Underwater? Private Company Stock Option Repricing Basics

In a volatile market, companies may see their stock value drop significantly. This can result in employees and other service providers holding stock options that are “underwater” or “out of the money” – in other words, options with exercise prices that are higher than the current fair market value of the underlying stock. Because equity packages often make up a substantial portion of private company employees’ compensation packages, team members holding underwater options may feel that they are being undercompensated and become less motivated, or even consider moving to another company (where they can be granted new options that are not underwater), and newer employees can end up holding options with lower exercise prices than longer-tenured employees. Because of these concerns, you might consider whether reducing the option exercise price on outstanding awards to the current fair market value – a move popularly known as “option repricing” – is needed or desirable to retain and motivate holders of underwater options.  

This article summarizes some of the business considerations to think through when evaluating whether a repricing is right for your company, possible option repricing approaches, and the key legal, tax and governance matters for companies to contemplate when reducing stock option exercise prices for their US-facing equity recipients.  

Is a repricing the right approach for your company? 

While lowering the exercise price of existing options can potentially help retain and motivate existing employees as discussed above, you will need to think carefully about whether it is in the best interests of your company and its stockholders as a whole. Below are some key topics to keep in mind when weighing a repricing. 

• Lowering the exercise price of options means that, all else being equal, a higher amount of proceeds in a future sale of the company will go to the repriced option holders, and a correspondingly lower amount of proceeds will go to other equity holders (including founders and investors). You will need to consider whether the repricing will create enough overall benefits for the company and its stockholders to justify this transfer of value. 
• The repricing may signal to employees that the company is in trouble, which could affect morale and retention, possibly undoing some of the positive effects of a repricing. 
• The repricing also may signal to potential investors that the company is in trouble, which may affect fundraising efforts. 
• If the company’s valuation may still decline, are you potentially setting yourself up for a series of repricings? 
• How “underwater” are the options? If the exercise price is still close to the fair market value, you might prefer to continue to grant options at the prior fair market value, rather than going through with a repricing. 

What are the terms of the repricing? 

If you decide to proceed with a repricing, the next step is to consider whether to simply reduce the exercise price of the options or to modify other terms. Both of these approaches are discussed below. 

‘Simple’ option repricing 

The simplest approach to repricing options is to notify the impacted holders that the option exercise price has been reduced to current fair market value of the company’s common stock. Under a simple option repricing approach, all other provisions of the repriced options – including the existing vesting schedule and number of shares subject to the option – remain unchanged. Because reducing the exercise price is a favorable change to the underwater option, often no consent from the holders of the repriced underwater options is required, although this depends on the terms of the company’s equity incentive plan. 

Option repricing with modification 

Companies also may combine the repricing with other modifications to the option terms. For example, companies may ask holders to agree to extend or restart their award vesting schedule or reduce the number of shares subject to the option, in exchange for the benefit of a new lower exercise price. This type of repricing typically requires the holders of repricing-eligible options to agree to such changes because they are giving up some rights under their existing option awards. As discussed below, this also may require compliance with “tender offer” rules under US securities law. Because this type of option repricing is characterized as a new grant from a US income tax perspective, the repricing modifications can include an extension of the expiration date of the repriced options. 

Which options are being repriced? 

Eligible participants 

In any option repricing program, you will need to determine which option holders are eligible to participate. The participant scope can be as selective or broad as desired, subject to any limitations imposed by the company’s equity incentive plan and applicable employment, tax and securities laws. In particular: 

• Non-US optionees: Any option repricing program that includes options held by non-US service providers must take into account the local laws in which the non-US service providers are located (including tax, securities, exchange control and employment law). A company considering including non-US optionees in an option repricing program should consult local counsel to determine any local law requirements related to the option repricing. 
• Former service providers: Former (potentially including furloughed) service providers who hold underwater options may not be able to participate in option repricing due to tax and US securities law complications – and because the terms of most US-facing equity incentive plans don’t allow this. 
• Nonexempt employees: Options that are exercisable by “nonexempt” employees – i.e., those subject to US state wage overtime rules – within six months after the date of grant may impact the calculation of overtime wages. The exercise terms of the repriced options held by nonexempt employees may need to be structured to avoid this pitfall. 

Eligible options 

In addition to determining which holders are eligible to participate, you also will need to determine which outstanding options will be repriced. Companies can be as selective or broad as desired in this regard. Some companies include all underwater options, while other companies limit participation by choosing a threshold above the current fair market value of the underlying stock, creating a cut-off point that limits the number of repricing-eligible options. The degree of flexibility may be limited by US tender offer rules or other similar rules in other jurisdictions. 

What are the key legal and governance considerations when repricing options? 

Tax considerations 

While stock option repricing is typically not a taxable event for US taxpayers, the following tax considerations should be evaluated in connection with option repricing: 

• New exercise price must equal or exceed fair market value: In order to comply with Section 409A of the Internal Revenue Code, the new exercise price of any repriced options to US taxpayers must be at least equal to the fair market value of the underlying stock as of the repricing date. While companies generally reprice options to fair market value, a company can set the new exercise price above fair market value without running afoul of Section 409A.    
• Generally no income recognition event, but holding periods for ISOs restart: An option repricing generally does not result in taxable income to option holders, but it may have tax implications for awards intended to qualify as incentive stock options (ISOs) for US tax purposes. Repricing of ISOs is deemed a grant of new ISOs. This means that the regular limit on ISOs ($100,000 per year in which the option first becomes exercisable) must be recalculated, and some holders of repriced options may end up with fewer ISOs and more nonqualified stock options (NSOs) as a result of these recalculations. Also, since the repricing of ISOs is deemed a grant of new ISOs, the ISO holding periods (two years from grant and one year from exercise) will restart from the repricing date. Whether these changes are sufficiently material to require consent or a tender offer should be analyzed under the terms of the plan and applicable securities law. For more detail on ISOs and NSOs, see this Cooley GO article. 

Securities law matters 

Because an option repricing is considered the grant of a new award and an offer to reprice may require participant consent, the following US securities law considerations may apply: 

• “Tender offer” rules: An option repricing where other terms are modified may require compliance with tender offer rules under US securities law, which are triggered because the holders of repricing-eligible options are making an investment decision over whether to accept the proposed terms of the repriced options. To comply with tender offer rules, the company must – among other requirements – provide a written disclosure document to holders of affected options setting forth the details of the repricing, and must hold the offer open to participate in the repricing for 20 business days (note that this period should be no longer than 29 calendar days to comply with applicable ISO rules). 
• Rule 701 issuance limitation: In addition, the repricing of an option is deemed a new grant for purposes of Rule 701 of the Securities Exchange Act of 1934, which means that repriced options (except those granted within the 12-month period as of the date of the repricing) will count against the $10 million limitation under Rule 701; once that threshold is exceeded, the company will need to comply with additional disclosure requirements. 

Accounting matters 

An option repricing program will often have accounting consequences for financial statement reporting purposes. Companies should consult with their accountants to confirm the consequences of any option repricing. 

Board and stockholder approval 

Any option repricing program must be approved by the company’s board of directors (or an authorized committee of the board). As noted above, this approval requires a careful consideration of whether a repricing is in the best interests of the company and its stockholders.   Stockholder approval is generally not required for an option repricing program, unless it is required by the terms of the company’s equity incentive plan or other governing documents.   

Option repricing can be tricky and cause unintended consequences, so be sure to consult your legal, tax and accounting advisers if you are considering implementing one.