Private Companies: Time to Consider Repricing Underwater Stock Options? | Insights & Resources | Goodwin (2024)

Given recent market trends, many private companies have seen valuations decline significantly, resulting in an increasing number of service providers holding “underwater” or “out of the money” stock options. As a result, companies may beconsidering repricing their stock options to help retain andappropriately incentivize employees and other service providers by reducing the exercise price of stock options that are abovethe current fair market value of the underlying stock. This article answers frequently asked questions from private companies that are contemplating a stock option repricing.

1. How are stock options repriced?

For private companies, stock options arealmost always repriced simply by the board ofdirectors amending the stock option to reducethe exercise price of the applicable stockoptions without generally changing other terms.Public companies may use different structures(e.g., a reduction in the overall number of stockoptions in exchange for the reduced exerciseprice or a conversion of the old stock options into a different type of equity award).¹

2. Who can participate in a stockoption repricing?

Private companies typically provide that allcurrent service providers with stock optionsthat have an exercise price above a specifiedprice participate in the repricing. Somecompanies, however, choose to only repricestock options held by a certain group of serviceproviders (e.g., employees below the C-suite).Companies should be careful of discriminationor human relations issues if all current serviceproviders will not be eligible to participate inthe option repricing. Companies should also bemindful of the considerations around repricingstock options held by officers and directors(see Q&A point 14 below).

Former service providers are often excludedfrom the repricing because of potentialcorporate waste concerns and difficulties withsecurities exemptions. Further, one purposefor a repricing is to incentivize current serviceproviders to build the company’s value andformer service providers are not able tocontribute in a similar manner to the futuregrowth of the company.

For the avoidance of doubt, a stock option thathas already been exercised cannot be repricedsince such stock option technically no longerexists but has rather been converted to a share.

3. What are the vesting and exerciseterms of the repriced stock options?

A company must decide on the vesting scheduleof the repriced stock option. The simplest andmost common approach with regard to vestingis to maintain an identical vesting schedule so that the only change to the stock option isa lower exercise price. Sometimes, additionalvesting terms or an exercise “blackout” periodis imposed on the repriced stock option, butthat can make the repricing more complicated(see point nine). Note that any such changewould generally require the consent of theoptionee, whereas simply reducing the exerciseprice may often be done without such consent(subject to the terms of the underlying equityplan and award agreement).

4. How should the stock option repricingbe communicated to the optionees?

The simplest and most common approach isto provide a one-page notice that informs theoptionees about the repricing and the lowerexercise price that now applies to their stock option(s). Some companies, however, may wantto amend and restate each optionee’s stockoption agreement to reflect the new exerciseprice and to establish new grant and expiration dates, if desired (since a repriced stock optionis effectively the cancelation of the old stockoption and grant of a new stock option).Again, the company should always considerwhether consent is necessary, particularly if therepricing may result in a recharacterization ofincentive stock options into nonqualified stockoptions or if additional vesting or exerciseterms are being applied.

5. Should the grant and expiration dates on the optionee’s paperwork andthe company’s capitalization tablebe updated based on the date of thestock option repricing?

Because a repriced stock option is a “newgrant” for tax and accounting purposes,companies must consider whether therepriced stock option should also includea newly calculated expiration date (e.g., formost options, an expiration date of 10 yearsfrom the repricing [the new “grant date”]rather than 10 years from the original grant).Whatever choice is made should be clearlycommunicated in the board action to adoptthe repricing and in any communicationswith optionees to avoid later confusion. Notethat such choice will generally impact theaccounting expense of the stock option.

6. Are there any special considerationsfor repricing stock options held byoptionees that are based outside ofthe United States?

Companies should discuss any stock option repricing with local counsel and tax advisorsbefore effectuating such a repricing foroptionees outside of the United States.

7. Is shareholder approval required?

Private companies are typically not requiredto obtain stockholder approval of a stockoption repricing unless they are contractuallyobligated to do so (e.g., pursuant to an investorrights agreement, a credit agreement or anequity plan). These documents, and all relevantgoverning documents, should be reviewedprior to commencing a repricing to confirm anythird-party consent requirements.

