Accelerated Vesting of Stock Options

The awarding of stock options to employees and managers is generally explained as a means of rewarding long-term performance. Stock options usually can't be exercised until they have "vested" over a period of years after they are awarded. And even then, stock options have little value unless the company's stock has risen over that time to a value above the "strike price" where the options can be exercised.
Many companies have included provisions in their stock option plans that sometimes allow for "accelerated" vesting of stock options. Managers and employees may not have to wait for years for their options to vest if the company achieves certain goals, such as an acquisition or an initial public offering of stock.
Many times, the accelerated vesting of stock options has been controversial. It's sometimes been seen as a way of awarding a large pay day to a management for actions that may not benefit small shareholders.

What is a Stock Option

A stock option is a contract that allows an option holder to buy stock in the future at a price that's set today. If a company executive is granted stock options with a strike price of $10, for example, they have the right to buy a number of shares in their company for $10 each. If the stock is trading in the public market for $20, the executive can immediately turn around and sell the stock they have acquired through exercising their options and turn a quick $10-a-share profit.
Stock options typically vest over a period of years. This is so a company's executives and employees have incentive to work toward increasing the company's stock price. The higher the stock price goes in the years after they are awarded their options, the bigger the profit they can make by exercising their options.

When is the Vesting of Options Accelerated

Terms of stock options often allow for them to be accelerated if the company is involved in a merger. For stock options granted in private companies, accelerated vesting is sometimes allowed if the company does an initial public offering of stock.

Controversy

The accelerated vesting of stock options has sometimes allowed top executives of companies to be able immediately to exercise options worth millions of dollars, upon completing a merger or upon selling their company.
The provision is meant to award an event that is often seen as a major success, but it has also brought controversy. Many times, mergers fail to achieve their expected benefits, such as lower operating costs and larger market share.
In fact, often, companies agree to mergers as a means of survival after a period of failure. These companies will sell themselves to avoid filing for bankruptcy or because they foresee losing market share for years to come without the help of a larger partner.
"Not all acquisitions are 'home run events.' Some acquisitions are survival events or strategic moves that in themselves do not constitute the 'success' which might justify acceleration," wrote Joseph Hadzima, professor at MIT's Sloan School of Management, in a 2005 column in the "Boston Business Journal."

Widespread Acceleration in 2005

The U.S. Securities and Exchange Commission made a new rule in 2005 to force companies to disclose the expense of issuing stock options. Before that, many companies did not record their stock-option grants as an expense since they did not involve any payment of cash. But the granting of stock options does have a cost for investors: The issuing of new stock when options are exercised dilutes the value of shares previously issued. When the SEC passed this rule, many companies accelerated the vesting of the stock options so employees could immediately exercise them. This allowed the companies to avoid disclosing to investors a large future expense for options previously exercised.

What an Investor Should Know

An investor who holds a large chunk of his stock portfolio in the shares of a single company may want to read the terms of that company's stock option plan, which is usually included in the company's proxy statement. Note the terms of the plan that allow for accelerated vesting. If the chief executive stands to make millions of dollars through the accelerated vesting of options, he may have incentive to agree to a merger even if it is not in the best interest of shareholders.