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February 27, 2023

What Business Leaders Can Do When Employee Stock Options Are Underwater

Manila folder with 'Sales Playbook' written on it in marker

This is the second in a three-part series about repricing of employee stock options. It summarizes a webinar I hosted with two experts: Ali Murata, a partner in the Compensation & Benefits group at the law firm Cooley, and Kristin O’Hanlon, special counsel in Cooley’s Compensation & Benefits group.

Part I discussed factors leading to a decision about whether and when options that have fallen underwater should be repriced. This part drills down into the alternatives for repricing options.

 

What Are the Alternatives for Managing Underwater Options?

Ali: “If you decide you need to make a change to your underwater options, there are several alternative courses of action. There isn’t a one-size-fits-all solution that is best for every company. Often, the right approach will manifest itself in a hybrid solution that contains more than one of the alternatives we’re going to discuss. I don’t want anyone to take away from our conversation that they’re just binary choices, that it’s all or nothing.”

 

When options are underwater, there are four categories of potential solutions:

1) Do nothing – Wait to see if conditions recover.

As we discussed in Part I, it is a mistake to decide too quickly to reprice options. Things could get better, in which case action wasn’t needed. Or, things could get worse, in which case the action taken could still leave the company and employees in no better position. We saw some of this in the early days of the COVID pandemic, when some companies give cash awards or option grants that in retrospect were either too large or not necessary at all.

Certain Benefits:

    • Avoids cost and effort required for changing options
    • Avoids overreaction to what may be a short-term dip

Certain Disadvantages:

    • Doesn’t address employee retention
    • May lower morale

 

2) Employee education – Educate team members on the long-term value of options.

Employees should understand that the initial stock options they were granted upon hiring are the primary opportunities for wealth creation and should be considered an asset for the long term. Expectations of a quick hit should be discouraged. That said, managers should also avoid making statements that could be interpreted as a guarantee of gains in the future, either in general or at a specific level.

Certain Benefits:

    • May improve perceptions of the value of options
    • May reduce skepticism
    • May foster patience

Certain Disadvantages:

    • Doesn’t change current economic realities
    • Could raise false hopes about the future value of options

 

3) Special grants – Issue one-time grants of options and/or cash.

This is a short-term solution that may allow you to target specific employees at risk of leaving, but it could set a dangerous precedent.

Certain Benefits:

    • Simpler, potentially lower-cost alternative (as compared to repricing/exchange)
    • Allows targeting of high-value employees

Certain Disadvantages:

    • May create a dangerous precedent
    • Could be dilutive to share pool
    • Doesn’t change the reality of underwater options

 

4) Repricing or exchange of options – Reduce the exercise price and/or swap options for new options or other equity.

This is the approach most commonly pursued. Even so, it has several variations, which we’ll discuss below.

Certain Benefits:

    • Removes a source of negative feelings
    • Cleanly restores incentives
    • Creates a new baseline
    • May reduce dilution

Certain Disadvantages:

    • Continued declines could put new options underwater
    • Could be perceived as rewarding optionees who were in charge when things went wrong

 

How to Select the Right Approach for Your Company

 

Once a decision has been made to reprice/exchange options, there are several alternatives:

1) Options-for-options exchange – Underwater options are exchanged for new options with new terms

The new exercise price cannot be less than the current fair market value (FMV). New terms may include a new term (usually 10 years), additional vesting conditions, and/or a reduction in the number of shares.

Certain Advantages:

    • Retains the attraction of options
    • May increase retention by establishing new vesting schedule
    • Simple to explain
    • Reduces burn rate, overhang, and dilution

Certain Disadvantages:

    • Consent of option holders required; could mean tender offer
    • ISO status could be impacted
    • New options also could fall underwater.

 

2) Options-for-RSAs/RSUs exchange – Underwater options are exchanged for a different type of equity

The different type of equity is often either a restricted stock award (RSA) or a restricted stock unit (RSU). RSUs are a common compensation method in public companies, so employees who have never worked in a public company may be confused as to how they work.

Certain Advantages:

    • Less volatile form of compensation; cannot easily fall underwater
    • Potentially more valuable than options
    • Potentially strong retentive value
    • May reduce dilution

Certain Disadvantages:

    • Potentially confusing to employees who are not familiar with RSAs or RSUs
    • Less upside leverage for employees
    • Consent of option holders required; could trigger a tender offer
    • May be interpreted as showing less confidence about the company’s future growth

 

3) Options-for-cash buyout – Underwater options are purchased for cash

This wipes the slate clean in terms of eliminating the problem of underwater options, but the complications and downsides can be numerous.

Certain Advantages:

    • Biggest reduction to overhang, burn rate and dilution
    • No more underwater options
    • Immediate value to participants

Certain Disadvantages:

    • Cash outlay by the company
    • Accelerates expense into current period
    • No leverage from future growth
    • No alignment of employee and stockholder interests
    • No incentive for long-term retention
    • Taxable event
    • Consent of option holders required; could mean tender offer

 

4) Simple option repricing – Underwater options are amended to reduce the exercise price to a point no less than the current fair market value (FMV)

A simple option repricing keeps all the terms of the option but for the reduced exercise price. The expiration date of the option stays the same, as does the vesting schedule and the number of shares. This is the most straightforward option for dealing with underwater options other than doing nothing. So, it’s relatively easy to explain to employees. Moreover, if the applicable equity plan permits, it can be done unilaterally by the board, so it can be relatively quick and inexpensive. Unfortunately, from a tax perspective the repriced option is deemed to be a new option grant.

Certain Advantages:

    • Easy to explain
    • Quick and simple to implement (if not a tender offer)

Certain Disadvantages:

    • New options also could fall underwater
    • ISO status could be impacted
    • Least impact on burn rate, overhangs, and dilution

Ali: “If a decision is made to take action on underwater options, #4 is the most commonly adopted approach. It can be done quickly, efficiently and with the least amount of corporate effort and legal expense.”

Whatever approach you decide on, plan carefully how you communicate changes to employees. “We generally try to steer companies away from projections around value because you can create expectations among employees,” Ali advised. “As we all know, it is impossible to predict the future with certainty.”

 

In Part III, we offer a guide for creating an action plan to reprice/exchange options.

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