What Can You Do About Underwater Equity Awards?

The markets are down from the start of the year, which means that for many of you, your stock price is down too. Everyone loves the equity program when the stock price is up, but, when the stock price is down, employees start to grumble or—worse—look for other opportunities. As an employer, it can be concerning for a significant component of employee pay to now be worth less than anticipated (or worse, worth nothing).  

In this blog entry I cover some ways to address underwater equity awards.

All Types of Discretionary Equity Awards Are Affected

Historically, the term “underwater” has referred to a stock option with an exercise price that is higher than the current stock price. Although underwater options often still have some time value—unless they are expiring in the near future, there is a chance the stock price will recover and they’ll be valuable again—but they don’t have any intrinsic value. This causes their perceived value among employees to plummet as well.

Full value equity awards can also be underwater. Most companies use a value-based approach to size grants and communicate that value to employees—e.g., an employee might be promised a grant worth $10,000. If the stock price has declined since grant and the award is now worth only $6,000, the employee may feel cheated. This can negatively affect how employees view the equity program.

Ditto for performance awards. If the target award is now worth less than what was communicated at grant, employees may feel a lot less incentive to accomplish the performance goals.

Approach #1: Wait It Out

My favorite approach is to give the stock price some time to recover (or to continue its decline). Oftentimes, companies feel pressure to respond immediately to the first price drop. But, in many cases, they would be better off waiting.

In early 2020, the market took a sudden dive and some companies rushed to reprice outstanding stock options or issue new grants. Only a few months later the market had largely recovered, making the expense resulting from these actions largely unnecessary.

When the housing market crashed in 2007, dragging the stock market down with it, we also saw some very early repricings. Unfortunately, the market continued to decline and the repriced options were back underwater just six months later.

Be wary of making a rash decision that could be very costly to the company. Waiting until the markets have stabilized can help mitigate the risks involved in any action that the company decides to take. In a tight job market, however, this approach increases the risk that employees will leave for other opportunities.

Approach #2: Issue Additional Grants

If the company has sufficient shares available in its plan reserve, the most straightforward action to take is to issue additional grants to employees. There is no complicated regulatory compliance required for this approach, it isn’t a modification of existing equity awards, and it doesn’t require shareholder approval. It also works for both stock options and full value awards.  

But most straightforward doesn’t mean that this is the least costly approach. The new grants will result in additional expense; increase plan overhang, burn rate, and dilution; and draw down the plan reserve (the lower stock price will amplify this effect).

This can be a perfect storm of adverse consequences: depleting the plan reserve could mean the company needs to request a new allocation of shares to the plan sooner than expected; the increased burn rate and dilution may cause shareholders to view the share request less favorably; and the added expense will negatively affect the company’s financial performance at time when shareholders already are unhappy with that performance.

Approach #3: Exchange Underwater Options for New Grants

For stock options, one alternative is to cancel the underwater options in exchange for new grants. This is considerably more complicated than simply issuing new grants, but it can be more cost effective because the cancelled options will offset some or most of the expense for the new grants.

For NYSE and Nasdaq-listed companies, all option exchanges require shareholder approval unless expressly allowed under the plan (which is rare). Many companies will need to structure the exchange in a manner that secures a favorable recommendation from ISS and other proxy advisors. ISS’s US Proxy Voting Guidelines explain how they evaluate repricing proposals (see pg 50). Each proposal is evaluated on a case-by-case basis taking the following factors into consideration:

• Does it seem likely that the options will be back in-the-money in the near term?
• Was the price decline due to factors outside the control of management?
• Is the exchange on a value-for-value basis (see below)?
• Will the shares underlying cancelled/exchanged options be added back to the plan reserve?
• Has the stock price been down for at least a year?
• Are the key terms of the new grants the same or less favorable than the exchanged grants? ISS specifically wants the new grants to be premium priced, to not be immediately exercisable, and to not have a term that is longer than that of the original options.
• Are officers and directors excluded?