8. Do securities laws impact a stockoption repricing?

Most private companies rely on Rule 701 of theSecurities Act of 1933, as amended, to issuestock options to service providers. Repricedstock options are generally considered a “new”sale of securities that must qualify under Rule701 as of the time of the repricing. While Rule701 allows for sales to current service providers,it may not be relied upon when issuing awardsto former service providers (i.e., such formerservice providers would generally not beeligible to participate in the repricing unless aseparate securities exemption applies).In addition, the value of the stock options beingrepriced should be included in the calculation ofthe amount of securities sold within a 12-monthperiod for purposes of Rule 701 volume anddisclosure limits.²For this purpose, if theoriginal grant was made in the 12-month periodpreceding the repricing, the U.S. Securities andExchange Commission (SEC) does not requirethe stock option to be “double-counted” andactually allows the lower repriced value to beused in lieu of the presumably higher value ofthe original grant. The Rule 701 calculationsshould be analyzed before the company’sboard of directors approves a repricing so thatthe company can prepare for any additionaldisclosure requirements that may be triggeredunder Rule 701.

9. Does a private company needto comply with the SEC’s tenderoffer rules?

Another factor for private companies toconsider when deciding whether to repricestock options is compliance with tenderoffer rules promulgated by the SEC. SECtender offer rules are generally implicatedwhen a securityholder is required to makean investment decision with respect to thepurchase, modification or exchange of thatsecurity. A basic stock option repricing in whichthe stock option is simply amended to reducethe exercise price arguably does not involveany investment decision, so it is unlikely toimplicate SEC tender offer rules. Moreover, abasic stock option repricing typically is doneunilaterally by the company, so no optioneeconsent should be required (assuming that the repricing is solely in the optionee’s favor).On the other hand, if the repricing is contingenton the optionee agreeing to an adverse effect(e.g., imposing additional vesting on the stockoption or blacking out an exercise period), thenthere is a strong argument that the optionee ismaking an investment decision and SEC tenderoffer rules may be implicated. In addition, if thecompany’s equity plan specifically requiresoptionee consent to a repricing, then SECtender offer rules could similarly be implicated.The SEC may consider a repricing of stockoptions that requires the consent of optioneesto be a self-tender offer by the issuer ofthe stock options. For private companies,compliance with SEC tender offer rulesbasically requires that the offer to amendstock options must remain open for at least20 business days and the impacted optioneesmust be provided with information necessaryto enable them to make an informedinvestment decision (e.g., information about theproposed amendment and information aboutthe company).

In the case of incentive stock options (ISOs), care should also be taken to ensure that any offer to amend does not remain open longer than 29 calendar days (as discussed below). It is unclear whether seeking consent or an acknowledgement from a holder of ISOs triggers an investment decision and the tender offer rules; however, we believe the better view is that a change in tax treatment in and of itself would likely not give rise to a tender offer concern.

10. Are there any accountingconsequences?

Companies should consider potentialaccounting consequences of stock optionrepricings. Most private company stockoption repricings will result in an incrementalaccounting charge under accounting rules(e.g., FASB ASC Topic 718). The incrementalcharge for repriced stock options is generallyfixed at the time of repricing and typicallyequals the increase of the fair value, if any, ofthe repriced stock options over the originalstock options. If the vesting of the repricedstock option is extended, then the company’srate of accrual may need to be adjusted, sinceany stock option expense is typically accruedover the vesting period. Companies that areseeking to go public in the near term mayhave heightened concerns with accountingconsequences of a stock option repricing.

11. How does a stock option repricingimpact ISOs?

Companies should also factor in potentialtax consequences when considering astock option repricing. To qualify for ISO treatment (and thus favorable tax treatment),the maximum fair market value of stock withrespect to which ISOs may first becomeexercisable in any calendar year is $100,000.In applying this limitation, the underlying stockis valued when the stock option is grantedand stock options are taken into account inthe order in which they are granted. For taxpurposes, a stock option repricing is deemedto be a cancelation of the underwater stockoption and a regrant of the repriced stockoption. Thus, when an ISO is repriced, the$100,000 limitation must be recalculated forthe year of the repricing, including with respectto stock options that became exercisableand counted against the $100,000 limit ina prior year. In addition, any stock optionsscheduled to become or that previouslybecame exercisable in the calendar year of therepricing would (i) continue to count againstthe $100,000 limit for that year (based on theprevious, higher exercise price), and (ii) becounted again as a new ISO for the year of therepricing. Accordingly, the number of stockoptions that can receive ISO treatment maybe reduced as a result of the repricing and deemed nonqualified stock options (NSOs).³

A stock option repricing restarts the holdingperiod requirement to qualify for ISO treatment.ISOs have to be held for two years from grantand one year from exercise in order to beeligible for favorable tax treatment. Repricingan ISO will restart the clock on the two yearsfrom grant requirement. Companies shouldprovide notice to any holders of repriced ISOsto inform them of the new holding period andthe potential for loss of ISO treatment due tothe $100,000 limitation, as discussed above.

