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 2023. 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.