Even if the repricing is not subject to shareholder approval, companies may want to structure the exchange in a shareholder-friendly manner. Shareholders who are angered by a repricing could express their displeasure by voting against the company’s Say-on-Pay proposal, voting against a future equity plan or request for additional shares, or voting against the directors who serve on the compensation committee.

In many cases, the exchange is also considered a tender offer by the SEC. If so, the company will have to file Schedule TO for the exchange and will have to give option holders a specified period in which to choose whether they want to participate in the exchange. Whether the exchange is a tender offer or not, there will be other required disclosures.

For more information on the accounting treatment of option exchanges, see my blog “ Accounting for Option Repricings.” For a summary of the legal requirements that apply to various types of award modifications, see the NASPP chart “ Award Modifications: Key Considerations.”

There are three types of option exchanges, which I describe below.

Straight Repricing

In this exchange, the underwater option is simply amended to reduce the exercise price or it is cancelled and replaced with a new option for the same number of shares but with a lower price. This is the most costly of the three exchanges.

If the only change is to reduce the exercise price, this exchange is not considered a tender offer. Employees may be asked to accept delayed or restarted vesting, agree to a period of inexercisability, or forgo other award features in exchange for the lower price. Where employees are giving up any rights, the exchange will likely be considered a tender offer.

Value-for-Value Option Exchange

In this exchange, the underwater option is cancelled, and the employee receives a new grant for a reduced number of shares that is roughly equal in fair value to the underwater option. This allows the fair value of the cancelled options to partially or entirely offset the fair value of the new grants, reducing or eliminating the incremental cost of the exchange.

This transaction is likely to be considered a tender offer by the SEC.

Companies typically require employees to agree to delayed or restarted vesting to participate and/or prohibit exercises for a period after the exchange.

Options for Full Value Awards

This is a form of value-for-value exchange in which the employees relinquish their underwater options and receive full value awards (usually RSUs) that are roughly equivalent in fair value to the options. Here again, the fair value of the cancelled options partially or entirely offsets the fair value of the new grants, reducing or eliminating the incremental cost of the exchange.

As with the value-for-value option exchange, this transaction is likely to be considered a tender offer by the SEC and companies typically require employees to agree to delayed or restarted vesting to participate.

Approach #4: Make a Cash Offer

Another possible solution is to provide a cash payment to employees, either in addition to or in exchange for their equity awards. Obviously, this approach requires the company to be in a position to afford the cash outflow and related P&L expense, which may not be the case during periods of economic volatility.

The NYSE and Nasdaq generally to not require companies to seek shareholder approval for exchanges of equity awards (including stock options) for cash, even if not expressly permitted under the terms of the plan. But the plan itself may require shareholder approval of this transaction. ISS considers an exchange of underwater stock options for cash to be a repricing and will usually issue an unfavorable recommendation on plans that allow this transaction without shareholder approval.

An exchange of equity awards for cash is likely to be considered a tender offer under the SEC’s rules.

Approach #5: Lean on Your ESPP (or Implement One)

You know what type of equity vehicle isn’t ever underwater? ESPPs! Whether the ESPP has a lookback or not, the discounted price ensures that employees are always purchasing at a gain, even when the stock price is down. When the value of discretionary equity awards is declining, focusing on your ESPP can alleviate some of the pressure to address underwater awards.

If you already have an ESPP, consider enhancing the plan to make it more compelling to employees. Explore ways to remove barriers–economic or perceived–that prevent employees from participating in the plan. This may mean offering alternative purchase financing to employees, converting to a nonqualified plan with a match, allowing fractional share purchases, upgrading your participant communications, or looking for other ways to enhance the plan.

If you don’t have an ESPP, a period when your stock price is down might be a great time to implement one. There’s a reason companies that are going public often push to launch an ESPP with the IPO—they want to lock in the IPO price for future purchases. An ESPP implemented while your stock price is in a slump could offer the same benefit.