Equity incentives – often in the form of stock options – are a key part of executive compensation. Option holders work for a company exit that can produce a big payday for them. Now more than ever companies need to keep their employees focused on better times in the future. When cash to pay salaries is short, equity gives them something to strive for. Yet, what happens when the options are “underwater,” that is, when the exercise price exceeds the market value of the optioned shares?
- Most likely, the options no longer motivate employees.
- Also, they are counted as part of “fully diluted” equity, reducing the deemed value of outstanding shares.
- And, they count against limits in option plans even though they are unlikely to be exercised.
So, what can a company do with an underwater option plan? There are a number of approaches. The following are the most common.
- Option for option exchanges
- Replacement with Stock Appreciation Rights (“SARs”)
Repricing is done one of two ways: (a) amending the exercise price of the underwater option to equal current fair market value; and (b) canceling the underwater option and replacing it with a new option at current fair market value. After a repricing, the employee will then hold options for the same number of shares under the same vesting schedule as before. Thus, to the extent that the underwater option had vested, the amended or replacement option should also be vested. Since the existing exercise price of the options being repriced is below fair market value, there is no tax consequence to employee or company from a repricing.
Easy, right? Perhaps.
In a private company option repricing may or may not require shareholder approval. It depends on the terms of the plan. Whether or not shareholder approval is required, shareholder views are a consideration. The shareholders may feel that it is unfair that they have to suffer from the company’s lower market value while the employees get an adjustment. Shareholders may be particularly unhappy if the option repricing works to the benefit of the senior officers or if shareholder investors purchased stock at prices higher than current fair market value. Nevertheless, shareholder investors should concentrate on what is necessary to incent employees under the changed circumstances.
Extension of Term
Along with repricing, the company may want to consider extending the term of the options. The pandemic and the related economic problems mean that any exit is unlikely until business conditions improve substantially, which may be years away.
Well, this sounds better if the shareholders won’t be upset, right? Well, now you have to option holders to think about.
Incentive stock options are limited to a ten-year term. Non-qualified options are not limited, but tend to have ten-year terms. When repricing options, a company should consider the term of the existing option. If there’s four years left on the option, the company may want to replace the option with one that has another ten-year term.
Option for Option Exchange
Option for option exchange may be more acceptable to shareholder investors than a repricing. In an option for option exchange, the existing options are valued. Even though they are underwater, they have a value that can be calculated by a valuation expert using a Black-Scholes or other model. They are then exchanged for options with a current fair market value exercise price. The number of new options granted will be based on achieving a value equal to the underwater options.
For example, assume 100,000 options with a $10.00/share exercise price and assume current fair market value of the stock is $5.00/share. The value of those options can be calculated because over the remaining option term there is a chance that the stock price will again be greater than $10.00/share. The employee could exchange those options for a lesser number of options with an exercise price of $5.00/share. Although the overall value would be the same, the employees could realize the benefit so long as the stock value raises above $5.00/share.
Now, we’ve addressed both shareholder and employee concerns. But what about Stock Appreciation Rights (SARs)?
Replacement with SARs
SARs will be covered in more detail in another post. The point of mentioning them here is that when options are underwater, exchanging them for SARs may be an opportunity to give the company more flexibility, keep investors happy, and, at the same time, give the employees an equity like incentive that can be exercised at no cost when the conditions of exercise are met.
For the time being, then, bear in mind that underwater options are an inescapable feature of the downside of the business cycle. We are certainly on the downside now, meaning that options issued in more optimistic times may well have exercise prices below fair market value of the stock. However, options don’t have to stay submerged. Consider repricing, replacement or exchanges as relatively simple fixes to pull options back to the surface.