Underwater stock options – what should I do?

We have seen more volatility in the market during this uncertain time than at any time since the Great Recession, with many share prices being adversely affected.

For companies offering equity as part of compensation such as stock options, you and your employees may be grappling with the reality of underwater stock options – stock options where the initial strike price (or exercise price) exceeds the current market value.

It means anyone looking to exercise their options would have to pay more for the shares than the actual trading price. Unsurprisingly, participants will not want to exercise options while that is the case.

What to do with underwater stock options?

So, what can companies do to address this issue when it arises and dispel potential unhappiness among participants?

There’re many possible courses of action, but no one-size-fits-all solution. Each company has its own unique set of circumstances to cater to those individual needs and objectives.

1. Option-for-option exchange

Under this approach, the company replaces the underwater options with new options, with the exercise price set to the current market value of the new grant.

This is a value-for-value exchange in which the value of the consideration received by the option holder equals the value of the stock options surrendered. The option holder will always receive fewer stock options than he or she surrendered. The value of the options would be determined by a valuation method such as Black-Scholes or binomial.

Terms and conditions, such as vesting or forfeiture rules, may be retained, added or modified in the newly issued awards.

Advantages:

• Relatively simple measure: This exchange is the most common approach because it’s easy to explain to employees (Source: Harvard Law School Forum)
• Better employee morale: Employees are likely happy as employers will have acted to address the issue.
• Improves the company’s stock option “overhang” (a measurement used to determine the dilutive effect of stock options) as fewer new options are granted than were canceled
• The stock option holder consent is generally not required if you do not modify any other terms. (Thus, you may be able to avoid a formal tender offer.)
• Greater likelihood of shareholder approval: The value-for-value exchange ratio appeals to shareholders who wish to limit share dilution as option holders receive fewer stock options than surrendered.

Surveys have shown that the exchange ratio in a value-for-value stock option exchange might be as high as 1:5 (i.e. 1 new stock option is issued for every 5 stock options that are surrendered). (Source: SHRM)

Disadvantages:

• It is possible that the new awards may become underwater in the future.
• It may require additional financial statement disclosures.
• Ordinary investors may become unhappy if they perceive that employees have been treated more favorably than them. Management needs to ease such concerns for employee retention by making other changes, such as to the vesting rules – the how and when of eventually exercising the options.

2. Option-for-stock/RSU exchange

With this option, the underwater options are canceled and the employee then receives a new equity compensation form – restricted stock units (RSUs), with the number of new shares usually less than the number canceled.

Terms and conditions may be added to the newly issued awards.

Advantages:

• Risk of falling underwater removed: RSUs require no upfront payment by employees so it always has value.
• Better employee morale: Employees are likely happy as employers will have acted to address the issue.
• Improves the company’s stock option “overhang”: There’s less equity in circulation.
• More shares on hand for future issuance.

Disadvantages:

• More difficult to explain to employees as this is a new equity vehicle.
• Additional financial statement disclosures may be required.
• Employees lose control over the timing of a tax event because ordinary income tax will be charged when your RSUs vest (while you can control the timing of tax event by considering when to exercise options).
• The consent of option holders is usually required and a ‘’tender offer’ is necessary for employees to formally choose the RSUs over the initial options.

3. Option-for-cash

Under an options-for-cash approach, options are canceled in exchange for an immediate cash payment. The value of the options would be determined by a valuation method such as Black-Scholes or binomial.

Advantages:

• Eliminates any future concerns around those options being underwater.
• Maximizes the overhang reduction because no new equity shares are issued.
• Provides immediate value to participants.

Disadvantages:

• Demands a cash outlay from the company
• Employees will be liable for tax when receiving the payment.
• Lacks employee retention
• Employees lose an opportunity to participate in future stock price growth

4. Wait and see

Another approach is to take no formal action and instead adopt a wait-and-see strategy. While being underwater is a negative situation, the stock price may recover in the future. A company might be confident that over time its true value will be reflected in a higher share price.

A lot of people don’t know that they have 10 years from grant, so they feel as though they have to exercise during their vesting window. However, taking more time during volatile periods may be reassuring

Chelsea Ransom-Cooper, a New York-based CFP

So, when faced with underwater stock in a time of general instability, particularly in a traditionally volatile sector, the best advice may be to settle in and play the long game.

Is shareholder approval required?

Option-for-equity exchanges are considered “repricing” for purposes of NASDAQ and NYSE rules. So, shareholder approval of any such exchange is required unless the applicable equity plan allows for repricing without the approval. An option-for-cash approach is not considered “repricing,” so shareholder approval is not required.

To approve an underwater stock option exchange, or not, these factors should be considered, as suggested by Institutional Shareholder Service (ISS):

• Proximity to a decline in stock value: At a minimum, the exchange should occur 12 months after the decline in stock value.
• Participants: Executive officers and directors should be excluded from participating in the exchange program.
• Grant date of exchanged stock options: Only stock options that were granted at least two years prior to the exchange should be eligible for the exchange.
• Exercise price: The exercise price of new stock options should be equal to or greater than the fair market value of the stock, and the exercise price of surrendered stock options should be above the stock’s highest price during the preceding 52 weeks.
• Value: The value of the consideration received in the exchange should be no greater than the value of the surrendered stock options.

There are many different possible responses to stock being underwater and companies need to look at what best suits their own needs and circumstances before committing to a course of action.

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