This appendix provides an overview of the legal and regulatory requirements that apply to the executive compensation programs discussed throughout this book.

Nonqualified Stock Options

• Overview. Nonqualified stock options (NQSOs) can be a highly motivating employee compensation program that provides unlimited upside potential based on future stock appreciation without a company cash expenditure. NQSOs can be highly dilutive, however, and require the grantor to incur a compensation expense that may not have a corresponding tax deduction if stock does not appreciate as forecast or if options expire out-of-the-money.

• Design. Nonqualified stock options provide an employee or other service provider with the opportunity to buy company stock, typically at the grant-date fair market value, for a specified period of years. Ten-year terms have been typical over the years, as a legacy from the incentive stock option (ISO) rules, although companies have been considering reducing this term to seven or eight years in light of the potential expense reduction that can be realized under FAS 123(R).

Options most often include a time-based vesting schedule that requires the recipient to render continued services over a period of years. Vesting can also be based on the attainment of performance goals, although these plans are less prevalent than those with time-based vesting. Vesting schedules can be graded (e.g., 25 percent vesting per year over four years) or cliff (e.g., 100 percent vesting after four years). Other forms of vesting are allowed.