Equity compensation can be a powerful employee recruitment and retention tool, but what happens if equity that is granted loses its incentive value in the eyes of the option/security holder? This can happen when a private company’s options go “underwater.”
The issue of underwater stock options is one that an increasing number of private company leaders and equity administrators may find themselves dealing with amidst economic volatility in 2022. When this happens, it is not uncommon for companies to consider implementing an option repricing to preserve the incentive value of their equity.
In this article, we’ll explore what an option repricing looks like and what companies may want to consider before implementing one.
What are Underwater Options?
Options are considered underwater when the exercise price for outstanding shares is greater than the fair market value of the company’s common stock. This can happen when a company receives a lower 409A valuation from their valuation provider that brings down the fair market value of their stock below the exercise price. Option holders suddenly owe more to exercise outstanding shares than the stock is worth. In essence, the outstanding options provide no value or benefit to the holder until the 409A valuation price moves back above the exercise price.
What Drives the Lower 409A Valuation?
While lower 409A valuations may be caused by a decline in company growth or revenue, they tend to become more common during periods of economic volatility. During the dot com bubble, 2008 financial crisis and 2020 pandemic, numerous companies experienced valuation declines that lowered the value of their stock. In some cases, the companies themselves were experiencing the impact of a downturn in the market while other companies were de-valued based on poor stock market performance.
When a company’s 409A value goes down and more equity holders are faced with holding underwater options, pressure may start to build for leadership to address the issue. This is particularly true if there is a subset of shareholders that wish to sell some of their equity through a liquidity event, or option holders that want to exercise expiring options.
Implementing a Repricing
If a company wants to bring its underwater stock options back to the surface, there are a few approaches it can take:
- Repricing the Underwater Options – A company can cancel outstanding underwater options and reissue them at the new fair market value (FMV) calculated in the latest 409A valuation. The company can choose to keep the details of grant - award type, number of shares, vesting schedule, expiration date, etc. – the same, or change them.
- Benefits: Employees receive grants at a lower strike price meaning that, if the valuation goes back up, they have greater upside. This approach may or may not require additional work or consent on the part of employees, depending on legal requirements.
- Considerations: Companies will want to consider the long-term view and whether the 409A valuation may get lowered again in the future. If that’s the case, a company may consider repricing those options again.
- Switching Options for Restricted Stock Awards (“RSAs”) – An alternative to repricing options is to exchange them for RSAs of the same or lesser value. With RSAs, recipients own the stock immediately, but typically must wait until completion of the vesting period to actually receive them (upon which they will be taxed).
- Benefits: RSAs have no exercise requirements, meaning they cannot be underwater even if the company’s 409A valuation drops again.
- Considerations: RSAs aren’t considered incentive-based equity meaning that, as long an employee stays with the company until the vesting date and meets any other vesting requirements, they will receive their shares. This may or may not align with the goals and incentives of a company’s equity plan.
- Issuing Additional Options – Companies can also simply issue more options to employees with underwater stock, to make up for the value that was lost.
- Benefits: Employees are “made whole” in their compensation and may appreciate the showing of commitment from the company.
- Considerations: Issuing additional options can dilute the equity pool, which can impact all current and future shareholders.
Waiting to Reprice
Of course, an alternative to repricing is for a company to simply wait to see if the 409A valuation price goes back above the exercise price of outstanding options. This strategy may make sense if a company believes that impact to their valuation is temporary or not reflective of the actual long-term value of their stock.
For companies who are not considering repricing, it’s important to weigh the pros and cons from the perspective of its option holders. Employees may become frustrated or feel differently about their equity if it no longer signals upside to them. Furthermore, option holders that must exercise their options while the strike price remains higher than the current FMV, may be doing so at a loss or be forced to abandon their shares by never exercising them.
Finally, it’s important to remember that while a company may not decide to reprice outstanding options, it can still be required to issue any new incentive-based stock options at the new 409A valuation price. While this can be a helpful recruitment tool, as new employees are receiving stock at a lower valuation, keep in mind that existing option holders may not appreciate having option grants at a higher strike price than their colleagues.
Conducting a repricing can impact a company’s capitalization table and equity plan. It’s important for companies to carefully think through the pros and cons and follow a course of action that meets the needs of both the business and its equity holders.
As you navigate option repricing and other equity-related issues, Morgan Stanley at Work is here for support. Our dedicated team of professionals and our technology have helped thousands of private companies simplify equity administration and get the most out of their equity. Request a demo to discover the benefits of the Shareworks platform.