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Our stock options are underwater, we might re-price them – Part 2 of a series

Apr 14, 2009

Last month, we started this series with a refresher on the basics of stock options. We wrote some about the current phenomenon of “underwater” options, those that have no current value because the stock price is less than the strike price. In this article, we discuss the more philosophical pros and cons of re-pricing these underwater options, and to the extent that there is some sort of exchange, what techniques are available for determining the exchange methodology.

The value proposition

In order to explore what we are referring to as the value proposition, we need to consider what that is. For purposes of this article, we think that companies that provide stock options are trying to achieve two key goals – to make employee compensation competitive in the marketplace and to align employee behavior with shareholder goals. When options are underwater, balancing these elements can be tricky. To understand why, let’s consider an example.

First, consider an employee who had base pay in 2008 of $150,000 and additionally was granted 5,000 options to purchase shares of company stock at $50 per share (“at the money,” meaning the strike price was equal to market value at date of grant). Assume for the sake of this example that the value at grant date of those options (based on the terms of the grant) was $40,000. So, the total compensation for this employee for 2008 was slotted at $190,000. If we go one more step and assume that the current price of the stock is $25, then the current value of those 2008 options has fallen to nearly zero. Thus, our hypothetical employee is feeling undercompensated for 2008. (For purposes of this discussion, it doesn’t matter to him that he may have been overcompensated in other years.) If the options were re-priced down to $25, the employee would feel better compensated.

Working with the same example, compare the employee behavior to shareholder goals. Obviously, shareholders want the stock price to increase. But, since the employee needs the share price to exceed $50 for his options to have any worth, might he be motivated to take significant on-the-job risks (that could lower share price) for the chance to increase it significantly? Here, we would conclude that employee behaviors are not necessarily aligned with shareholder interests. On the other hand, if the options were re-priced to $25, behaviors and interests would be aligned, but we would have a different mismatch. The shareholder has already lost $25 per share – that’s real money – while the employee gets a fresh start.

The key appears to be to reach some sort of happy medium. Let’s consider some of the mechanisms that are available.

One-for-one exchanges

This was the old way of re-pricing options, and in the last significant market downturn (2001-2002 roughly), this method was common. Referring back to our earlier example, we can consider the mechanics of the transaction. Most typically, the original options were cancelled and replaced with new options with a more favorable strike price. In some cases, the original options were simply amended to have that new strike price.

Other than optics, what put an end to this practice? There were two key changes. In 2003, the major US stock markets (NYSE and NASDAQ) instituted a new requirement whereby shareholder approval must be granted for such a re-pricing. And, just the next year, as the Financial Accounting Standards Board revised FAS 123 to become FAS123(R), the accounting cost for such a re-pricing was often prohibitive.

Value-for-value exchanges

This is probably a misnomer in the current economy since too many options have a Black-Scholes value  (the most common valuation method in this type of exchange)  that is so close to zero as to be immaterial.  However, in a value-for-value exchange, the idea is that the option holders cancel the underwater options for a re-grant of new options at some reduced ratio intended to have equal current value. So, if each of the 5,000 options in our example had a value of $1, the re-grant might allow for 1,000 options under terms (i.e., a higher strike price) that would produce a value of $5 for each option.

If we buy into the theory, however, value-for-value exchanges generally are more palatable to shareholders. There is less dilution to shareholders because a smaller number of shares are being reallocated. And, if the exchange is truly value-for-value, the FAS 123(R) expense impact is zero. Finally, employee behaviors and shareholder interests are better aligned.

Exchanges for restricted stock units (RSUs)

This is a subset of the value-for-value exchange where options are cancelled and replaced with a much smaller number of RSUs or phantom shares. Again, since the value being exchanged is (nearly) equal for the options canceled and the RSUs granted, shareholders have less difficulty with this exchange. However, there is no purchase or strike price for an RSU – the employee ultimately gets some value unless the company goes bankrupt or the RSUs do not vest.

A positive side of this transaction may be that employee behavior becomes inextricably tied to shareholder interests. For each increase in share price of $1, the value of an RSU increases by $1. A negative is that the employee has been offered the opportunity to exchange an option that likely had no ultimate value for an RSU which necessarily does.

Exchanges for cash

This is the latest arrival in the group of exchange mechanisms. The math is simple (Black-Scholes calculators are readily available on the Internet). Determine the total current Black-Scholes value of the underwater options. Cancel them and exchange them for cash. There is no dilutive effect on the balance sheet. The overhang (options outstanding divided by shares outstanding) is reduced. Analysts generally view this as beneficial to the capital structure of any company. Companies need to take care in such a transaction that they do not exchange non-vested options for cash.

Next month

Next month, we will delve into some of the compliance issues related to re-pricing options. Some of the issues that we will address include accounting treatment, tax treatment, 409A issues, and SEC considerations.