Spring 2003

Repricing "Underwater" Stock Options

Many companies that have traditionally relied on stock options to attract, retain and incentivize employees are now finding themselves wondering how to deal with "underwater" stock options (i.e., stock options whose exercise price exceeds the fair market value of the underlying stock). Many such companies are considering "repricing" their stock options as a way to make their stock options more valuable to employees. Traditionally repricing simply involved canceling the existing stock options and granting new stock options with a price equal to the current fair market value of the underlying stock; but over the years alternative approaches to traditional repricing have been developed to avoid the unfavorable accounting treatment now associated with a simple repricing. We advise our clients that repricing is not a straightforward process and that they should carefully consider the following three aspects associated with a repricing - corporate governance, tax and accounting aspects.

Corporate Governance Considerations

The decision of whether to undertake a stock option repricing is a matter of corporate governance for the board of directors to consider and approve. In general the board of directors of a company has the authority to reprice stock options, although some thought should be given to whether this is an appropriate exercise of the board's business judgment. The company should be attentive to the obvious shareholder concern that management and employees (who may bear some obvious responsibility for the very problem being addressed) are in some way being made whole, unlike the shareholders who are left to hold their underwater stock. A company's stock option plan should also be reviewed to make sure that it does not preclude a repricing of stock options. Other issues that should be considered include the terms of the new option grants, including the number of replacement shares and whether to continue the current vesting schedule or introduce a new vesting schedule for the repriced options.

Tax Considerations

Tax concerns weigh heavily in repricing decisions if the stock options being repriced are incentive stock options (or "ISOs") under Section ?§422 of the Internal Revenue Code. In order to preserve the favorable ISO tax treatment that is permitted under that section of the Code, the new stock options must be granted at the current fair market value of the underlying stock. Assessing the current fair market value of a privately held company will require the board to set a new value on the common stock of the company.

Accounting Considerations

The accounting implications are typically the most troublesome aspect of repricing stock options. Under present Financial Accounting Standards Board (or "FASB") rules, the typical employee option grant has no effect on the company's income statement. [1] This is the case, for example, where the option is granted to an employee subject to a known and fixed number of shares and with a fair market value exercise price. In this case, any income statement impact relates solely to the "intrinsic" value of the option, which is determined based on the difference, if any, between the fair market value of the underlying stock and the exercise price (in our case zero).

In contrast, when an option is repriced the fixed nature of the stock option arguably no longer exists because in the course of the option's life the exercise price has been changed. This causes the option to be treated under so-called "variable" accounting rules. These rules require the constant remeasurement of the difference between the exercise price of the stock option and the fair market value of the underlying stock during the life of the option, resulting in constant uncertain impacts on a company's income statement. For this reason, most companies no longer undertake a traditional "repricing" of stock options.

Alternative Repricing Approaches

Over the past year several of our clients have considered repricing their underwater stock options and we have participated in at least three repricing approaches that seek to avoid the accounting concerns described in the prior section.

• One approach is referred to as the "six month and one day exchange". Under the FASB rules, the cancellation of an existing option and the grant of a new option is essentially not a "repricing," and therefore avoids variable accounting treatment if the cancellation and repricing are more than six months apart. This is put into place by canceling the underwater stock option and then offering the employee the grant of a replacement option, six months and one day later, with an exercise price equal to the then fair market value of the underlying stock, whatever that may be at the time.
  
  
• A second approach is referred to as the "restricted stock swap". Under this approach, a company cancels the underwater stock options and replaces them with an outright restricted stock award.
  
  
• A third approach that we have seen clients consider is referred to as a "make up grant". Under this approach a company grants additional stock options at the lower stock price on top of the old underwater options without canceling the old underwater options.

Each of these approaches should avoid variable accounting treatment. However, each of these approaches is not without its own separate concerns and should be reviewed in light of the facts and circumstances of the particular situation. For example, when considering a six and one day exchange, there is risk to the employee that the fair market value will rise as of the reissuance date; or when considering a restricted stock award a company should consider whether the employees will have the cash available to pay for the stock at the time of award. Additionally, when considering a make up grant, a company should consider the potential unwarranted dilution to existing shareholders.

Conclusion

Repricing of stock options should not be lightly undertaken. A company considering repricing its stock options should consult with its legal and accounting advisors to consider all of the implications, since a repricing implicates several sometimes conflicting sets of rules. That being, said repricing often remains a necessary undertaking given the critical importance of retaining and incentivizing employees.

Footnotes:
[1]This rule has been under fairly consistent attack over the last several years and a number of initiatives are ongoing to propose replacement formulations that would result in immediate expensing of all option grants based on some notion of fair value.