Terminations and Modifications
Private Company Focus Group
February 9, 2010
Jon W. Burg, FSA
Vice President
415.486.7137
jburg@radford.com
Types of Modifications
A modification is a change in any of the terms or conditions of an award, including:
> Acceleration of vesting
> Extension of post-vesting exercise term
> Reclassification of an award (from equity to a liability or vice versa)
> Re-pricings or exchange program
> A modification in connection with an equity restructuring (e.g., spin-off or stock split)
> Exchange of awards in a business combination
> A modification to add an anti-dilution provision in anticipation of an equity restructuring
First three are fairly common with private companies
1
Accounting for Modifications under Topic 718: General Principle
A modification of the terms or conditions of an equity award shall be treated as an exchange of
the original award for a new award
Two-step process to account for the modification of an equity-classified award:
1. Reassess probability of vesting immediately before and immediately after the modification
2. Calculate the difference between the fair value immediately before and immediately after
the modification (incremental fair value)
2
Identifying the Type of Modification
>
For awards with service and/or performance conditions, assessment of the probability of
vesting results in one of four types of modifications
-
Type I: Probable-to-Probable
-
Type II: Probable-to-Improbable
-
Type III: Improbable-to-Probable
-
Type IV: Improbable-to-Improbable
Before ↓
Probable
After →
Improbable
Modification
Probable
Improbable
Type I: Probable to Probable
Type II: Probable to Improbable
Example 13(a)
Example 13(b)
Expense = at least equal the fair value of
the award at the [original] grant date
Expense = at least equal the fair value of
the award at the [original] grant date
+ Incremental Expense, if any
+ Incremental Expense, if any
Type III: Improbable to Probable
Type IV: Improbable to Improbable
Example 13(c) & (e)
Example 13(d)
Fair value of new grant only
Fair value of new grant only
3
Type I: Probable to Probable
>
Modification does not affect the probability of vesting
>
Accounting for a Type I modification:
>
-
Recognize original grant-date fair value plus incremental fair value (if any)
-
Recognize compensation cost immediately if vested, or over remaining requisite service period if
unvested
-
Original grant-date fair value represents the “floor” for the amount of compensation cost to be
recognized if either the original or modified vesting conditions are satisfied
Example:
-
On January 1, 20X6, a company grants 1,000 restricted stock units with a grant-date fair value of
$10
-
The awards vest only if cumulative net income over the succeeding four year period is greater than
$10 million
-
On January 1, 20X9, the company believes it is probable the original performance target will be
achieved
-
On January 1, 20X9, the company modifies the award to change the performance target to an
EBITDA target
-
After the modification, the company continues to believe the performance target is probable of
being achieved
-
The fair value of the award before and after the modification is the same (the type of performance
target does not impact fair value)
4
Type I: Probable to Probable (continued)
>
Example (continued):
-
How much total compensation cost should the company record over the service period, if the
modified performance target is achieved?
> If the modified performance target is achieved, the company would record compensation cost
($10,000) based on the number of awards that vest (1,000) and the grant-date fair value ($10), since
there is no incremental fair value conveyed as a result of the modification
-
If the original performance target is achieved?
> If the original performance target is achieved, the company would record compensation cost of
$10,000 calculated based on the grant-date fair value even if the modified performance target is not
achieved (the “floor” requirement)
-
If neither of the targets are achieved?
> If neither the modified or the original performance target is achieved, the company will record no
cumulative compensation cost for this award
5
Type II: Probable to Improbable
>
Modification negatively affects the probability of vesting
-
>
Accounting for a Type II modification:
-
>
Not expected to be common because the employee is expected to vest under the original
conditions, but not the modified conditions
Same as Type I, except no incremental compensation cost would be recognized until vesting is
probable
Example:
-
Same as before except the modified EBITDA target is not expected to vest
-
No additional expense is recognized after the modification, but the company continues to
recognize the original grant date expense since the company continues to believe the original
performance target is probable of being achieved
-
The fair value of the award before and after the modification is the same (the type of performance
target does not impact fair value)
6
Type III: Improbable to Probable
>
Award is not probable of vesting prior to the modification, but is probable of vesting under the modified
conditions
>
Accounting for a Type III modification:
>
-
Recognize fair value of modified award only
-
Any compensation cost recognized for original award is reversed (vesting is not probable at modification date)
-
Recognize compensation cost immediately if vested, or over remaining requisite service period if unvested
-
No “floor” for original grant-date fair value; only fair value of modified award is recognized
Example:
-
On January 1, 20X6, a company grants 1,000 “at-the-money” employee share options, each with a grant-date fair
value of $10
-
The awards vest only if cumulative net income over the succeeding four year period is greater than $50 million
-
On December 31, 20X8 based on the financial performance of the company over the preceding three years, the
company does not believe the awards are probable of vesting, as such the company has recognized cumulative
compensation cost of zero
-
On January 1, 20X9 the company modifies the performance target to decrease the cumulative net income target to
$35 million
-
After the modification the company believes it is probable the awards will vest based on the revised net income
target
-
The fair value of the award on the date of modification is $7
7
Type III: Improbable to Probable (continued)
>
Example (continued):
-
How much total compensation cost should the company record over the service period, if the
modified performance target is achieved?