The length of time that a repricing offer is opencan also result in negative tax consequences.If a repricing offer is open for more than 29days with respect to stock options intendedto qualify for ISO treatment, those ISOs areconsidered newly granted on the date theoffer was made, whether or not the optioneeaccepts the offer. The consequence of thenew grant date is that the $100,000 limitationmust be remeasured and the holding perioddiscussed above is restarted.

12. What are the Section 409Aconsiderations?

Any repriced stock options must have anexercise price of no less than fair market valueon the date of the repricing (i.e., ideally basedon a new valuation report procured consistentwith Section 409A of the Internal RevenueCode) in order to avoid subjecting the optioneeto potential Section 409A penalties. Certainpractitioners have argued that engaging insuccessive repricings of the same stock optioncould raise issues under Section 409A as wellas accounting rules due to the fact that it maybe argued that the original stock option hadan adjustable exercise price that did not meetthe Section 409A stock rights exemption onthe date of the grant. We would recommendcompanies avoid the appearance of serialrepricings in an attempt to capture the lowestexercise price but rather reprice only upon amaterial change to the value of the underlyingstock, particularly if the stock price drop islargely understood and/or there is a reasonableexpectation that fair market value has reachedits lowest point. If subsequent, materialchanges nevertheless occur, an additionalrepricing may be considered, however, suchrepricing would require further analysis of theunderlying facts and circ*mstances.

13. Can a stock option repricing impactovertime pay?

Subject to compliance with Section 7(e)(8)of the Fair Labor Standards Act (FLSA), anyincome that a non-exempt employee earnsfrom the exercise of stock options is excludedfrom the employee’s regular rate of pay forpurposes of determining overtime pay. One ofthe conditions of Section 7(e)(8) of the FLSAis that the stock option cannot be exercisablefor at least six months after grant, with limitedexceptions for death, disability, retirement ora change in control. Therefore, a companyshould consider the potential overtime payobligations if it plans to grant a repriced stockoption to a non-exempt employee without avesting condition of at least six months. Whatcomplicates the assessment is the absence ofguidance in Section 7(e)(8) regulations, opinionletters or published caselaw addressing howovertime pay would be determined underSection 7(e)(8) if the vesting period is less thansix months.

14. Will the stock option repricing be aninterested party transaction?

Companies should consider whether theholders of repriced stock options will be heldby “interested parties” (i.e., board membersor officers) under Section 144 of the DelawareGeneral Corporation Law (DGCL). If any ofthe repriced stock options will be held by“interested parties,” the company’s board ofdirectors should consider such stock optionrepricing an interested party transaction andtake steps to obtain additional corporateapproval if appropriate.

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[1]The purpose of these various structures is generally to lessen the potential windfall effect to optionees. To be clear, the purposeof stock option repricings is generally to assist in retention of personnel when the stock options do not appear to hold value,but this must be weighed against the fact that simply reducing the exercise price of stock options without lessening the stockoption count directly cuts into the capital investments made by investors. For example, if the exercise price is reduced from $10 to $5, an investor that bought stock at $10 per share with a 10% stock option pool previously would have shared withoptionees 10% of the upside of the company. Following the repricing, the same investor would forfeit 10% of their investmentbetween $5 and $10, assuming the company does recover to $10 (thereafter the economics are the same).
[2]Applicable state securities laws (i.e., “blue sky” rules) should be reviewed as well.
[3]While an optionee may lose favorable ISO tax treatment in connection with a stock option repricing, it is important to rememberthat in instances where the value of the exercise price reduction is material, the additional value received by the optionee fromthe repricing will outweigh any potential lost tax benefits of ISOs. Again, consider the example of a reduction of the exerciseprice from $10 to $5. If an ISO is not repriced and is rather exercised at $10 and later sold in accordance with the applicable ISOrules for $20, the post-tax value of the $10 of appreciation may approach $8 (assuming 20% long-term capital gains tax rate).If the same stock option is repriced to $5 (now a ‘new’ NSO) and is never exercised but rather cashed out at $20, the post-taxgain to the optionee on the $15 of appreciation would be over $9 (assuming a 39% ordinary income tax rate). In this example,the underlying stock price would have to exceed $26 before the old ISO (without a repricing) would start to outperform thenew NSO (with a repriced exercise price of $5). Note, that with this example, this effect can be eliminated as long as the NSOis exercised (at which point the NSO stock would start to qualify for long term tax rates on appreciation) at any point prior to thestock being worth $26. Additionally, in many instances, holders of ISOs do not exercise their stock option and actually qualifyfor ISO treatment, in which case the repriced stock option will always be more valuable.

This informational piece, which may be considered advertising under the ethical rules of certain jurisdictions, is provided on the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin or its lawyers. Prior results do not guarantee a similar outcome.