What Is Option Repricing?
Option repricing is a corporate finance strategy where a company lowers the exercise price of previously granted stock options that have become "underwater," meaning their exercise price is higher than the current fair market value of the underlying stock. This practice falls under the broader category of equity compensation adjustments. The primary goal of option repricing is to restore the incentive and retention value of these awards for employees, particularly when a company's stock price has declined significantly. When options are underwater, they no longer motivate employees as intended, as there is no financial gain in exercising them.
History and Origin
The practice of option repricing gained prominence during periods of significant market downturns, when broad declines in stock prices rendered many employee stock options worthless. For instance, following the dot-com bust in the early 2000s and the 2008 financial crisis, numerous companies faced a widespread issue of underwater options. During these times, the incentive value of outstanding equity awards diminished, leading companies to consider repricing to maintain employee motivation and retention. Between 2004 and 2009, a total of 264 stock option repricings were announced, involving prominent companies.13 Early repricing methods often involved a simple amendment of the option's terms or a direct cancellation of old options and issuance of new ones at a lower exercise price.12 Over time, the regulatory landscape and shareholder sentiment evolved, leading to more structured approaches like "value-for-value" exchanges, which typically involve exchanging existing options for fewer new options with a lower exercise price.11
Key Takeaways
- Option repricing aims to restore the motivational value of employee stock options that have become "underwater" due to a decline in the company's stock price.
- It typically involves lowering the exercise price of existing options or exchanging them for new options with a more favorable price.
- Companies consider repricing to retain talent and maintain the effectiveness of their equity compensation programs.
- Repricing can have significant accounting, tax, and shareholder implications, often requiring careful consideration and shareholder approval.
- Regulatory bodies like the SEC provide guidance on the accounting and disclosure requirements for option repricings.
Accounting Implications
From an accounting perspective, option repricing is generally treated as a modification of a share-based payment award under accounting standards such as ASC 718 (formerly FAS 123R). This means that the original expense attributed to the award must still be recognized, and an additional "incremental expense" is typically recorded. The incremental expense is calculated as the difference between the fair value of the modified award and the fair value of the original award immediately before the modification.10
The Securities and Exchange Commission (SEC) has provided guidance on the accounting for share-based payment arrangements for public companies, including modifications like option repricing, through Staff Accounting Bulletin (SAB) No. 107.9 SAB 107 expresses the views of the SEC staff regarding the application of Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004), Share-Based Payment (Statement 123R), emphasizing that compensation cost for share-based payment transactions should be recognized in financial statements at fair value.8 This guidance covers valuation methods, including assumptions like expected volatility and expected term, and highlights the need for full disclosure, particularly during transitions.7
Interpreting the Option Repricing
The decision to undertake option repricing is often a nuanced one, reflecting a company's attempt to balance employee incentives with shareholder value and market perception. When a company reprices options, it signals a commitment to its employees, especially in challenging market conditions where their equity awards might have lost significant value. This can be interpreted as a strategic move to prevent top talent from leaving and to maintain morale. However, it can also be viewed by shareholders as a management-friendly action that potentially dilutes their existing ownership and rewards employees for a stock decline, even if the decline is due to broader market forces rather than company-specific performance.
Therefore, the interpretation of option repricing often depends on the context and the transparency with which it is executed. Companies typically aim to justify the repricing by demonstrating that it is essential for talent retention and ultimately benefits the long-term health and growth of the company, which in turn should benefit shareholders.
Hypothetical Example
Consider "Tech Innovations Inc." which granted 1,000 non-qualified stock options (NSOs)) to its software engineers at an exercise price of $50 per share. These options had a vesting schedule over four years. Due to a general market downturn, the company's stock price dropped from $50 to $25 per share, making all outstanding options underwater. The engineers, seeing no immediate value in their options, began to feel demotivated.
To address this, Tech Innovations Inc.'s board decided on an option repricing. They offered to reprice the outstanding underwater options to a new exercise price of $25 per share, aligning with the current market value. For accounting purposes, this repricing triggered an incremental compensation expense over the remaining vesting period of the options, calculated based on the new fair market value of the repriced options compared to their original value. This move helped to rekindle motivation among the employees, as their options once again offered potential upside, assuming the company's stock price recovered.
Practical Applications
Option repricing is primarily applied in scenarios where a company's stock price has declined significantly, causing previously issued employee stock options to become "underwater." Its practical applications are centered on talent management and maintaining competitive equity compensation programs.
- Employee Retention: When stock options lose their value, they lose their power to incentivize and retain employees. Repricing can restore this incentive, preventing key talent from seeking opportunities elsewhere.