> If the modified performance target is achieved, the company would record compensation cost
($7,000) based on the number of awards that vest (1,000) and the modified-date fair value ($7),
since the original awards were not expected to vest
-
If the original performance target is achieved?
> If the modified performance target is not achieved, the company will record no cumulative
compensation cost for this award
-
If neither of the targets are achieved?
> Whether or not the original performance target is ultimately achieved does not impact the amount of
compensation cost recognized because the award were not expected to vest as of the date of the
modification (no “floor” requirement)
8
Type IV: Improbable to Improbable
>
Modification does not affect probability of vesting; vesting is not probable before or after
the modification
>
Accounting for a Type IV modification:
-
Same as Type III, except no compensation cost would be recognized until vesting is probable
9
Modification of Awards with Market Conditions
>
Similar to modification of awards with performance or service conditions, but no
assessment of probability of achieving the market condition
>
Generally, recognize original grant-date fair value plus incremental fair value (if any)
>
Not applicable for private companies
10
Modifications: Change in Classification of Instrument
>
Equity-to-liability modification
-
Amount of the liability is equal to fair value on the modification date multiplied by the portion of the
requisite service period that has been rendered
-
If the fair value of the modified liability award is less than grant-date fair value of the original equity
award, the difference remains in APIC
-
If the fair value of the modified liability award is greater than grant-date fair value of the original
equity award, the difference is recorded as additional compensation cost
-
Re-measure the modified liability award each reporting period until settlement
-
Floor” requirement:
> Total compensation cost should at least equal the grant-date fair value of the original equity
award
> At each reporting period, cumulative recognized compensation cost should equal at least the
proportionate amount of the grant-date fair value of the original equity award for which the
requisite service has been rendered
> If the liability decreases below original grant-date fair value, the difference is recorded in APIC
>
Liability-to-equity modification
-
Amount previously recorded as a share-based liability (fair value of the award on the modification
date) is recorded as a component of equity by a credit to additional paid-in capital
-
The modified award ceases to be re-measured each reporting period
11
Calculating the Incremental Fair Value
>
>
Recall the two-step process to account for the modification of an equity-classified award:
-
Reassess probability of vesting immediately before and immediately after the modification
-
Calculate the difference between the fair value immediately before and immediately after the
modification (incremental fair value)
Calculating the incremental fair value:
-
Fair value immediately before the modification should be based on current assumptions and may
differ from grant-date fair value
-
If the fair value immediately after the modification is less than the fair value immediately before the
modification, the incremental fair value is $0.
-
Fair value immediately before the modification should also include the effect of a contemplated
event (e.g., a business combination, spin-off, or employee’s termination)
12
Calculating the Incremental Fair Value (continued)
>
>
Model considerations:
-
Modified stock options are different than regular at-the-money options and may require using a
different model
-
Depending on the complexity of the modification, it may be appropriate to use a lattice model or
Monte Carlo simulation to value out-of-the-money grants
-
A company would be able to use a different model for a modification purposes, but still use Black—
Scholes for future at-the-money grants
Assumption considerations:
Valuation Model
Assumptions
Consideration
>
Pre-Modification
Post-Modification
Black-Scholes-Merton or Lattice
Black-Scholes-Merton or Lattice
Expected Term
-
>
Historical data likely not
representative
SAB 110 not applicable
Expected Term
-
>
Volatility
-
>
>
Volatility
-
Implied, Historical or Blend
Dividend yield
-
Long term expectations
>
Historical data likely representative
SAB 110 may be applicable
May not be same in the pre and post
modification calculation due to
different look-back period
Dividend yield
-
Long term expectations
Consistency is key
13
Common Modifications at Private Companies
>
Acceleration of vesting
>
Extension of post-vesting exercise period
>
Change of terms post-employment
>
Repurchase of awards
>
Others?
14
Questions?
Jon W. Burg, FSA
Vice President
415.486.7137
jburg@radford.com