Restoring Incentives of Underwater Stock Options
May 10, 2020
COVID-19 induced declines in private and public company valuations have left many employee stock options “underwater” or “out-of-the-money”, i.e., exercise prices exceeding fair market value. This is a problem for employees and companies alike. Underwater options don’t no longer serve their retention and incentivization objective, but nevertheless use up finite authorized shares and count against authorized capital and option plan caps. Consequently, companies should seriously consider restoring financial incentives by either repricing or exchanging the underwater options. This post will review stock option repricings and exchanges, and will address relevant corporate governance, securities law, accounting and investor relations considerations relating to each technique.
In a true repricing, the company unilaterally reduces the exercise price of the underwater option, either by amending the existing option grant/option agreement or by cancelling the option and replacing it with a lower priced option.
The primary advantage of the repricing technique is its simplicity. Another advantage applicable to public companies is that repricing does not generally trigger the federal securities laws’ tender offer rules.
There are a few disadvantages. First, stockholders generally view repricings unfavorably as a windfall to employees not shared by existing stockholders. Second, NYSE and Nasdaq listed companies must secure stockholder approval unless the plan under which the options were granted explicitly allows repricings without such approval. In soliciting stockholder approval, a public company must disclose in a proxy statement all material information necessary for stockholders to make an informed decision, including the reason for the repricing, historical price variations, the employees eligible to participate in the offer and what happens to shares underlying repriced options. Proxy advisory firms (e.g., ISS, Glass Lewis) generally oppose repricings unless the vesting schedule is adjusted, the exercise price is reset at or above fair market value and the repricing proposal excludes officers and directors. ISS has indicated that repricing underwater stock options after a recent precipitous drop in a company’s stock price demonstrates “poor timing and warrants additional scrutiny.” Further, ISS has indicated that the options being repriced should have been granted “far enough back (two to three years) so as not to suggest that repricings are being done to take advantage of short-term downward price movements.” As a result, repricings as a practical matter are typically limited to underwater options where the exercise price of the surrendered option is above the stock’s 52-week high, where officers and directors are either excluded or included on less favorable terms and where the new stock option has a longer vesting period than what remains under the cancelled stock option.
On April 8, 2020, ISS issued COVID-19 specific guidance, which stated that, during the pandemic crisis, ISS will generally recommend opposing any repricing that occurs within one year following a steep drop in a company’s stock price and will examine specific repricing factors, such as whether surrendered options are added back to the plan reserve, whether replacement awards vest immediately and whether executive officers and directors are able to participate.
Even if a company’s option plan explicitly allows repricing (meaning that stockholder approval is not required), ISS has indicated that a repricing without stockholder approval will likely result in an adverse recommendation for the company’s say-on-pay proposal and, in certain circumstances, for the election of the members of the company’s compensation committee.
For private companies, both the underwater stock option and the repriced stock option will count towards the “hard cap” and “soft cap” limits under Rule 701 of the Securities Act of 1933, the safe harbor for compensatory offerings. The hard cap is a limit on the number of equity awards that a company may grant in reliance on Rule 701 in any 12-month period; in certain situations, a repricing will blow the cap, making the exemption unavailable. Under the soft cap, a company that exceeds $10 million in equity awards in any 12-month period must provide sensitive disclosure (including financial and risk disclosure) to its equity award holders. See previous blog post on Rule 701 here.
Finally, repricings may result in an accounting charge to the extent the value of the new options exceeds the value of the repriced options.
The alternative to option repricing is exchanging the underwater options for fewer lower exercise priced options, i.e., at a ratio of less than one-for-one, so that the value of the new options is no higher than the underwater options.
The primary advantage here is that it reduces the overhang of (useless) equity inasmuch as it results in fewer options being outstanding. Further, there should be no accounting charge as a result of the exchange because the value of the new options is no higher than the exchanged options.
Companies effecting an options exchange must comply with federal securities law tender offer rules which are generally triggered when stockholders are asked to make an investment decision about selling or exchanging one security for another or modified one. The tender offer rules require that the company file a Tender Offer Statement (Schedule TO) with the SEC, attach a detailed Offer to Exchange (which makes the offer to the optionholders) and deliver it to the optionees. The company must keep the tender offer open for at least 20 business days.
As is the case with repricings, option exchanges effected by listed companies must be approved by the stockholders under NYSE and Nasdaq rules (unless the underlying plan provides otherwise). See above regarding the process of seeking stockholder approval. Proxy statement disclosure is somewhat more complicated in an exchange as compared with a repricing because the company must explain how it determined the value of the exchanged options.
Under current accounting rules, an option exchange is considered a modification of the old option. If there is an increase in value when comparing the new option with the old, then an accounting charge is taken. But if there is a true value-for-value exchange (underwater option is exchanged for option subject to a fewer number of shares), then the exchange is a neutral event with no accounting charge.
One quick tax point that relates to both repricings and exchanges. In either case, it’s critically important to make sure the exercise price of the new options is at or above fair market value at the time of the repricing or exchange. If it isn’t, the new discounted option may be immediately taxable and subject to a 20% penalty and interest under dreaded Section 409A.