Presidio Pay Blog Providing Thoughtful, Strategic Advice for Critical Compensation Issues

Issues & Alternatives For Underwater Stock Options

The U.S. stock market has now lost over 40% of its value since its peak in 2007, wiping out trillions of dollars in shareholder wealth.  Certain industries, like financial services and housing, have been hit even harder.  Most executives and many employees now face the unpleasant fact that their stock options are underwater, and want their employers to fix the problem by repricing them.  Before acting, management and Boards should carefully consider the pros and cons of an option repricing and make informed decisions about their option programs.

Reasons Not To Reprice

There are a number of reasons why companies should not reprice options, including:

• Stock options are called a long-term incentive for a reason.  Most have a 10 year term and there is still plenty of opportunity for stock prices to recover.
• Shareholders don't get to reprice their stock purchases, and option repricings eliminate the linkage between shareholder and optionholder interests used to justify option programs.
• Repricings remove risk from option programs, making them a "heads I win, tails we flip again" game for optionholders.
• Repricings are a signal that management does not expect the company's stock price to recover.
• Bailing out underwater options can create an entitlement mentality that companies will always intervene to protect optionholders.
• Shareholder activists do not like repricings, and in response may vote against future option programs or requests for additional shares for existing programs.
• Option repricings may require shareholder approval and/or trigger SEC tender offer filing requirements.

Rationale for Repricings

Arguments for repricing options include:

• Employees can "reprice" their options by getting new grants at a new employer.  Companies may need to reprice to retain valuable employees.
• A stock market crash like we're experiencing is extraordinary and warrants an unusual response.  Other than housing and financial services, most industries and companies are healthy and their stock prices are being unfairly punished.
• Options that are deeply underwater have no incentive value and may even be a disincentive.

Questions To Ask

• Before implementing any repricing, there are some important questions that companies should ask:
• How much of a problem do we really have?  To what extent are we losing key employees because of underwater options?
• How far underwater are outstanding option grants?  Are they concentrated in the hands of a few key employees or widely dispersed across the company?
• What's driving our stock price down - temporary market conditions?  Poor company performance?
• What needs to happen to improve our stock's value?  How long should this take?
• How will our shareholders react to a repricing? (shareholders now need to approve most repricings).  What can we do to make a repricing less shareholder unfriendly?

Methods Of Repricing

Technically, an option repricing is a cancellation of existing options and a new grant of options.  Optionholders have to agree to cancel existing option grants, and companies can offer something of value other than options.  Here are some ways of making repricings more palatable to shareholders.

• Exclude senior managers from a repricing.  Senior management has the greatest impact on stock price and have the greatest financial ability to "weather the storm".  Most executives should have a portfolio of options and are likely to have realized gains from prior option grants.
• Do not offer a "one-for-one" option exchange, but rather provide an economic value exchange.  Even deeply underwater options have economic value, even if not appreciated or understood by optionholders.  Consider the following example:
  • An option with a $40.00 exercise price on a stock currently worth $10.00 may have a Black-Scholes value of $1.25.
  • A new option with a $10.00 exercise price may have a Black-Scholes value of $5.00.
  • In this case, the exchange ratio should be 4 to 1 ($5.00 / $1.25 = 4), that is, only 25 new options should be offered for each 100 options cancelled so that the economic value is unchanged.
• Restart the vesting schedule on repriced options.
• Shorten the option term for repriced options (e.g., five years rather than the standard 10 year term).  This helps reduce overhang over time.
• Offer shares of restricted stock rather than a new grant of options, on an economic value exchange basis.  Restricted stock's value is easier to understand and it can't go underwater.
• Offer cash payments to repurchase options; this can be payable in the future (e.g., in one year) as a retention device.

Alternatives to Repricings

Option repricings really should be considered a last resort.  There are a number of other actions companies can undertake if they ultimately conclude that they must do something, including:

• Accelerate the normal grant cycle to make new option grants now or make a special one-time grant.
  • Unless companies can accurately time the market and catch market troughs, this creates the risk of more options going underwater if stock prices decline further.
• Switch from stock options to restricted stock.  Now that both vehicles generate earnings charges, the fundamental accounting advantage of options is gone, and restricted stock doesn't go underwater.
• Trim participation in option programs going forward.  Only a small number of key employees truly impact stock price, and many optionees are just riding on their coattails.
• Replace option grants with cash incentive awards, based on attainment of key company, business unit, or project milestones.  Line of sight and degree of control is better, and cash is easy to understand.