What do you do, when you receive a 409A valuation for your company that is lower than the exercise price of previously granted stock options?
A few years ago I read an article titled, We Spend Too Much Time Celebrating “Start Ups” and Not Enough Time Celebrating “Keep Goings.” Too true. Starting a new company, like buying a lottery ticket, can foster dreams of Italian sports cars and beach condos. That is in fact part of the reason why stock options can be such a powerful motivational tool. But when company value goes down, you may find your workforce in need of a morale booster.
If you’re facing this situation, consider doing a downward stock option repricing. At its simplest, this just means you lower the exercise price of options to the current fair market value. You message this in a positive way to employees and with the hope that they will double down on their effort to make the company succeed.
There are of course a few technical things to consider. These include:
Determine who Participates
To participate an option holder must be a current service provider on the date the repricing or exchange occurs, and it is common to let all current service providers with unexercised underwater options participate in the program. However, you can, for example, allow only officers to participate, or make exchange terms more favorable for officers. After all, officers may have the most underwater equity, and are often the group a company is most concerned about retaining.
Repricing vs Exchange
Decide whether you want to conduct the program as a repricing or an exchange.
- Repricing: This is an amendment to the exercise price of existing options.
- Exchange: This is the cancellation of current options in exchange for a new options with the lower exercise price.
In a repricing, the option keeps its original grant date and expiration date. In an exchange, the new option has a current grant date, and could therefore if desired, have a new 10-year term.[1] In addition, an exchange may make more sense if the company has adopted a new equity incentive plan and wants to move the underpriced option grants to the new plan.
ISO Rules
Incentive stock options (ISOs) have to be retested on the date of the repricing. They’ll pass the fair market value test if the company is repricing based on a new 409A valuation, however the $100K limitation may kick in to disqualify certain large grants. This is made more likely by the fact that the $100K limit counts both the old option and new option in the year of the repricing, so there’s some double counting that occurs. Also, repricing an ISO restarts the 2-year holding period required for a qualifying disposition.
Consent and Tender Offer Rules
A downward repricing can generally be made unilaterally with respect to nonstatutory stock options, because it’s just a benefit; no harm is occurring. The downward repricing of an incentive stock option (ISO), on the other hand, can have the negative consequences discussed above, so absent express authority in a plan to reprice without consent, consent is needed.
If consent is needed from more than say ~10 folks (market rule of thumb), the tender offer rules generally need to be followed, including the 20-business day rule.
Since companies taxed as partnerships can only grant nonstatutory stock options, such companies can usually simply get board consent to downward reprice options, hand out the updated grant paperwork, and be done.
Corporate Waste
To hedge against a risk that the repricing is viewed as poor corporate governance wasteful, I’ve often seen the option holders be required to extend vesting by three months as consideration for the repricing.
Non-Exempt Employees (Worker Economic Opportunity Act)
Generally, option gain is included in “regular rate” of pay for purposes of Fair Labor Standards Act overtime rules, unless an option is not exercisable for 6 months after grant. I am not aware of any express guidance as to whether a repricing or exchange would be treated as a new grant for purposes of the 6-month exercise prohibition. I think it is likely that a cancellation and exchange will restart the 6-month period, whereas a repricing may not.
Accounting
An option repricing or exchange can affect the compensation expense charge of the stock options. Companies should consult their accountants for the impact under FASB ASC Topic 718.
Steps to Implement (assuming Tender Offer is necessary)
1. Obtain a 409A valuation.
2. Have legal counsel draft exchange or repricing offer.
3. The Board approves exchange offer and it starts. It stays open for 20 business days (terminating at midnight ET).
4. The day after the end of the exchange offer, the Board approves the current fair market and the grant of the new options in exchange for the old ones, or the amendment of the options, if done as a repricing.
5. Updated option paperwork is distributed.
Final Note: Use Sparingly
While a one-off repricing is ok, a company that makes a habit of downward repricing can put the validity of all option grants at risk.
Mike Baker frequently advises with respect to stock option repricings and exchanges. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.
[1] As always, incentive stock options held by greater than 10% stockholders must have a term of 5 years or less.