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‘Underwater’ stock options and ‘repricing’– The next dilemmas

Are your stock options under water?

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Editor’s note: “The Angel Connection” is a regular feature in WRAL Local Tech Wire. LTW asked consultant Bill Warner to share advice for entrepreneurs seeking angel investors and/or venture capital investment. He is chairman of the Triangle Accredited Capital Forum, an angel investor network with over 100 members throughout the Southeast.

RESEARCH TRIANGLE PARK, N.C. — As in most market downturns, the value of employee stock options often drops below the stock price at which they were offered. This undermines their primary purpose of providing an incentive for employees to stay with their companies and later reaping the proceeds of having high-valued stock in their company once the vesting period has ended.

Well, we are here again as most public company stock options are “under water.” Some reports say that more than 80 percent of public technology companies have “under water” stock options thanks to the Wall Street meltdown and the global financil crisis. Getting capital is not the only big challenge entrepreneurs and business leaders face.

The same stock-option problem could be true of private companies as their market valuations get tamped down over the next several months.

Companies, usually with stockholder approval, can “reprice” employee stock options, or offer a stock option swap for new options at a lower price, thus resetting the option price to a new level consistent with the current company stock price. This would naturally make employees quite happy.

The dilemma is that it will not make stockholders very happy. Hey, stockholders don’t get a chance to reprice their stock. Why should the employee stock be repriced?

Stockholders took the risk to invest. Why should the employees be sheltered from the same risk? After all, employees knew what they were getting into when they hired onto the company. Stockholders are not terribly interested in further diluting their stock by such a repricing action.

On the other hand, employees say that the decline in the stock price had nothing to do with them. They didn’t cause the credit meltdown that started the downturn. They need to be rewarded for achieving their milestones, those things that they have control over. Of course, employees should also be accountable for their results. If they have not met their milestones, then it becomes harder for them to argue that their options should be repriced. The real situation is usually a mixture of missed milestones and general market downturn. So, where do you draw the line?

The lesson here is that employees don’t really act like stockholders and view their stock options as a form of compensation that could represent great upside potential if the company performs well. They are not thinking of the broader market risks when they get a grant of stock options from their company.

The answer to the dilemma probably will come as a compromise between the interest of employees and stockholders. Some companies are trying to pre-empt shareholder opposition, designing "value-neutral" plans that allow employees to exchange existing options for a smaller number of new ones at lower exercise prices. That will help protect part of an employee's grant but avoid large-scale dilution or additional accounting charges.

Company boards are very motivated to solve this issue quickly. None of them want a mass exodus of key employees and executives to other companies that will grant their stock options at today’s prices.

About the author: Bill Warner is the managing partner of Paladin and Associates, a business consulting firm in the Research Triangle Park area of central North Carolina, and is the chairman of the Triangle Accredited Capital Forum, an angel investor network with over 100 members throughout the Southeast.

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