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.
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Disadvantages:
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:
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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.
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.
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Disadvantages:
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.
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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.
May 22, 2020
