Stock Option Repricing – What You Need to Know
This article outlines the concept behind repricing and what a company should consider when implementing option repricing.
Now that the use of stock options in private companies has become so prevalent, it’s important to understand the mechanism of repricing options. As a matter of fact, stock options offer employees the right to purchase shares at a certain price within a particular time frame. While this price is the strike price or exercise price based on the stock’s fair market value at the time when the options are exercised. As such, stock option repricing to the current fair market value is one of the most important aspects of stock options. This article outlines the concept behind repricing and what a company should consider when implementing option repricing.
Stock option repricing and underwater stock options
Stock option repricing is resetting an option’s strike price to the current FMV of the share to ensure that the employee receives fair compensation. Typically, it allows replacing the worthless options with new, valuable, and fair options. While the term underwater stock options refer to the options with high strike price compared to the FMV, making it costly for an employee to exercise.
As a result, the principles of stock option repricing can be applied in instances where an employee has a high strike price in relation to the FMV, thus making the option value. It is important to understand the concept behind repricing and its implications.
What are underwater stock options?
Underwater stock options refer to the situation where the strike price of an option is higher than the FMV of stock at the time of exercising such options. Generally, the options are priced based on the FMV of the share. However, in the case of underwater stock options, the strike price is much higher than the FMV, making it expensive for the employees to exercise such options. These options are usually canceled by the company concerned, and in their place, a new option with a new strike price is issued. This way, the employee can exercise the replacement options at an affordable cost.
What is stock option repricing?
Stock option repricing is the technique that allows the adjustment of an option’s strike price to the current fair market value of a share. Repricing is widely used to replace old, worthless options with new options with a strike price equal to the current FMV of a share. The complete repricing process should be carried out promptly, accurately, and transparently.
The primary objective of stock option repricing is to ensure that the employee receives a fair value for the options. However, it is essential to note that repricing does not offer any monetary gain; rather, it ensures that the employee receives valuable options at that particular time.
How does stock option repricing work?
Before implementing stock option repricing, it is crucial to calculate the FMV of the stock. Unlike public companies, where market forces determine the FMV, 409A valuation is used to determine the FMV of private companies. As such, when the FMV of the stock is determined, it is then compared with the strike price at the time of issuance. In case the FMV is lower than the strike price, the process of repricing takes place.
Further, these options are canceled, and the employees are issued new options. Usually, a new strike price and grant date are assigned to the options. As a private company, the Board of Directors is responsible for conducting the stock option repricing. Thus, it is essential to ensure that the repricing percentage should be accurate and in accordance with the current FMV of the stock. So, why do companies reprice stock options?
Why do companies reprice their stock options?
Stock option repricing is commonly used to ensure that the worthiness of stock options is restored. Further, it is used to revalue the option in order to match the current FMV of the stock. This allows for establishing the fair value of the options, and the employee has compensated accordingly. While the implementation of options repricing can be viewed as a cost, it is essential to note that it does not involve monetary gain. To better understand the importance of repricing, let us look at an example:
For instance, during an economic downturn, the FMV of the share drops. In order to ensure that the options are worth it, the company can implement stock option repricing. This gives a sense of belongingness to the employees as they feel that their options are still valuable regardless of the market conditions. This may help the employees to feel more engaged with the company and ensure their continued employment.
Key terms to know in repricing stock options
The overall stock option repricing process is carried out in a timely manner and involves the following key terms:
- Exchange Ratio – The exchange ratio is used to determine the precise number of options being replaced by new options. It is a relative number of new options that are granted for every old option, which must be set appropriately. In the case of value-neutral options, there are multiple exchange ratios, wherein each one will be assigned to a different range of option exercise prices
- Option Eligibility – The company is required to analyze and state the number of options that are available for repricing, either all the underwater options or only those options that are significantly underwater. However, this depends on the company’s management, the perception of shareholders, as well as future expectations. Thus, it is essential to understand and decide the options that should be repriced.
- New vesting period – The period for which the new options shall be vested must be decided. The company can assign a new vesting period for the new options, the old vesting period for options that are being repriced, or provide another alternative between the two. Therefore, the company needs to make a decision on the vesting period that must be fair and reasonable.
How does repricing eliminate the negative effect of underwater stock options?
In underwater stock options, when the strike price is higher than the FMV of the stock, the employee may opt to not exercise their options at all. This makes the options worthless, thus defeating the purpose of granting such options to employees. Stock option repricing can be used to ensure that the employee does not lose out on the value that was offered to them at the time of granting such options.
In addition, it allows employees to receive options that are still valuable at that specific point in time. The employer can either use the outstanding option to change the strike price or cancel the options and grant a new option with a strike price that is equal to the FMV of the stock. This way, employees get the option with the strike price, which is fairly corresponding to the FMV of the stock, thereby eliminating the negative effect of an underwater stock option.
Pros and cons of repricing stock options
While there are many benefits of stock option repricing, it is important to note that it does have certain disadvantages. Following are a few pros and cons of stock option repricing:
Pros of repricing
- As an employer, you would want your employees to retain and grow with the company. In the case of underwater stock options, the employees may not have the incentive to stay with the company. Well, stock option repricing can help employees to feel more engaged with the company and earn fair value for the option.
- Typically, options are considered a cost-effective source for increasing employee compensation. However, when options are not valuable, employees may either demand high salaries, thereby having a negative impact on the company’s financial position.
- It helps your employees in the situation of an economic downturn. As a result of this, the company can maintain a positive environment and build better working relationships with employees.
