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Help! Our stock options are underwater – Part 1 of a new series

Mar 12, 2009

Stock options have been around as a tool for rewarding employees, particularly executives, for many years. One can argue why they are an appropriate form of compensation, or conversely, why they are not. The 1990s saw an unprecedented use of stock options as a sometimes primary means of compensating employees. As the stock market ran upwards, options were all the rage in Silicon Valley and were quite popular in other parts of the country.

While this phenomenon produced significant amounts of wealth in that decade, stock performance generally has not been as positive in this one. In fact, employees whose compensation is heavily weighted to stock options are feeling underpaid. Why? Generally  those options are now “underwater.” Or, in plain English, for most of those stock options, if an employee were to exercise them, he would lose money.

One of the arguments in favor of compensating employees, and especially executives, with stock-based compensation such as options is that this aligns employee behavior with shareholder interests. That is, if the value of company stock goes up, both shareholders and employees who hold options are winners. However, when the value of company stock goes down, while shareholders are certainly losers, one could argue that since the employees have lost nothing, the alignment of interests has ceased to exist.

In this series, we will explore the issues with underwater options, looking at the good, the bad and the ugly. But, before we get too far into any of that, it is worth a refresher on stock options. What are they? How do they work? How much are they worth and how do we know this? In this article, we’ll try to answer those questions and a few more.

Types of employee stock options

In its most basic form, an option that is granted to an employee gives him the right to purchase a stipulated quantity of shares of company stock at some point in the future (or perhaps over a period of time) at a specified price (without regard to the actual fair market value of the stock). That price is often known as the strike price or exercise price. Sometimes the strike price is set lower than the market price of the stock on the day that the option is granted. Such an option is known as a discounted option.

Employee stock options might fall into four broad categories:

employee stock purchase plans (ESPPs or 423 plans)

nonqualified employee stock purchase plans (non-ESPPs or non-423 plans)

incentive stock options

nonqualified stock options

ESPPs are described in Code section 423, thus one of their alternate names. In a nutshell, options are granted to a broad group of employees. These options may carry with them as much as a 15% discount (there are some quirks in the rules that allow the discount to be based on any of a few prices). Options under a 423 plan are limited to $25,000 per year. Typically, these options are purchased through a payroll deduction arrangement where employees have their compensation reduced (after-tax money) by an amount which will be used to purchase shares of company stock on the exercise date (often three or six months out). ESPPs are eligible for favorable tax treatment for the employee if they meet certain criteria, and favorable accounting treatment for the employer if they meet certain other criteria. We’ll address those treatments in a future article.

Non-ESPPs are similar to ESPPs, but they differ not surprisingly in that they fail to meet at least one of the criteria required of ESPPs. For example, they might not be offered to a broad enough group of employees, or the discount on the options may be too steep. Non-ESPPs do not provide the same favorable tax treatment for employees. Similarly, they may not provide the same favorable accounting treatment for employers.

Incentive (or qualified) stock options (ISOs) are described in Code section 422. There are two key characteristics (ISOs have other requirements, but we will limit to these two in this article) in order for these options to be classified as ISOs:

Grants that are first exercisable by any individual during any calendar year are limited to $100,000 per person.

The options are not discounted.

ISOs generally are eligible for favorable accounting treatment for the issuing employer and for favorable tax treatment for the employees who receive the grants (again, we will discuss tax and accounting treatment in later articles).

All other employee stock option plans are nonqualified options. In general, these have the least favorable tax treatment for employees and the least favorable accounting treatment for employers. However, while heavily discounted options are far less prevalent now than they once were, employees who benefit from heavily discounted options will appreciate the high income potential and are therefore less concerned that they will be taxed at ordinary income tax rates.

Underwater options

When the current market value of a share is less than the strike price, the option is said to be underwater, or “out of the money.” As is common during a bear market, a significant portion of all employee stock options currently are underwater. This creates several issues that we will discuss in future articles.  Among them are:

To the extent that the options are a significant part of the employee rewards package, the value of that package may be significantly depleted.

The mismatch between market price and strike price may create a misalignment of employee behaviors with shareholder goals.

A way to realign those employee behaviors with shareholder goals may be to “reprice” the options so that they are at or near the money.

Next month, we’ll explore some of them.