5 steps to reprice your options after a 409A valuation
The purpose of this article is to discuss the mechanics of repricing stock options.
In privately held companies, stock option plan participants (employees) are typically granted the right to buy shares of the company’s stock at a fixed price after a certain period of time. While the 409A valuation is generally used to better calculate the fair market value (FMV) of common stocks of the company. As such, the strike price of the stock option is determined based on FMV per share of the company on the date of grant. In this regard, repricing is a method by which the value of an option is reset to FMV. The purpose of this article is to discuss the mechanics of repricing stock options.
Repricing stock options and 409A valuation
The concept of repricing stock options is extremely important to privately held companies. An option holder’s rights under the plan are valued based on the value at which the option can be exercised or the strike price. If a company’s stock price were to increase after the options are granted, then it would make sense for the plan to repurchase those options so that they could be re-granted at an exercise price equal to FMV per share of stock.
Unlike public companies, where the strike price is determined by the market forces, the senior management sets the strike price of stock options in a privately held company, usually based on the fair market value of common stocks. In this way, 409A valuation acts as a basis for the strike price on options. Thus, the principle of repricing stock options is to adjust the strike price of stock options to equal the fair market value per share of common stocks of the company.
What are underwater stock options?
Stock options are typically granted with a strike price that is fixed to the FMV of the common stock at the grant date. However, if the strike price is greater than the FMV at the date of grant, then the option is considered underwater. In this situation, the options are very likely to be canceled by the company. As such, an employee may receive new equity compensation from the company with a new grant price that reflects fair market value on the date of the grant.
It is crucial that the repricing of options be done properly in order to ensure that the value of options is still consistent with the stock price of the company. Repricing stock options is typically done in situations when the strike price is more than the market value of the common stock. Companies may choose to repurchase the options in order to adjust the exercise prices of the underlying stock options.
The purpose of repricing stock options after 409A is not to provide a profit opportunity for option holders. Instead, it is used to reset the value of options in accordance with market value on the date of repricing. In order to correctly calculate the FMV per share of the company, 409A valuation is used. As a result, the options’ strike price is then adjusted to reflect the FMV per share of common stock on the date of repricing.
How does repricing stock options work?
In order to keep the worthiness of the stock options consistent with the stock price of the company, the senior management should reprice their option grants whenever the strike price is out-of-line with the market value of the common stock. Essentially, to do repricing, companies need to compare the current FMV and strike price of each option granted. The difference between the strike price and the FMV is the value of re-pricing.
To repurchase options and adjust the stock price, companies need to conduct a 409A valuation for their stock options and adjust the strike prices accordingly. In this way, the company can adjust the strike price to a value that is the same or close to the FMV per share at the time of repricing. Therefore, the mechanism of repricing stock options is basically that the strike price and FMV of the company are compared, and the difference between them is used to repurchase and adjust the exercise prices of options. But why do companies reprice stock options?
Why do companies reprice their stock options?
In general, companies want to maintain the value of their options grants so that when employees exercise their options, they can be granted a strike price that is fair and consistent with the FMV of the company. Let us say, during an economic crisis, the price of the common stock of a company declined significantly.
In order to retain those employees during the economic crisis, they may opt to reprice their options. As such, employees feel that the value of their options is still relevant given the current price of common stock. Hence, employees are motivated to remain with the company, even during tough economic times. In this way, the company can reward employees for their hard work and dedication through the repricing of stock options.
5 steps to reprice your stock options
In the bid to reprice the options and adjust the exercise price, companies need to ensure that the process is done correctly. After all, the process of adjusting an option’s exercise price is crucial to the economic health of a company. Therefore, companies must ensure that the process is done methodically and appropriately in order to maintain their options plan. Following are the steps to reprice stock options:
1. Find out the new FMV (Exercise price) of the options
To find out the new FMV of the options, companies must conduct a 409A valuation of the stock options. As a result, the company can find out the fair market value of its common stock. The FMV per share is then used to determine the new strike price of each option.
2. Methods to reprice your options
While there are two acceptable methods for repricing stock options, companies must decide which is most appropriate for their situation.
