impact on option holders, although it can restart the clock on certain holding period requirements. Cancellation or the amendment of the old option does not generally trigger any tax. Moreover, the new repriced option is taxed under the normal tax rules applicable to options. That is to say, if the option is a nonqualified option, it will not be taxed until the option is exercised. At that time, the option holder will have to pay taxes, at ordinary income tax rates, on the spread (if any) between the fair market value of the shares received and the new option exercise price. If the option is an incentive stock option — commonly referred to as an ISO — it will not be taxed at the time of exercise but, instead, taxation will be delayed until the stock received on the option exercise is sold or exchanged. Under the ISO rules, if the stock is sold no earlier than two years from the date of the option grant and one year from the date of option exercise, the entire gain on the sale (i.e., the amount received on the stock sale over the new option exercise price) is taxed at favorable capital gains rates. If the stock is sold before the expiration of these holding periods, the portion of the gain attributable to the appreciation in value of the stock prior to the option exercise is taxable as ordinary income and the balance, if any, is taxable as capital gains. What is significant to note is that, for purposes of this ISO holding period rule, the downward adjustment in the option exercise price will be treated as a grant of a new option. As a result, in order to receive capital gains treatment on all of the gain realized on the sale of the stock, the sale cannot occur earlier than two years from option repricing and one year from the option exercise. By contrast, if in the context of an acquisition, existing options are replaced with options to purchase shares of the buyer (or a parent of the buyer) and the number of options and/or the option exercise price are merely adjusted to reflect the substitution of the buyer’s stock for the seller’s stock — but the economic benefit to the option holder is not enhanced — then, in general, the adjustments will be disregarded for federal income tax purposes, even for purposes of the ISO rules. As long as certain conversion ratios are maintained, any ISO will continue to be treated as an ISO, and the ISO holding period will be measured from the date of issuance of the original option. Although the repricing of stock options has been a commonly used strategy in response to downward pressures on the valuations of new economy companies, the consequences of such a modification are now potentially more severe. Accordingly, repricing proposals require careful scrutiny, taking into account the recent FASB interpretation, as well as existing business and tax considerations. Harold Flegelman and Jay Fenster are partners in the corporate and tax departments, respectively, at Loeb & Loeb LLPin New York.

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