Cons of repricing
- While stock option repricing generally requires additional reporting and formalities, thereby increasing the workload for the company. The repricing process may also require assistance from an expert to ensure that the process is carried out accurately.
- According to the new FASB accounting rule, companies are required to charge against earnings in the case when stock option repricing is carried out. This increases the overall cost burden of the company.
- Sometimes, the impression of stock option repricing may not be positive for the company. This is because when the FMV of the stock price falls below the strike price of the option, the company may lose out on the impression of its stocks.
How to reprice stock options?
Well, stock option repricing is generally carried out either by amending the outstanding option by lowering the strike price that is equal to the FMV of the stock or by canceling the option and granting a new one with a new strike price. As a result, the option’s value is adjusted to the new FMV of the shares. The overall process is done in an orderly manner and is governed by experts.
The valuation expert has certain rules and regulations that have to be met and followed to ascertain the true and reasonable value. Any private sector who is looking to reprice stock options can seek assistance from a valuation firm to take the necessary actions ahead. For clarifications on when and how to start the repricing works, connect on a quick discussion with our in-house professionals.
Common things to consider while repricing stock options
When repricing stock options, it is important to consider certain factors. Following are a few factors of consideration of repricing stock options:
- Choose the right approach – It is essential to choose the right approach before starting the repricing. Basically, there are two approaches to stock option repricing, either by modifying the outstanding option or by issuing a new option. Proper planning and analysis must be done to determine the best approach to deal effectively with the situation. Moreover, the approach should be implemented in an organized manner and carried out with proper oversight.
- Change structure – As a part of stock option repricing, the structure of options is generally changed in accordance with the new strike price, which is equal to the FMV of the stock. This change in structure might include changing the strike price, changing the vesting period, or even changing the terms and conditions of the options. Thus, if you are planning to change the structure, be sure to analyze and take all the essential factors into consideration. Hence, it is advisable to get the approval of your shareholders before starting the stock option repricing.
- Get shareholder approval – It is necessary to get the approval of your shareholders when repricing stock options. As a part of this process, you must set out the reasons for repricing with supporting data and information which proves that such changes are necessary. However, make sure to be prepared with a detailed plan of stock option repricing and ensure that the process is properly organized and executed.
- Communicate with option holders – You must take all possible steps to ensure that option holders understand the process of repricing and are comfortable with the changes being made. In case you decide to issue a new option, make sure that you keep option holders informed and updated. Therefore, it is important to communicate with option holders and ensure that they are fully aware of the repricing process and the changes being made to their options.
How does a 409A valuation help repricing stock options?
The 409A valuation helps in determining the FMV of the shares, which is used as a base for repricing. While the need for stock option repricing is dependent on the shares’ current FMV. In the case of repricing the stock option, the strike price is modified to the level equal to the FMV of the stock. Therefore, FMV is the most important factor and plays a key role in planning the repricing of your stock options. Without knowing and understanding the FMV of the shares, it is impossible to base the strike price.
What can affect repricing stock options?
A company should primarily focus on the following when it comes to implementing the repricing process:
- $100,000 Limit for Incentive Stock Options – $100K ISO limit applies to incentive stock options, ensuring that the value of ISOs does not exceed $100,000 in a single year for any employee. In stock option repricing, the $100,000 ISO limit may impose certain restrictions. While in some cases, due to the exhaustion of the $100K limit, the company is required to reprice and allocate the options in the next year. Thus, this limitation may cause a delay in the process of repricing.
- International participants – The interest of the employees who are engaged in overseas operations must be taken into account while deciding the conditions of repricing. Typically, international participants are not required to get any approval from the shareholders, and even they have relief from US tender rules. However, this special consideration for international participants can be challenging for companies that are incorporated in the US.
- Rule 701 – While Rule 701 was issued by the SEC to help private companies issue securities with no registration requirement under the Securities Act. However, Rule 701 requires private companies to show that the securities were issued for the purpose of a compensatory benefit plan. However, when stock option repricing is carried out, it can be challenging to prove this as the repricing is not tied to any compensatory benefits plan.
- Accounting treatment – Under ASC 718, companies are required to record employee compensation in their financial statements. In the process of repricing, the charge of the new option is not only fixed upfront but also can be an incremental value, if applicable, of the new options over the canceled options. This may create an accounting issue, as the company is required to estimate the charge of the new options, which can differ significantly from the actual charge.
- Tender offer – The tender rule is applicable when the holder of a security makes an investment decision in regard to purchasing, modification or exchange of that security. Stock option repricing is all about modifying or exchange of existing options. Thus, a tender offer will be applicable to repricing as the holder of options will be making an investment decision in this regard.
- Tax Treatment – Generally, the new grant of options restarts the period of holding required for the beneficial tax treatment of shares that are purchased upon the exercise of the options. This complicates the process of stock option repricing and can lead to inefficiencies. As a result, the company should ensure that the tax treatment is not impacted by the repricing process.
Get your 409A valuation with Eqvista today!
Do you want to reprice the stock options? Well, in that case, you need a 409A valuation in order to carry out the entire process of repricing. Getting a 409A valuation from a third party like Eqvista is the most effective way to ensure the success of your stock option repricing. We have a team of highly skilled and experienced professionals to provide accurate 409A valuation reports. Our software and tools are built on the latest accounting standards, which can assure you that the valuation report will be legally compliant. Contact Eqvista today and get a 409A valuation.