- Value-for-value repricing – In the case of underwater stock options, the option holder has the opportunity to cancel the option and receive the new option grant with a new strike price that reflects the fair market value of their stock. As the name suggests, this method works by adjusting the exercise price of the option to equal the FMV of the common stock at the time of repricing. Typically, Black-Scholes or other option pricing methodology can be to value the stock options.
- One-for-one option repricing – This method notes that, in the case of underwater stock options, the strike price will be decreased to equal the FMV of the common stock. However, the terms and conditions of the option contract will remain the same, such as the number of shares to be issued, the vesting period, and the vesting schedule. Basically, there is only a reduction in the strike price. Thus, this method is considered to be more consistent with the fair value of the common stock.
3. Establish items for new options
Usually, when the existing options are canceled and new options are granted, it is important to consider the items for the new options. Here is a list of some of the items to consider:
- Number of options – Essentially, companies must decide how many options are necessary to be re-granted in accordance with the new strike price. Some companies may require that each employee receives the same number of options.
- New strike price – The fair market value of the common stock on the date of repricing is used as the new strike price for each option. This can be done through 409A valuation or through other statistical methods, such as the Black-Scholes method.
- Vesting schedule – When re-granting the options, the vesting schedule also needs to be considered. Vesting schedules may be structured in a way that is consistent with new terms and conditions.
- Other option conditions – Terms and conditions, ASC 718 reporting, ISO $100k, and other qualification matters are also to be considered when re-granting stock options.
4. Cancel old options and re-issue new options
The process of canceling options and re-issuing new options may require the approval of the board or other officers. The modifications to the stock option plan should be described under ASC 718. When canceling old options, companies need to include the stock’s fair market value at the time of cancellation in the fair value amounts related to option grants previously made.
Furthermore, properly reporting under ASC 718 is important in maintaining and providing accurate and complete disclosure of the stock option plan. While in the case of re-issuing new options, companies need to consider the number of options to be issued, the new strike price, the terms, and conditions imposed on the new options, and other items. Similarly, reporting requirements under ASC 718 must be met.
5. Consult Tax Laws
As with any change to the stock option plan, it is important to consider tax laws. Here are a few considerations:
- Considerations on repricing options under ISO $100k – ISO $100k describes the limit of issuing options up to 100k per employee per year. Thus, in the case of re-pricing options, companies must consider whether the ISO $100k rule applies when re-issuing stock options.
- Considerations under ASC 718 – Essentially, ASC 718 provides rules for measuring and disclosing the expenses of stock options. In this regard, the changes to the stock option plan must be recorded under ASC 718.
- Considerations under Rule 701 – Companies need to consult their tax advisors regarding the effects of repricing options on withdrawable tax benefits. As such, the stock option plan should be updated in accordance with provisions under Rule 701.
- ISOs & NSOs – In the case of ISOs and NSOs, companies need to consider whether the vesting of their options will be accelerated in the event of a change to the stock option plan. Companies should consult with their tax advisors if they are uncertain about these types of issues.
Other Alternatives: Options Exchanges
Well, other equity grants can be issued in alternative to stock options. Here are some other alternatives:
- Shares – As a part of the equity grant, shares can be issued. In addition to granting stock options, when the process of repricing stock options takes place, companies can issue shares in lieu of granting options. Shares may be issued to employees to add to the equity dilution when re-granting stock options.
- RSU/RSA – Restricted Stock Unit (RSU) or Restricted Stock Award (RSA) are other equity grants that are issued by companies. As opposed to granting stock options as per the equity grant, when the process of repricing stock options takes place, companies can issue RSU/RSA to employees.
- Other equity awards – Other equity awards that may be issued when re-granting stock options include: performance shares, deferred shares, and other types of equity grants.
Manage your shares and equity with Eqvista!
Often, repricing stock options provide a way for companies to show their commitment to employees. Repricing stock options eliminates a historical practice where employees’ options were underwater and worthless. As such, repricing the options allows the value of the options to be consistent with current market prices. Eqvista assists companies in managing the equity grants that they make to their employees. The team at Eqvista is well-versed in the issues surrounding stock option repricing. Contact Eqvista today.