In periods of volatility, companies might consider repricing underwater stock options to preserve the incentive value of outstanding equity. A repricing can affect a company’s equity compensation plan; therefore, understanding both the mechanics and potential impacts can be a critical first step.
In this article, we'll walk through what companies might consider before conducting an option repricing.
Why do Companies Reprice Stock Options?
Options can be a valuable equity-based incentive and form of compensation for a privately-held company. However, when a private company receives a lower 409A valuation - due to financial performance or market volatility - its outstanding stock options may become "underwater." Options are considered underwater when the fair market value of a company's stock price drops below the exercise (“strike”) price of the outstanding option. Underwater options can be problematic to a company and its shareholders for two reasons:
- Holders of underwater stock options may view their outstanding equity as "worthless" since they now owe more money to exercise those options than they are worth. Essentially, the incentive value of those outstanding options is gone until the exercise price is back below the fair market value price (“in the money”).
- Meanwhile, newly-granted options are typically issued at the lower strike price determined by the latest 409A valuation. This dynamic creates inequality across the employee base, as new option holders are (at least temporarily) holding options with greater upside value.
Considerations Before Repricing
Conducting a repricing can potentially mitigate the negative impact underwater stock options can have on the perception of the value of the equity compensation given to employees. However, there are a couple considerations private company leaders should keep in mind:
- Is it better to wait? Suppose the leadership team and board of directors expect the 409A valuation to return to or above the prior level. In that case, they might hold off on repricing existing underwater options to avoid the administrative burden. The merit of this strategy may likely depend on how long it will take for the company's valuation to recover, which is not always easily knowable.
- Is it more beneficial to swap existing options for another type of equity? Some companies will circumvent underwater options by exchanging them for a different kind of equity award of the same or lesser value. For instance, RSAs (Restricted Stock Awards) do not have any exercise costs to the employee but will have preset vesting periods.
The Mechanics of a Repricing
When a company decides to reprice its options, its leadership may need to think through some mechanics. For instance, a repricing can simply be an adjustment to the strike price, or it can include additional changes to the vesting schedule, option expiration date or award type. Another important consideration is whether the repricing will apply to recently laid off employees who are within their post-termination exercise period.
Once a company decides to move forward with a repricing, a board of directors vote of approval is needed. There may also need to be a separate vote by the majority shareholders (even if they are the founders and board members) to finalize the repricing.
Lastly, company leaders may want to consult with their legal counsel on how to engage holders whose options are being repriced. Option holder approval may be required prior to repricing if the terms of the agreement are changing beyond the option strike price. However, even if a repricing can be done unilaterally without option holder consent, additional outreach and disclosure may be required.
Expensing Repriced Options
From a financial accounting perspective, a repricing is not considered a forfeiture; it will be considered a Type 1 (Probable-to-Probable) modification of the award, according to ASC 718; therefore, the original expense attributed to an award must still be recognized in addition to the incremental expense of the replacement award.
The expense for repriced options is determined by taking the difference of the re-calculated fair value of the original award at the time of repricing and the fair value of the new award.
Repricing underwater stock options can help to preserve the incentive value of a company's equity; however, it is a tactic that requires careful planning and consideration. For private company leaders that have not conducted a repricing before, it can be helpful to partner with equity experts to help absorb some of the planning and mechanics involved.