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An Acquired Expense

Rolling over unvested options in a merger is no longer a matter of goodwill.

1Jul

Last year, the Financial Accounting Standards Board issued FASB Interpretation No. 44, on accounting for stock options. Intended to clarify the board's stand on options accounting under previously established rules, FIN 44 has made its biggest mark so far in the area of stock option repricing. It has made the repricing of underwater options to a lower exercise price potentially prohibitive, because it requires that the repriced options be treated under variable accounting, in which they are marked to market.


But FIN 44 is having an effect on mergers and acquisitions, too. Effective for deals completed as of July 1, 2000, the rule also requires that companies that employ purchase accounting treat the unvested stock options of the acquired company differently than the vested stock options. In the past, companies could lump both into goodwill, which was then amortized over a period of up to 40 years. Now, a portion of the value of the unvested stock options must be booked as unearned compensation and charged against earnings over the remaining vesting period, which is usually just a few years.


Certainly, the charge is never large enough to be a deal-breaker. But in some cases, it could amount to a significant expense to be taken against earnings in the first few years after an acquisition--when management is especially keen on proving the wisdom of the merger. So far, at least, analysts and consultants say that the charge has not been a burdensome one.


To date, the greatest impact FIN 44 has had on M&A has been indirect, in the designing of stock option plans. Since, under the rule, changes in an existing stock option plan can lead to a compensation expense, companies need to be more explicit from the start about what happens to vesting in the case of an acquisition or any other eventuality. Beginning July 1, however, FIN 44 should gain more weight in M&A situations. That's when pooling-of-interests accounting will be banned. In the future, FIN 44 will apply more often in acquisitions, and the effects of the unearned-compensation expense on earnings will become a lot more visible.



TREATING UNVESTED OPTIONS


In an acquisition, the acquirer frequently rolls over the target company's stock options into options on its own stock ("rollover options"). In FIN 44, FASB dealt with the issue of where to put those options on the financial statements. The board's reasoning was that unvested options, rather than being categorized solely as goodwill, also in part represent compensation for work not yet performed; therefore the portion of those options representing the remaining unvested part should be booked as unearned compensation and expensed as it is earned. What's actually booked as the compensation expense is a portion of the spread between the price of the stock at the closing of the deal and the exercise price--the so-called intrinsic value.


So far, few companies have been affected by the merger side of FIN 44. For one thing, since the measure took effect, stocks have fallen and merger fever has cooled considerably. "FIN 44 is a significant change," says Andrew Nussbaum, a corporate partner at Wachtell, Lipton, Rosen & Katz, in New York, "but the demise of the Internet stock bubble has mitigated the issue to a degree." What's more, the market's tumble has wiped out option spreads at many companies. And if a target's stock options are under water, the acquirer takes no charge at all on the unvested options, because they have no intrinsic value.


Apart from the market conditions that have softened FIN 44's impact, most companies have stipulations in their stock option plans that provide for automatic vesting of all options with a change of control. In that case, of course, there would be no unearned compensation. However, many companies--particularly high-tech and E-commerce companies, which tend to make greater use of options in general than other companies--do not provide for automatic vesting. And few acquirers would have any interest in accelerating a target company's options, since they are such a good retention tool. "I know of only a couple of companies that have accelerated vesting to avoid unearned compensation going forward," says Ben Neuhausen, a partner in the professional standards group at Andersen.



SMALL CHANGE?


In those relatively few instances where FIN 44 has had an impact, it has been a mild one. Take the July 2000 acquisition of TV Guide Inc. by Gemstar International Group, a Pasadena, California-based consumer- entertainment technology and media company (the combined entity is now known as Gemstar­TV Guide International Inc.). In a $7.9 billion deal, the unearned compensation amounted to $88 million, compared with $6.1 billion of goodwill that is to be amortized over up to 15 years. For the nine months ended December 31, the unearned-compensation expense amounted to 5 cents a share in the context of Gemstar losing 64 cents a share. If the $88 million were to be amortized over 15 years, the expense would come to about 1 cent a share.


And look at America Online Inc.'s $147 billion acquisition of Time Warner Inc., which closed in January. The deal included $128 billion of goodwill, $9.7 billion in stock options, and $32 million in unearned compensation stemming from acquired unvested options. Think of that last sum in the context of the $36.2 billion in pro forma AOL Time Warner 2000 revenues and the $3.9 billion pro forma net loss, and you can see why CEO Gerald Levin is not losing a lot of sleep over the new rule.


