Repricing stock options implies changing the price of stock options when the market value of stocks falls below the initial grant price. The purpose of this is to give room for the employees to exercise underwater options at the new grant price.
What is repricing of stock options?
Repricing of stock options is a strategy of a company to replace the worthless stock options that employees hold with new ones. Through this strategy, companies deal with underwater stock options. Underwater stock options refer to the options whose exercise price is greater than the fair market value of the underlying stock.
If for example, the initial exercise price also known as the grant price was $37 but market volatility then brought about a drop in the market value of the company’s stocks to $18, then the company may reprice its stock options to a new exercise price of $18. Here, employees are allowed to exercise their initial options at this new exercise or grant price. Although the repricing of stock options is legal, investors may not like it.
During the internet bubble burst in 2000 and during the economic crisis in 2008, repricing stock options became popular. Traditionally, many companies are reliant on stock options to attract and retain their valued employees as well as to incentivize them.
Repricing stock options enable companies to retain those employees during the economic crisis by taking back the stocks that are worthless and issuing new ones that have intrinsic value.
During the economic crisis, the strategy of repricing stock options becomes necessary as the price of the stocks faces a sharp decline thereby making employee stock options to become worthless. Otherwise, the employees may take up new employment with another company. In such cases, the companies always pull their incentive programs sharply and grant restricted stocks instead of stock options.
Others may issue stocks that are convertible into shares immediately avoiding any risks in the future. A company’s board of directors has the authority to make decisions with regard to repricing stock options as it is a matter of corporate governance. Repricing stock options has a direct effect on existing shareholders and it brings about an increase in the option expenses which must be deducted from net income.
The strike price of stocks that are newly issued must be based on the current fair market value of the underlying stocks to avoid tax consequences to the employee recipient. According to the rules of FASB (Financial Accounting Standard Board), if the issuance of stocks takes place six months after the cancelation of existing stock, it is not repricing.
Companies may avoid variable accounting treatment by going by this. In such instances, the company assures the employees that they will be granted new stocks after that period of time. Also, the company may swap worthless stocks of employees with restricted stocks. The makeup grant is another approach to dealing with this issue. Here, the company keeps the original options in place and issues additional stock options for employees.
This tactic places existing shareholders at risk of additional dilution. If a future hike in the price of stocks puts the original underwater stocks back in money, then that would bring about a further dilution of existing shareholders. There is a need for a company’s management to make the decision of opting for any of these approaches with utmost care and caution to avoid any further risk.
Repricing stock options tax implications
There are bound to be tax implications if the options that the company reprices are incentive stock options (ISOs). One of the requirements for an ISO is that no value more than $100,000 can first vest in a single year. If more vests, the option can either make provision for deferral of vesting or the additional amount can be non-statutory options.
In a repricing or an ISO-for-ISO exchange, the rules for ISO take the position that the vesting of both ISOs counts toward the $100,000 annual limit. In other words, if during the repricing or exchange year, the old options had already vested before the repricing or exchange, and the new options also vest in part that same year, the aggregate value of the vested ISOs cannot exceed $100,000.
For example, a participant had an option where a portion with a value that has been determined at the time of the grant of the option of $80,000 vested on February 4, then on May 10. If the option was repriced and the participant vested in $30,000 worth of options in that same year, under the rules of ISO, $110,000 worth of options would have vested and $10,000 could not be ISOs. This, basically is a math problem that is avoidable with careful planning.
Back to the tax implications, stock options can either be ISOs or non-qualified stock options (NSOs) for federal tax purposes. Tax law limits the aggregate value of ISOs which may first become exercisable in a single calendar year to $100,000. When repricing takes place on incentive stock options, both the original grant and repriced grant count towards the $100,000 limit. This means that any portion of the repriced grant that exceeds the $100,000 limit will automatically be taxed as a nonstatutory stock option.
Under the federal income tax law, an incentive stock option that is repriced will begin a new holding period, commencing with the grant date of the repriced option. That has to be satisfied to receive the federal income tax advantages potentially available to incentive stock options.
If the stock purchased upon exercise of a repriced ISO is held beyond two years from the grant date of the repriced option and beyond one year from the date of exercise, then the entire gain or spread between the exercise price and the sales price will be treated for the purposes of federal income tax as a long-term capital gain at the time of disposition of such stock. If the requirement of two-year and one-year holding periods are not met, then a disqualifying disposition will have taken place and the spread on the exercise date will be taxed as an ordinary income.
Under the current tax law, capital gain treatment will bring about a benefit to many taxpayers since the maximum tax rate on long-term capital gain is less than the maximum tax rate on ordinary income.
See also: Early Exercise of Stock Options
Repricing stock options accounting
Accounting considerations are significant when it comes to structuring a repricing. Prior to the adoption of ASC 718 in 2005, companies usually structured repricing with a six-month interval between the cancellation of underwater options and the grant of replacement options. The aim of this structure was to avoid the impact of mark-to-market charges. However, under ASC 718, the charge for a new option is not only fixed upfront but it is for only the incremental value if any, of the new options over the options that have been canceled.
Since the advent of accounting standard FAS 123R, repricing stock options will no longer have a significant detrimental impact on the earnings of the company. The increase in the value of the repriced option is charged to earnings over the remaining period of vesting or immediately if the option is fully vested.
If a company grants additional awards without canceling outstanding options, then the fair value of the new awards is charged to earnings over the vesting period, as opposed to the incremental value compared to the underwater options. The underwater options’ original fair value will continue to be expensed unless they had already been fully expensed.
In a situation of an exchange offer, both the original fair value of the underwater stock options and the new awards’ incremental value are required to be expensed. However, companies that wish to avoid additional accounting charges may devise a value-for-value exchange such that the value of the replacement awards will be equal to the value of the options surrendered. Several factors come into play in crafting a value-for-value exchange. These factors include reducing the size of the award, extending the vesting period, and reducing the life of the award. Additionally, if a new award has a longer vesting period, the expense may be recognized over either the original grant’s remaining vesting period or the new award’s vesting period, at the company’s option.
See also: Stock Options Vesting Schedule
Stock option repricing considerations
- Exchange ratio
- Option eligibility
- New vesting periods
- Corporate governance issues
The above-listed are the factors to be considered in repricing stock options. They are explained below.
The exchange ratio for the exchange of an option represents the number of options that has to be tendered in exchange for one new option or the other security. This has to be set appropriately to encourage employees to participate and satisfy shareholders. In order for repricing stock options to be neutral in value, there will usually be a number of exchange ratios and each of them addressing a different range of the exercise price of options.
It is necessary for the company to determine whether all underwater options or only those that are significantly underwater or granted before a certain date are eligible to be exchanged. This will be dependent on the perceptions of shareholders and proxy advisor guidelines. It will also depend on the volatility of the company’s stock and the company’s expectation of future increases in the price of shares.
New vesting periods
A company that is issuing new options in exchange for underwater options must determine whether to grant the new options on the basis of a new schedule, the old vesting schedule, or a schedule that makes provision for other vesting mechanics between these two alternatives. In this regard, practices quite vary although a new vesting schedule is most common to gather shareholder support.