Bringing Underwater Stock Options Back to the Surface some legalize on the subject:
Underwater stock options may create
multiple problems for companies. For example,
underwater stock options may not provide a
meaningful retention tool or performance
incentive for employees, as the value of the
underlying stock may have to substantially
increase before the stock options are “in the
money.” In addition, allowing unvested underwater
stock options to remain outstanding is a
poor use of a company’s resources, as the
company must continue to recognize an
accounting charge for stock options that likely
provide no value to the company.
Historically, one solution that was widely used
to deal with the problems caused by underwater
stock options was to “reprice” the stock
options. Repricing simply involves lowering the
exercise price of the stock option, generally to
equal the current fair market value of the
underlying stock. However, because of changes
to accounting and stock exchanges rules as well
as increased scrutiny from proxy advisory firms,
repricing underwater stock options is no longer
a viable alternative for most public companies.
Instead, many companies are now offering their
employees the chance to exchange their
underwater stock options for other forms of
consideration, such as new stock options,
restricted stock, restricted stock units
(“RSUs”), or cash.
This update briefly describes underwater stock
option exchanges as well as some of the
hurdles that companies will face in implementing
these exchanges.
Option-for-Option Exchanges
In an option-for-option exchange, an option
holder will surrender his or her underwater
stock options in exchange for new stock
options. If this exchange is structured as a
value-for-value exchange (i.e., an 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 less stock options than he or she
surrendered. Some surveys have shown that the
exchange ratio in a value-for-value stock option
exchange may be as high as 1:5 (that is, one
new stock option is issued for every five stock
options that are surrendered). Because the net
result of such an exchange is a reduction in the
number of outstanding stock options, the
exchange will have the effect of improving the
company’s stock option “overhang”—a measurement
used to determine the dilutive effect of
stock options that is calculated by expressing
the sum of the number of stock options granted
and the number of stock options available for future
grant as a percentage of total outstanding shares.