As COVID-19 continues to cause significant volatility and steep declines, stock options granted in better times are posing particular challenges. Underwater stock options have a number of negative consequences. First, they fail to provide their intended incentive, motivational and retentive benefits. Second, they cause companies to take accounting charges for equity awards that are not providing value to employees or the company. Finally, they are an inefficient use of a company’s equity reserves as they continue to count against a company’s share plan limits, thus limiting the number of new awards that may be granted. Currently, we are seeing a renewal of discussion regarding option repricing, which would revive issues last considered on a large scale during the 2008 financial crisis.
This memorandum discusses the key considerations for companies and their boards as they contemplate repricing options.
How to Handle Underwater Stock Options
One way companies can counteract the negative effects of underwater stock options is to conduct a stock option repricing or option exchange program. Under an option exchange program, underwater stock options are surrendered by employees and replaced with options that have a lower exercise price, typically the fair market value of an underlying share on the date of the exchange. In an option repricing, the option is unilaterally amended by the employer to provide for a lower exercise price.
Companies are typically reluctant to reprice options due to restrictions imposed by the New York Stock Exchange (“NYSE”) and The NASDAQ Stock Market (“NASDAQ”), prohibitions of such programs under existing equity plan terms and the negative perception of these programs by shareholders and the media. Given recent market declines, however, a resurgence of stock option repricing and exchange programs may occur as we saw following the 2008 financial crisis.
When a decline in a company’s stock price is not a result of management’s poor performance, but instead is due to global market declines, an affected company may wish to reset option exercise prices. In assessing whether to proceed with a stock option repricing or exchange offer, boards and management must weigh multiple considerations, such as: whether employees will be rewarded in an outsized manner upon a quick recovery in the stock price, how to motivate and retain employees—who may be exerting herculean efforts in extreme circumstances—and the reaction of shareholders who also may have sustained significant losses.
In many instances, a stock option exchange program benefits both a company and its shareholders. Cash-poor companies that rely on equity awards as a means to provide long-term incentive compensation may be depleting existing share reserves under their equity compensation plans on options with little chance of coming into the money during their terms. Underwater stock options may cause a company to incur accounting expenses for a compensation award that provides little retentive or incentive value. As a result, a company may be forced instead to use cash to provide incentives. By permitting a stock option exchange, shareholders can reduce overhang, thereby increasing the available share pool under a company’s equity plans and stem undesirable accounting consequences. The following is a summary of various forms of stock option exchange programs and the associated issues that companies should consider in determining whether such a program is appropriate.
Forms of Stock Option Exchange Programs
For purposes of this memorandum, the term “stock option exchange” program broadly refers to a number of practices summarized below. The primary difference among these programs is the form of consideration given by a company in return for an employee’s participation.
Stock Option-for-Stock Option Exchange Programs. In a stock option-for-stock option exchange program, underwater stock options are cancelled and replaced with new stock options that have an exercise price that is equal to or greater than the market price at the time of the new grant. The company determines the applicable exchange ratio for the program (which is often less than one-for-one, providing employees with fewer new stock options for each option exchanged). Companies frequently use a value-for-value exchange ratio whereby the value of new stock options equals the value of the cancelled stock options, using a common option valuation method, such as Black-Scholes or binomial lattice. The terms of the new stock options can differ from the terms of the cancelled stock options. Employers commonly modify the term of the new stock options and subject the new stock options to additional vesting and forfeiture conditions.
Stock Option-for-Other Security Exchange Programs. In a stock option-for-other security exchange program, underwater stock options are exchanged for a different type of equity-based award, such as restricted stock, restricted stock units or phantom stock. The amount of the new equity award is generally determined on a value-for-value exchange basis, but this is not required. The new equity awards typically have additional vesting and forfeiture conditions.
Cash Exchange Programs—“Stock Option Buyouts.” In a cash exchange program, which is sometimes referred to as a “stock option buyout,” underwater stock options are purchased by the company for cash. The cash payment amount is typically determined pursuant to a stock option valuation methodology, such as Black-Scholes or binomial lattice. The cash payment to employees may be made immediately, or over time, and may be subject to future vesting or forfeiture conditions.
Stock Option Repricing Programs. In a pure stock option repricing program, the exercise price of underwater stock options is unilaterally reduced by the company by amending the option award without any exchange of rights.
Choosing an Approach
Decisions regarding the type of stock option exchange program to implement are fact specific. The table below compares some of the advantages and disadvantages of each of these programs.
