If Your Private Company’s Options Are Underwater, Consider Repricing or Exchanging to Boost Employee Morale
COVID-19 has caused the stock market to be on a rollercoaster. The last time we experienced a similar volatility was in the last recession, over a decade ago. Just like in 2008, companies find themselves once more evaluating their equity program and what should be done to ensure it delivers its long-term intended value.
No single solution will work for all employers. But if your private company has underwater stock options or stock appreciation rights (SARs) — we’ll address these collectively as “underwater options”— and you want to take what employees may perceive as the most beneficial action, you have two main choices:
1. Reprice underwater options. You do an immediate replacement of the underwater options with a new option or SAR that has an exercise price equal to the market value at the time of the new grant date. All remaining terms (vesting, expiration date, etc.) will generally remain the same, but these could also be modified to help offset investor concerns.
Advantages:
- Non-cash employee morale boost because employees believe the company is willing to invest further in “me” and our collective future.
- Stock option holder consent is generally not required if you do not modify any other terms. (Thus, you may be able to avoid a formal tender offer.)
- Relatively easy to explain and easy for employees to understand.
Disadvantages:
- May be negatively perceived by investors.
- New awards may become underwater again.
- Modification and incremental value calculation require new Black-Scholes assumptions or even a lattice model.
- Requires additional financial statement disclosures.
2. Exchange underwater options for Full Value awards. You exchange the underwater options for a different type of equity-based award, for example, Restricted Stock Units (RSUs). Since these are considered Full Value awards, the number of shares in the new award is usually less than the number of shares from the cancelled options. The ratio is generally between 1/4 and 1/2. Other terms such as additional vesting could be added.
Advantages:
- Non-cash employee morale boost because employees believe the company is willing to invest further in “me” and our collective future.
- Protects employees against potential further stock price declines.
- Reduces overhang and the number of shares outstanding.
- Preserves shares available for future issuances.
- Modification and incremental value are easier to calculate and could be minimized or eliminated.
- Generally, the new RSUs are structured as liquidity-based RSUs, and thus you’re able to defer any incremental expense.
Disadvantages:
- May be negatively perceived by investors.
- Typically, requires a tender offer and consent of option holders to agree.
- Employees have no control over the timing of a future taxable event.
- All tax is ordinary income until sale, whereas ISOs offer a portion to be taxed under Alternative Minimum Tax (AMT).
- It may be more difficult to explain to employees why they have fewer shares than before.
- Requires additional financial statement disclosures.
Potential negative perception by investors is a common disadvantage between both alternatives. However, in many private companies, employee retention is one of the biggest challenges. Even for businesses that are thriving during this time, retention is always a concern. And as a recovery begins, employees may believe they can go elsewhere to get a “better starting point.” Thus, the goal of employee retention generally helps curb any negative investor sentiment.
Other Alternatives
In addition to a reprice or exchange, there are some other alternatives, but just remember that they may not be as well received by employees.
Grant additional equity compensation. Instead of repricing underwater options, you simply grant more options or SARs at the new price.
Advantages:
- The company does not have to go through the legal or accounting process of a reprice/exchange.
Disadvantages:
- Dilution: by issuing more awards without cancelling the prior awards, the amount of overhang and dilution will increase.
- To avoid at least some dilution, you likely will not give employees the same amount of new options that they have underwater, so they may not feel made whole.
- Reduces your option pool that is allocated for future hires.
Do nothing. You simply wait and see if the stock price will recover and attempt to reassure employees that the market volatility does not reflect the company’s true long-term value.
Advantages:
- Investors do not get reset, so there is the perception that employees are aligned with them.
- No additional actions are needed beyond employee messaging.
Disadvantages:
- Employee discontent can lead to future retention issues.
- New employees coming in get better economics than existing employees.
- Current employees may not participate in future liquidity to much or any extent.
Other Considerations for Repricing or Exchanging
For tax purposes, if you reprice Incentive Stock Options (ISOs), some of the new options may be converted to Non-Qualified Stock Options (NSOs). This is due to the IRS rules around how the $100,000 limit is calculated when ISOs are modified. You must double-count the options that first become exercisable in the calendar year of the repricing. Generally, if you modify the expiration date of the options, this will cause the entire option to be an NSO.
Under ASC 718, a repriced or exchanged option is considered a modification. Incremental compensation expense is recognized to the extent that the replacement grant’s fair value is greater than the fair value of the cancelled options. On the positive side, your pool of shares available for future grants may increase significantly if you chose an RSU exchange program.
Check out our related article on valuation timing. And if you need help, our experts can walk you through the various options (pun intended) for your specific situation. Reach out to Scott Schwartz, Hung Tran or Laura Verri. And for more information on running your business through disruption, visit our COVID-19 Resource Center.