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Employee Stock Option Value in a Falling Market

Achaessa James

August 2008

(Achaessa James)A roller-coaster stock market with more downs than ups can leave stock options underwater, with exercise prices higher than the stock's current market price, and unless a corporate culture thrives on change and challenge, employees are likely to be depressed, demotivated, and even a little scared. One approach to this situation is option repricing. It's not the right solution for every company, but it is often considered under these circumstances.

Repricing for Employee Options

Although repricing is a logical remedy, it is not without consequences and should never be undertaken without consulting experts in the fields of tax, accounting, securities law, and corporate governance.

Accounting consequences. A plain vanilla employee option is valued at the time it is granted. That fixed value is expensed across the life of the grant. Under FAS 123(R), a repricing is considered a modification. Whatever the actual mechanism used for the repricing, it is treated as the cancellation of the original option and the issuance of a replacement option. However, while the company will recognize some additional expense associated with the repricing, the amount of the expense is fixed upon the repricing date and does not require periodic adjustment. Under FAS 123(R), the original expense for the cancelled option is kept on the books and the company continues to record the remaining estimated expense. The company must also calculate the incremental expense of the replacement option and add that to the original expense.

Tax consequences. The biggest tax consequence of an option repricing falls to the employee holders of statutory stock options, also known as incentive stock options (ISOs). ISOs, regulated under Internal Revenue Code Section 422, receive favorable tax treatment only when they have met certain holding periods. Specifically, an ISO must be held both two years after the date of grant and one year after the date of exercise in order to receive preferential tax treatment. In an option repricing, the grant date is reset to the repricing date, thus extending the post-grant holding period.

Corporate and securities laws. When a stock loses value, there is no recouping that loss except by waiting for the company's fortunes to turn around. Option repricing is often perceived by shareholders as providing economic protection to employees that is not available to holders of already purchased stock.

Shareholder perception is important for two reasons:

Indeed, some states' corporate laws, such as Delaware, require that the repricing be in exchange for "sufficient consideration" so as not to invoke the corporate waste statutes. To avoid this, corporate counsels regularly advise the inclusion of new conditions on the replacement grants as an affirmative defense against such shareholder challenges.

Additionally, for a public company, a repricing may be considered a tender offer under Section 13e-4 of the Securities Exchange Act of 1934. When implementing a tender offer, a company must distribute materials to employees and also file these communications with the Securities and Exchange Commission (SEC); this offer to reprice must be open for 20 days and confirmation of elections will need to be distributed.

Employee Education

Whether or not the company is convinced that repricing is a suitable mechanism, the most important element in the equation is employee education. If an employee feels unheard and unconsidered, the situation can be easily remedied by finding a new job with new options. But human nature demonstrates that when a person feels understood, even an untenable situation can be tolerated for a time. Thus, a company that wishes to retain valuable human assets in a time of economic instability needs to demonstrate that the company:

If the conclusion reached is to reprice options, the conscientious company will also provide employees with sufficient information about how the repricing affects them and their options. This comprehensive communications plan will strengthen your relationship with your company's most valuable asset, your employees.

Conclusion

Since the introduction of FAS 123(R) and the Sarbanes-Oxley Act of 2002, equity compensation administration has become increasingly complex. Current economic turbulence only heightens the complexity as companies search for ways to motivate and retain employees while simultaneously recognizing the losses suffered by their shareholders and moving to prevent further losses.

Equity compensation is serious business and looking to experts for assistance in making hard decisions about equity compensation—like whether to reprice options—is requisite to ensuring compliance on the many levels of governmental and industry regulation.
About the Author

Achaessa James is the product manager-equity services at Corefino, Inc., a provider of outsourced accounting and finance solutions. She is also the recipient of the 2007 Marilyn J. Perkins Claassen Memorial Scholarship awarded by the Certified Equity Professional Institute at Santa Clara University's Leavey School of Business.

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