I Come From Down in the Valley, Where the Options Are Now Underwater: Companies Look to Modify Incentives as Declining Markets Hurt Employee Stock Options

by John Ludlum

This is the 3rd major economic upheaval we have had in 20 some years, and once again we have a climate of widespread business uncertainty, employment instability, and economic suffering.  Most of our clients have experienced a decline in company stock values, but we are expecting that as the uncertain business environment stabilizes, companies will start to consider changes to their equity awards to maintain incentives because many stock options are “underwater” where the exercise price is higher than the current fair market value.  There are several approaches that companies can use to either reprice or exchange underwater stock options, and each has advantages and disadvantages.

For public companies, there will be considerations in the listing exchange rules, but for private companies, there are two basic alternatives (the descriptive terms vary) to get the options priced to the new stock value: a repricing, where the exercise price is reduced on existing options but the terms otherwise are not changed, and an exchange, where the old options are cancelled and new ones issued (or sometimes another type of award is made).  Both alternatives can implicate the tender offer rules even for a private company if more than a handful of optionees are offered the investment choice.  There can be advantages to the exchange approach in that new awards generally have a new 10 year term, and they can be adjusted for different number of shares or vesting schedule as needed (potentially giving “value” for the company).  Vesting is often given for new options equal to the amount prior awards were vested, and in some cases an exchange will be done for a full value award like restricted stock or RSUs.  Both approaches usually involve an incremental accounting cost (the company auditors should be consulted), and there are some details in how the $100,000 annual limit works for ISOs if there are ISOs involved. 

With either approach, serial exchanges or repricings can be a problem under Code Section 409A, so we advise companies that they should only do this once (which can make full value exchanges attractive because those awards won’t later go underwater).  It is undesirable to complete a repricing and then have the newly repriced options go underwater, so most companies wait until their business outlook stabilizes to conduct equity award adjustments, and in some cases, cash based plans like carve-out or change of control bonus plans may make more sense.

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