LeapFrog 2007 Annual Report Download - page 129

little or no value due to the difference between the exercise prices and the current market price of our common
stock. As a result, for many employees, these options are ineffective at providing the incentives and retention
value that our board believes are necessary to motivate our management and our employees to complete and
deliver the important strategic and operational initiatives that we began implementing in late 2006 to increase
long-term stockholder value. In addition to providing key incentives to our employees, the Option Exchange
Program is also designed to benefit our stockholders by reducing the potential dilution from stock option
exercises in the future and by providing us better retention tools for our key contributors due to the extended
vesting terms for certain of the New Options. We estimate a reduction in our overhang of outstanding stock
options of approximately 2.8 million shares, assuming full participation in the Option Exchange Program, market
price of our Class A common stock of $7.00 per share, an exercise price of the New Options of $7.50 per share
and exchange ratios that result in the fair value of the New Options being equal to the fair value of the Eligible
Options surrendered based on valuation assumptions made as of the close of the Option Exchange Program. The
actual reduction in our overhang that could result from the Option Exchange Program could vary significantly
and is dependent upon a number of factors, including the actual level of participation in the Option Exchange
Program.
Consideration of Alternatives
When considering how best to continue to incentivize and reward our employees who have underwater
options, we considered several alternatives:
Increase cash compensation. To replace equity incentives, we considered that we could substantially
increase base and target bonus compensation. However, significant increases in cash compensation would
substantially increase our compensation expenses and reduce our cash flow from operations, which would
adversely affect our business and operating results.
Grant additional equity compensation. We make annual equity grants of stock options and restricted stock
units to our employees in order to keep total employee compensation packages competitive with those of our
peer companies from year to year. In addition to this year’s annual equity grants, we considered granting
employees special supplemental stock option grants at current market prices in order to restore the value of
previously granted stock options that are now underwater. However, such supplemental option grants would
substantially increase our overhang and potential dilution to our stockholders and would also decrease our
reported earnings, which could negatively impact our stock price.
Implement Option Exchange Program. Finally, we considered implementing an option exchange program.
We determined that a program under which employees could exchange stock options with an exercise price
greater than the higher of $7.50 or the Adjusted Market Price for stock options covering fewer shares with, in
some cases, an additional vesting requirement and with an exercise price equal to the higher of $7.50 or the
Adjusted Market Price was most attractive for a number of reasons, including the following:
•Reasonable, Balanced Incentives. Under the Option Exchange Program, Eligible Participants would
be able to surrender certain underwater options for options covering fewer shares with exercise prices
equal to the higher of $7.50 or the Adjusted Market Price (which will be $0.25 above the closing NYSE
price of our stock on the day prior to the close of the exchange offer) and with vesting requirements
that would be the same as the surrendered options, except that the vesting schedules for any
surrendered options that are already vested or that will vest within 12 months of the closing date of the
exchange offer will be reset such that the New Options granted in exchange for the surrendered options
will vest upon the 12-month anniversary of the closing date of the exchange offer. In addition, we
would calculate the exchange ratios to result in a fair value, for accounting purposes, of the New
Options being equal to the fair value of the Eligible Options surrendered based on valuation
assumptions made as of the close of the Option Exchange Program, which we believe should result in
no adverse impact on our reported earnings. We believe this combination of fewer shares subject to
options with exercise prices equal to the higher of $7.50 or the Adjusted Market Price, issued with no
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