Equity Compensation and the Trouble with the Overhang

I was recently working for a client who needed help justifying an additional share reserve allocation. The company’s stock plan was running low on shares. The company needed to hire some key employees and could only attract the right talent with a compensation package that included some form of equity award. The reason the client needed help was due to one word…overhang. There was just too much overhang, and the company’s major shareholders said the overhang was already high as it was and adding more shares to the share reserve would only make it worse. The shareholders were right. The overhang was high and adding more shares would only make it worse.

This situation has played out hundreds of times and often reminded me of what Robert Baden-Power wrote over a hundred years ago in Scouting for Boys…”Be Prepared”. It has stood the test of time serving as the Boy Scout motto. In 1994, the song Be Prepared sang by the character Scar in the movie Lion King emphasized those words, but with a more sinister intention. But in this case, I am more inclined to think of a modified version, namely, “Be Equipped.” That phrase comes to mind when I think about the character Bo Gentry in the 2012 Clint Eastwood movie, Trouble with the Curve. Bo gets drafted as the #1 pick by the Atlanta Braves as the next young power-hitting phenom, shown hitting monstrous home runs against hard-throwing high school hurlers and hitting coaches throwing batting practice. Unfortunately for Bo, and the Atlanta Braves in this story, Bo cannot hit a major league fastball, and particularly not a major league curveball. He wasn’t even close.

But could Bo have prepared better? Of course. Could he eventually become better equipped to hit major league fastballs and curveballs? Yes again. Will he get another chance to prove it? Maybe, but probably not. The movie wasn’t that great, and his character was not likable, but sequels have come from much worse. If Bo had a chance to do it all over again, I suspect he would prepare differently. He would be better equipped to handle the situation he found himself.

The same questions asked about Bo could be asked of the companies regarding their use of equity awards. The company in question had gone through its reserve, not once but twice, building the leadership team and adding headcount during the past five years to support their growth. The company achieved revenue for the first time, and the stock price quadrupled. Still, the major shareholders felt the company should have done a better job managing its share reserve, and ultimately its overhang. So, while management did what it felt it needed to do get where they were, they were not prepared, or in this case not equipped, to handle the situation they found themselves in.

The Basics of Overhang

Before digging into these concepts, let us understand what overhang is and look at the pieces that go into calculating it. Overhang represents the potential dilution from all outstanding equity awards plus the remaining share reserve of the equity plan. It is a simple calculation where:

A = Shares represented by equity awards outstanding (mostly unexercised stock options and some unvested restricted stock units)
B = Shares remaining in the equity plan reserve (available but unissued)
C = Shares of common stock outstanding

The overhang calculation is represented by the following formula: (A + B) / (A + B + C).

For the client in question, those amounts are as follows:

A = 1.8 million outstanding stock options and restricted stock units

B = .1 million shares remaining in reserve

C = 7 million shares of common stock outstanding.

 Using these amounts, the overhang is calculated as (1.8 million +.1 million) / (1.8 million + .1 million + 7 million), resulting in an overhang of 21.3%. To many companies this is considered a high amount, but for companies in some industries or at a certain stage in their life cycle, this amount may not be high at all. Determining whether it is too high or not is not the objective of this discussion, but to recognizing that it is perceived to be too high by one or more stakeholders. It is important to understand some of the nuances underlying certain elements of the overhang calculation, namely the 1.8 million outstanding stock options and restricted stock units.

 The Challenge

In this case, the number of unvested restricted stock units is minimal, representing just a few special grants to key employees totaling less than thirty thousand shares. The remainder is in stock options with strike prices between $2 and $8, most of which are incentive stock options (ISOs). The vesting schedule for the ISOs is 4 years/25% with a term of 10 years. Early exercise is not permitted. The stock options outstanding are a mixed bag of vested and unvested options that are expected to remain outstanding for a good number of years. Grant sizes range from 4,000 for analyst level employees hired over the past year up to 400,000 for the CEO hired 4 years ago. To date, no options have been exercised.