FIN 44 certainly has come into play in the acquisition of stock- option-heavy high-tech companies. But here the impact is also often light, largely because the assets of technology firms generally have shorter lives than those of other industries. Therefore, goodwill is often amortized over a much shorter span than the average--so short, in fact, that it would not have made much, if any, difference if unearned compensation had been part of goodwill.


For example, in February, fiber-optics giant JDS Uniphase Corp. completed its acquisition of SDL Inc., a fiber-optics networking company, for $41.5 billion. The deal generated about $39.5 billion of goodwill, which will be amortized over just five years. JDS also issued 42.2 million rollover options, valued at $4.1 billion; the expense of the unvested options comes to $203.7 million, to be amortized over four years.


On July 5, 2000, Vignette Corp., an Austin, Texas-based provider of Internet applications, completed its $1.5 billion acquisition of OnDisplay Inc., which designs software for E-commerce. About $52.9 million was recorded as deferred stock compensation, and will be amortized over the remaining life of the options. Most of that--$33 million--was expensed in 2000. Meanwhile, goodwill is being written off over only two to four years. Last year, the amortization charge for goodwill and other purchased intangibles was $328.7 million, accounting for most of the company's $532 million loss on its $367 million in revenues.


The unearned-compensation expense "was something we certainly were aware of and had to consider in the purchase," says Vignette CFO Joel Katz. "It did not make a significant difference going forward. We did make sure that in providing guidance to analysts, we included expected charges."



EVENTUALITIES AND DOUBLE TRIGGERS


In the context of M&A, one clear impact of FIN 44 is that when a stock option plan is designed, greater attention is being paid to the details of change-in-control vesting. "More companies are spending more time in planning options, designing the plan, and thinking up scenarios and options," says Ron Sonenthal, head of the human-capital practice at Andersen in Chicago. That's because under the rule, any change in the terms of a company's stock options could result in a charge to earnings.


"It used to be that we'd advise companies to draft plans as broadly as possible to give themselves discretion," says Susan Eichen, a senior compensation consultant at William M. Mercer Inc. "FIN 44 says the opposite: build in eventualities." So companies need to balance the desire for flexibility against the potential accounting costs.


For example, let's say that the question of whether vesting would accelerate in the case of a company's acquisition has been left open. Then the company makes a deal to be acquired, and the board's compensation committee decides to accelerate vesting, because it has learned that most companies have a provision that does this automatically. According to FIN 44, the cost of the options then becomes the spread between the price of the target company's stock on the day that the modification is made and the exercise price. The target company will have to expense the spread at the time the deal closes. Had the stock option plan originally provided for accelerated vesting, there would be no expense charge for the target company.


Actually, however, some companies that have automatic acceleration now wouldn't mind if they could do away with it. That's because automatic vesting leaves no incentive for employees of a target company to stay on. Even if the acquirer grants those employees new options with new vesting schedules, "you still have just put a lot of money in people's pockets," says Eichen, and they might then be inclined to leave.


"Companies don't want their employees to have windfalls," says Carol Silverman, another senior compensation consultant at Mercer. So more Mercer clients, especially high-tech companies, are designing plans that provide for "double trigger" vesting instead of automatic acceleration. A double trigger specifies that in a change of control, an employee's unvested options would vest only if he or she lost his or her job within a specified period, usually two years. Of course, the acquirer would have to book and amortize the unearned compensation, but the incentives would remain in place.



MORE VISIBLE


FIN 44 should become more significant in M&A situations after June 30, when purchase accounting will become the rule and pooling-of- interests accounting banned. Therefore, FIN 44 will be felt in more acquisitions. What's more, for fiscal years beginning after December 15, FASB will no longer require that goodwill be amortized at all, unless it is deemed to be impaired. So FIN 44's treatment of unvested options will stand out much more in terms of its impact on earnings, especially at technology companies.


Rolling over stock options "will now be a question of amortization versus no amortization," says Robert Willens, managing director at Lehman Brothers, "and it will come up in almost all acquisitions."



Hilary Rosenberg is a contributing editor of CFO.



THE EFFECT OF FIN 44 IN FIVE DEALS

DateCompany AcquisitionPriceUnvested-options expense
7/00VignetteOnDisplay$1.5 billion$52.9 million
7/00Gemstar International GroupTV Guide$7.9 billion$88 million
9/00 Quest Software TechnologiesFastLane $100 million$5.3 million
1/01 America Online Time Warner $147 billion $32 million
2/01JDS Uniphase SDL$41.5 billion$203.7 million

Source: Company reports

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