If an award is adjusted based on an existing antidilution provision that requires the adjustment in the event of an equity restructuring and is properly structured to preserve the value of the awards upon completion of the equity restructuring incremental fair value generally should not result from the modification. In this situation, the fair value of the award immediately before the modification will reflect the required adjustment to the award’s terms in accordance with the antidilution provision. Thus, the fair value of the award immediately before the contractually-required modification should be equal to its fair value immediately after the contractually-required modification. However, this calculation should be performed to confirm that no incremental fair value is generated by the modification. As described in SC 4.5.4.3, the notional value (or consideration) used to keep the award holder “whole” may not be the same as the fair value of the award for accounting purposes and, as a result, modifications may inadvertently result in incremental fair value that would need to be recognized as additional compensation cost.

In order for a company to conclude that an award’s terms require modification in the event of an equity restructuring, we believe the terms of the award need to, at a minimum, specify that an “equitable” or “proportionate” adjustment is required (not just that the company “may” make such an adjustment). It is not necessary for an antidilution provision to specify exactly how the awards will be adjusted. When assessing whether an antidilution provision is mandatory or discretionary, consideration should be given to whether the employees could require the company to make “equitable” adjustments to an award’s terms if an equity restructuring event occurs. In some cases, input from legal counsel may be necessary.

EXAMPLE SC 4-9
Modification of stock options pursuant to an antidilution provision using a “make-whole” cash payment

On June 1, 20X1, SC Corporation grants 10,000 at-the-money equity-classified stock options with an exercise price of $20 and a grant-date fair value of $9.03. The options cliff-vest in four years based on a service condition. The options’ original terms include antidilution protection.

One year after the grant date, SC Corporation pays a special dividend of $15 per share to shareholders. To meet the requirements of the antidilution protection, concurrent with the dividend payment, SC Corporation makes a cash payment of $15 per option to all option holders. The cash payment is fully vested when paid.

Assume for purposes of this example that all valuation assumptions remain the same before and after the modification: expected volatility of 40%, expected term of 6 years, dividend yield of 0%, and risk-free interest rate of 4%.

How should SC Corporation account for the make-whole payment?

In accordance with ASC 718-20-35-6, the make-whole payment required by the antidilution provision is considered a modification of the option award. As a result, SC Corporation must compare the fair value of the options immediately before the modification to the fair value immediately after modification, including the cash payment. SC Corporation calculates incremental value of $1.02 per option as follows:

While the market price of SC Corporation’s stock decreases $15, or an amount equal to the cash payment to the award holders, because there is remaining time value to the options, the reduction in the fair value of the option is less than the cash payment. Thus, the $10,200 (i.e., $1.02 x 10,000 options) of incremental fair value is a result of the cash payment. Additionally, because the cash payment is fully vested at the time of modification (i.e., no additional service is required from the employee to receive the payment), the entire $10,200 should be recognized as compensation cost immediately.

The remaining $139,800 cash payment (i.e., $150,000 total cash payment less $10,200 recognized as incremental fair value) is effectively a cash settlement of a portion of the original award because no future service is required to earn the cash. Because the options are unvested at the modification date, the settlement accelerates the recognition of compensation cost for the portion of the arrangement that was settled, in accordance with ASC 718-20-35-7.

To determine the amount of the original award that was settled, we believe an acceptable approach is to assess the relative fair value of the remaining cash payment ($139,800) to the options’ aggregate fair value immediately before modification ($357,500). Using this approach, 39% ($139,800 / $357,500) of the original award was settled.

Prior to the modification, SC Corporation had recognized compensation cost equal to one year of the four-year requisite service period, or a total of $22,575 (grant-date fair value of $9.03 per option for 10,000 options for an aggregate grant-date fair value of $90,300 × one-fourth of vesting period completed). The settlement of 39% of the original award results in the acceleration of $26,413 (39% of the remaining 75% (3 out of 4 years) of the $90,300 grant-date fair value) of compensation cost. SC Corporation would record the following journal entries to account for the modification:

SC Corporation would recognize the remaining compensation cost for the unsettled portion of the award of $41,312 ($90,300 grant-date fair value less $22,575 of expense in the first year less $26,413 of accelerated expense at time of vesting) over the remaining requisite service period of 36 months.

In summary, the total compensation cost recognized for the arrangement is $100,500:

Recognized as follows:

A modification also occurs when an antidilution provision is added to an award's terms. However, ASC 718 provides that if an award is modified to add an antidilution provision and the provision is not added in contemplation of an equity restructuring event, then the company is not required to calculate the incremental fair value of the modified award.

If an antidilution provision is added in contemplation of an equity restructuring event, modification accounting is required and would likely result in incremental fair value and, in turn, additional compensation cost. Similar to Example SC 4-8, the fair value immediately before the modification to add the antidilution provision would reflect the anticipated effect of the equity restructuring and assume no antidilution protection. ASC 718 does not define “in contemplation,” but Case B of Example 13 of ASC 718-20-55-105 indicates that once an equity restructuring event has been publicly announced, a modification would be considered “in contemplation.” Prior to the announcement of an equity restructuring event, judgment will be required to determine whether the antidilution provision was added in contemplation of that event.

In a spin-off, a company distributes shares of a subsidiary to its shareholders, thereby reducing the parent company's share value. Consider a situation in which the parent company's market value was $30 per share immediately before the spin-off. The parent company distributes one share of the subsidiary's stock for each parent company share outstanding. Immediately after the spin-off, the parent company's shares trade at $25 per share, and the subsidiary's shares trade at $5 per share.

Companies will generally modify outstanding awards to keep employees in an equitable position after the spin-off. For example, employees holding options to purchase shares of the parent may receive options to purchase shares of the entity that has been spun off, or the exercise price and number of options on the parent company shares may be adjusted to reflect the decline in value of the parent company stock. Companies can use a variety of methods to keep employees “whole” upon the spin-off. Regardless of the method used, any exchange of awards or adjustment in connection with a spin-off transaction is accounted for as a modification in accordance with ASC 718. A spin-off generally creates a number of complex stock-based compensation issues. In this section, the following aspects of a stock-based compensation modification involving a spin-off are addressed: