CEP Equity Compensation Plans & Design 3 — Questions and Answers
Question 1: Under Section 409A of the Internal Revenue Code, a stock option is generally exempt from deferred compensation rules if it is granted:
- With a premium exercise price above fair market value on the grant date
- With an exercise price at least equal to fair market value on the grant date (Correct answer)
- With a discount exercise price below fair market value to incentivize retention
- With any exercise price, provided the vesting period exceeds three years
Correct answer: With an exercise price at least equal to fair market value on the grant date
Options granted at or above FMV on the date of grant satisfy the Section 409A exemption, avoiding the 20% excise tax and interest penalties on discounted options.
Question 2: A 'clawback' provision in an equity plan most commonly allows a company to:
- Increase the number of shares an employee receives upon vesting
- Recover previously paid compensation if an employee engages in misconduct or a restatement occurs (Correct answer)
- Accelerate vesting upon a company merger
- Extend the post-termination exercise window beyond ten years
Correct answer: Recover previously paid compensation if an employee engages in misconduct or a restatement occurs
Clawback provisions—required under Dodd-Frank Rule 10D-1 for listed companies—mandate recovery of erroneously awarded incentive compensation following a financial restatement.
Question 3: Which of the following is a key distinction between a stock appreciation right (SAR) and a stock option?
- SARs require payment of an exercise price; options do not
- SARs can only be settled in cash; options can only be settled in stock
- SARs pay out the spread without requiring the holder to pay an exercise price (Correct answer)
- SARs are always subject to ISO tax treatment; options are not
Correct answer: SARs pay out the spread without requiring the holder to pay an exercise price
A SAR grants the holder the gain (spread between grant price and current FMV) without requiring cash outlay to exercise, and may be settled in stock or cash.
Question 4: A company's equity plan requires shareholder approval to reprice outstanding stock options. Which of the following transactions would be considered a repricing?
- Adjusting option terms for a stock split under anti-dilution provisions
- Canceling underwater options and reissuing new options at a lower exercise price (Correct answer)
- Extending the post-termination exercise period from 90 days to one year
- Accelerating vesting on outstanding options for a departing executive
Correct answer: Canceling underwater options and reissuing new options at a lower exercise price
Canceling and reissuing options at a lower strike price is the classic form of repricing and requires shareholder approval under most NYSE/Nasdaq listing standards.
Question 5: For purposes of IRC Section 422, what is the annual limit on the value of ISOs that can first become exercisable in any calendar year for a single employee?
- $50,000
- $100,000 (Correct answer)
- $200,000
- No statutory limit applies
Correct answer: $100,000
The $100,000 ISO limit (based on grant-date FMV) governs how much vesting value can qualify as ISO in any single calendar year; excess vests as NQSOs.
Question 6: A performance share unit (PSU) plan uses a relative TSR metric measured against a peer group. The plan pays out 150% of target if TSR ranks at the 75th percentile. This design feature is best described as a:
- Cliff payout schedule
- Linear interpolation payout curve
- Leveraged payout with upside opportunity (Correct answer)
- Absolute performance threshold
Correct answer: Leveraged payout with upside opportunity
Paying above 100% of target for above-median relative performance creates a leveraged, upside payout opportunity designed to reward exceptional relative results.
Question 7: Which equity plan design element is most scrutinized by institutional shareholders as a measure of potential stockholder dilution?
- The post-termination exercise window length
- The overhang percentage (shares outstanding plus available under plan divided by total shares) (Correct answer)
- The number of plan participants
- The grant-date fair value accounting method used
Correct answer: The overhang percentage (shares outstanding plus available under plan divided by total shares)
Overhang represents the total potential dilutive impact of all outstanding and available equity awards, and institutional investors closely monitor it relative to industry benchmarks.
CEP Equity Compensation Plans & Design 3
Under Section 409A of the Internal Revenue Code, a stock option is generally exempt from deferred compensation rules if it is granted: