How to Handle Underwater Options
What alternatives make the most sense?
In a bear market such as experienced of late, the performance of a stock can drop to the point that t he exercise price of an employee stock option is greater than the fair market value of the company's stock. As a result, the company loses the intended motivation factor in granting these options, and shareholders are diluted with stock not working in their behalf. This is the situation faced by a large number of companies today, and there are multiple approaches to alleviate and avoid this problem.
Although the most commonly used method is re-pricing, shareholders typically react negatively to firms that simply re-price the employee options by canceling the underwater options to re-issue at the current market price. Additionally, current accounting rules (Interpretation 44) require an open-ended charge to earnings for companies who cancel options and then re-issue within six months and one day of the cancellation.
L&A has recommended several alternatives to companies facing underwater options, as well as methods to avoid such a situation. Companies need to keep away from re-pricing the underwater options and yet maintain the motivation factor that long-term incentives provide for the employees. Therefore, the company can offer a variety of alternatives, including:
- Acceleration of new stock option grants
- Acceleration of new restricted stock awards
- Acceleration of vesting schedules
- Paste Grants
- Cancel outstanding options and delay
new awards for
six months and one day - Option cancellation in exchange for restricted stock awards
To help avoid the situation of underwater options, a company should consider diversifying the exercise prices of the options by increasing the frequency of the grants. By dividing the annual grants into four equal quarterly grants, the company can reduce the risk of granting stock options on extreme highs and low days in the stock fluctuation.