 The grant to the CEO is particularly noteworthy. It is now fully vested with an exercise price of $2. Let us see what happens to the overhang calculation if the CEO were to exercise all her options. The number of stock options outstanding (the “A” part of the formula) immediately drops from 1.8 million to 1.4 million in both the numerator and the denominator as they are no longer outstanding. That change alone results in an overhang calculation of 17.6%.

A = 1.4 million

B = .1 million

C = 7 million

Using the formula (A + B) / (A + B + C), we get:

(1.4 + .1) / (1.4 + .1 + 7) = 1.5/8.5 = 17.6%

 But when we add the 400,000 new shares issued upon exercise to the common stock outstanding (the “C” part of the formula), the overhang is reduced further to 16.9%.

A = 1.4 million

B = .1 million

C = 7.4 million

Using the formula (A + B) / (A + B + C), we get:

(1.4 + .1) / (1.4 + .1 + 7.4) = 1.5/8.9 = 16.9%. The results in a reduction of 4.4% on overhang compared to the pre-exercise overhang.

 That is a sizeable drop, no matter how it is measured. As a result, it leaves a lot of headroom in the overhang compared to where it was, making overhang less of an issue for management to request additional shares. If management were to request and receive authorization for 500,000 more shares under the equity plan reserve, the overhang calculation would be 2.0 million / 9.4 million = 21.3%. That is the same it was before the CEO exercise. The additional 500,000 shares represent 5.3% of shares outstanding. They are valued at $4 million if granted as restricted stock units (using an $8 stock price) or $1.8 million if granted as stock options (assuming a 45% option valuation as a percentage of the stock price). That amount of grant date value can go a long way in attracting and hiring additional key talent needed to drive growth for another couple of years…maybe more. It’s probably enough shares to hire five more C-level executives or 500 more analyst level employees. What a difference one exercise can make!

Of course, it is not that simple. The CEO will have to come up with $800,000 to exercise the stock options, and the gain of $2.4 million will most likely trigger alternative minimum taxes or AMT. Consequently, the CEO will incur a significant cash layout to cover both the exercise price and the resulting taxes. If the stock options were nonqualified instead of ISOs, or instead the ISO shares were subsequently sold in a disqualifying disposition, such actions would likely trigger a significant income tax event for the CEO. For publicly traded companies, the CEOs cash outlay could be covered via cashless exercise or sell-to-cover, if allowable, where the public market can cover those costs. However, for most privately held companies, there is no comparable way to offset the cost because the exercise is often required to be paid in cash, the individual is responsible for the taxes, and there is no readily available market to sell any shares. In fact, many privately held companies may require such shares acquired upon exercise to be held indefinitely, only to be passed on to family members upon death or until some sort of liquidity event occurs. Many companies include a Right of First Refusal clause where the employee must find a willing buyer but offer first to sell the shares back to the company at the same price.

The Solution

To effectively promote or encourage employees to exercise their stock options, privately held companies would need to implement a well-thought out program, or combination of programs, to allow employees to sell shares either back to the company or to some other buyers, possibly through an internal marketplace or an external marketplace involving unknown 3rd party buyers. These types of marketplaces are becoming more commonplace to create some liquidity at privately held companies for employees who acquire shares upon exercise of their stock options or vesting of their restricted stock.

So, what does this all have to do with overhang? Well, basically overhang is a snapshot of a situation at that point in time, and can change quickly and readily in some circumstances, yet remain stubbornly high in others. If a company has prepared by reserving an adequate pool of shares to grant to their employees to support their growth needs, then it needs to be equally equipped to deal with a situation where their pool is depleted and their overhang is still high because none of the employees are willing to exercise their stock options. After all, they have no way to monetize any of their holdings. Consider two companies in the same industry, at the same point in their life cycle, with the same overhang based on the same relative number of equity awards outstanding and shares remaining in its reserve. A well thought out program allowing employees the ability to sell just a portion of their shares acquired upon exercise, together with executives and other employees holding vested in-the-money stock options, can ultimately be the difference between whether one company can hire the critical talent it needs to drive future growth, while the other one strikes out and wonders what just happened.