We have seen more volatility in the market during this pandemic than at any time since the Great Recession, with many share prices being adversely affected. This has created a situation in which many companies and employees are grappling with the reality of underwater stock options – options where the initial strike price exceeds the current market value.
What that basically means is that 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 are many possible courses of action, but no one-size-fits-all solution. Each company has its own unique set of circumstances and any proposed course of action needs to cater to those individual needs and objectives.
That said, the two most common approaches are to reprice or exchange underwater options.
Reprice underwater options
The market always has a potential to be volatile and see upswings and downswings - something you need to be ready for (Picture Source)
Under this approach, the company effectively replaces the underwater options with new options, with the exercise price set to the current market value. There are upsides and potential downsides attached to this solution.
- Formal option holder consent will most likely not be needed, assuming no other terms are modified. From there, it follows that no formal tender offer will be necessary.
- It is a relatively simple measure and as such is easy to explain to employees.
- Employees should be happy as management will have acted to address the issue. This will lead to better morale and generate positive feeling towards the company.
- Ordinary investors may become unhappy if they perceive that employees have been treated more favourably than them. Most businesses will be aware of this potential downside, and might move to ease such concerns by making other changes, such as to the vesting procedure and expiration date – the how and when of eventually exercising the options.
- It is possible that the new awards themselves may become underwater. In a volatile market, this cannot be ruled out.
- Pursuing this option brings with it the obligation to make additional financial statement disclosures.
Exchange underwater options
With this option, employees can exchange their underwater options for restricted stock units (RSUs). Here, the underwater options are cancelled and the employee then receives new shares of restricted stock, with the number of new shares usually less than the number that has been cancelled. As with the above, this option has advantages and disadvantages.
- The risk of falling underwater in the future is removed.
- With less equity in circulation, there is reduced overhang.
- There are more shares on-hand for future issuance.
- This approach usually requires a tender offer and the consent of option holders. With the exchange, participants are being asked to make an investment decision and so the “tender offer” is necessary for them to formally choose the RSUs over the initial options.
- Employees lose control over the timing of a taxable event.Employees lose control over the timing of a taxable event. Basically, when you swap options for RSUs, they can be taxed in line with ordinary income tax - whereas with ordinary shares there are potential tax breaks (such as capital gains) when vesting.
- It may be difficult to explain to employees why this solution sees them end up with fewer shares than previously.
While the above are two of the most popular approaches to addressing underwater stock options, companies can also pursue other courses of action.
Under an options-for-cash approach, options are cancelled in exchange for a cash payment. This eliminates any future concerns around those options being underwater and maximises the overhang reduction, but it also demands a cash outlay from the company and employees will be liable for tax on receipt of that payment.
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. An upside of this approach is that it ensures that investors won’t feel disadvantaged compared to employees, but it also means that new employees will end up getting a better initial deal than those who have been with the company for some time, which is not ideal.
It's also worth remembering that a certain measure of volatility comes with the territory. 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.
So, 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.