- Motivation and Morale: Underwater options can negatively impact employee morale. A repricing can revitalize employee motivation by making their equity awards valuable again, aligning employee interests with potential future stock price appreciation.
- Strategic Compensation: Repricing allows companies to adjust their compensation strategy in response to market realities without issuing an entirely new set of options, which might be more dilutive or require additional shareholder approvals if the equity reserves are limited.
- Compliance and Disclosure: For public companies, any option repricing activity requires adherence to specific regulations and detailed disclosure to shareholders and the SEC. The SEC views a repricing of options that requires the consent of option holders as a "self-tender offer" by the issuer, implicating U.S. tender offer rules.6 The SEC has provided exemptive orders from certain rules for exchange offers involving employee stock options, provided specific conditions are met, such as the issuer being eligible to use Form S-8 for registration.5
Limitations and Criticisms
Despite its potential benefits for employee morale and retention, option repricing faces several limitations and criticisms, primarily from a corporate governance and shareholder perspective.
One major criticism is the perceived unfairness to shareholders. If a company's stock price has fallen, shareholders have typically also incurred losses. Repricing options effectively shields employees from these losses, allowing them to benefit from any future stock price recovery without having fully shared in the downside. This can lead to a negative perception among shareholders and the media.4 Many institutional shareholders and proxy advisors advocate for requiring shareholder approval for option repricings, and major stock exchanges like the New York Stock Exchange (NYSE) and Nasdaq adopted rules in 2003 requiring such approval absent express permissive language in the relevant plan.3
Furthermore, repricing can result in dilution of existing shares if new options are issued in exchange for old ones, or if the lower exercise price makes it more likely that employees will exercise their options in the future. There are also accounting complexities; while option repricing is not considered a forfeiture, it is treated as a modification, leading to additional accounting charges for the "incremental expense."2
Additionally, repricing incentive stock options (ISOs)) can have adverse tax consequences for employees, as it may restart the holding period requirements necessary for favorable tax treatment.1 For these reasons, companies often weigh the benefits of employee retention against potential shareholder backlash and the administrative and financial complexities involved.
Option Repricing vs. Stock Option Exchange
While often used interchangeably or as part of the same strategy, "option repricing" and "stock option exchange" refer to slightly different mechanisms in the context of adjusting employee equity awards.
| Feature | Option Repricing (Pure Repricing) | Stock Option Exchange |
|---|---|---|
| Mechanism | Unilateral amendment by the employer to lower the exercise price of existing options. | Underwater options are surrendered by employees and replaced with new options (often fewer in number) at a lower exercise price. |
| Employee Consent | Typically does not require employee consent, as it's a direct amendment. | Requires employee consent, as it involves an "exchange" or "self-tender offer." |
| Shareholder View | Can be viewed less favorably by shareholders due to unilateral nature. | Often more palatable to shareholders, especially "value-for-value" exchanges where employees receive fewer new options. |
| Regulatory Impact | May still have significant regulatory and accounting implications. | Often triggers SEC tender offer rules for public companies. |
In essence, a pure option repricing involves directly lowering the strike price of an existing option. A stock option exchange, on the other hand, is a specific method of repricing where existing underwater options are formally exchanged for new options, often with different terms (e.g., fewer options, new vesting schedule), but at a more favorable exercise price. The latter is now more common, particularly for public companies, partly due to evolving regulatory guidance and shareholder preferences.
FAQs
Why do companies reprice options?
Companies reprice options primarily to restore the motivational and retention value of employee stock options that have become "underwater" (their exercise price is higher than the current market price). When options are underwater, they no longer provide a financial incentive for employees to stay with the company or to contribute to its growth.
What are "underwater" options?
Underwater options are stock options where the exercise price (the price at which the option holder can buy the company's stock) is higher than the current market price of the underlying stock. This means exercising the option would result in an immediate loss.
How does option repricing affect shareholders?
Option repricing can have mixed effects on shareholders. While it can help retain valuable employees, which benefits the company long-term, it can also be seen negatively as it essentially provides a benefit to employees for a decline in stock value that shareholders also experienced. It can also lead to share dilution if more shares are effectively granted through the new, lower exercise price.
Is option repricing common?
Option repricing tends to be more common during periods of significant market downturns or prolonged declines in a company's stock price. The frequency fluctuates with market cycles and regulatory changes. Companies also need to consider Generally Accepted Accounting Principles (GAAP)) and potential tax implications.
Does option repricing involve a formula?
While option repricing itself involves changing an existing exercise price, the accounting for repriced options requires calculations to determine the compensation expense. This often involves valuing the options using models like the Black-Scholes model and calculating the incremental expense based on the fair value of the original and modified awards.