Equity Compensation in a Bear Market

No-one knows for sure how long the current bear market conditions will last. The stock price declines seen in recent weeks and months may prove to be relatively short-lived; alternatively, a longer lasting spell of turbulence may be ahead of us.

It is an established fact among those in the know that it is impossible to “time the market”, which can make this a period of uncertainty and anxiety not only for investors, but also for companies who reward executives and other employees through equity compensation.

In a bull market – when stock price valuations are on a solid upward trajectory – there is little for such companies to worry about, beyond choosing the right equity compensation strategy to meet their needs. Once the value of stock is trending upwards, plan participants will most likely be happy, and company objectives around recruitment, engagement, and retention will tend to be met. In that scenario, employer and employee alike get what they want – a textbook win-win scenario.

In a bear market environment, the situation becomes more challenging for all concerned. The term itself describes a situation in which securities prices fall by 20% or more compared to recent highs, either for individual stocks or an overall index, such as the S&P 500, which officially entered bear market territory on June 13, when it ended the day down 21.8% on its all-time closing high recorded on January 3.

You can never ascribe the slide into a bear market to any one factor. Indeed, the current woes befalling Wall Street and further afield have been described by experts as a function of a “perfect storm,” with various related and unrelated elements coming together to spook investors into risk averse mode, including pandemic-related supply chain disruptions, the food and energy crises linked to the Russian invasion of Ukraine, high inflation, and rising interest rates.

All of the above have combined to fuel negative investor sentiment, with a herd-like drive to protect downside losses then becoming something of a self-fulfilling prophecy – investors expect stock values to decline, leading them to look to sell quickly, which, in turn, drives prices down, and so it goes, until the cycle is broken and, perhaps after a false dawn or two, a stable recovery begins.

Again, it is impossible to state with certainty how long this bear market will last, but history offers us clues. Since 1930, and prior to the current slump, the S&P 500 had entered bear market territory on 21 separate occasions. The average length of these previous bear markets has been 343 days – just under a year. However, useful as average figures can be as a guide, they don’t capture the extremes. The length of those bear markets ranged from just 32 days (2020) to 783 days (beginning in 1930) – two very different experiences.

The same logic holds true for the losses stocks endure in a bear market. The average loss recorded by the S&P 500 during these negative cycles up to now has been 37%, but the meanest bear took 80% off the market (1930), while the least severe just about met the definition of being a bear – 20.6% (1948-1949).

However, after each bear, the market has ultimately recovered. While some individual stocks may not bounce back, the trend for the market as a whole has been to rebound from these slumps and go on to new heights – with this fact behind the oft-stated view that the key to investment success is not timing the market, but time in the market.

However, companies offering equity compensation packages and employees receiving those incentives won’t necessarily get to play the long game. For them, when stock valuations plunge and those conditions persist beyond the short-term, the bull win-win risks becoming a bear lose-lose.

For example, if you grant stock options with a strike price of $20 at a point when the stock is valued at $25, recipients will have every reason to believe that they will make a tidy profit when they are able to exercise those options. However, if that valuation slumps to $15, those options are said to be “underwater”, i.e., they are effectively worthless, as they can only be exercised at a loss. It would make no sense for individuals to exercise options in those circumstances, therefore those options will no longer function as a magnet for retention. In that scenario, the individual loses the prospect of acquiring stock at a profit, and the company will have lost an effective tool for retaining key personnel, meaning that those same employees will be less likely to stick around in the event of receiving an attractive offer from a competitor.

Of course, the stock valuation dropping below the agreed strike price level will not necessarily trigger a crisis. It is a matter of timing. If the options involved are not due to vest for another 1-2 years, then, at the very least, there is time for the value to recover and those options to once more be “in the money”. However, as mentioned above, it is an act of faith more than science to assume that bear market conditions will abate in the short-term as opposed to the medium-term or even the long-term. Yes, it is true that all bear markets end at some point, but it is impossible to know a) how long one will last and b) how deep the decline will go.

So, does that mean companies are at the mercy of the whims of the market? Not necessarily. Bull markets tend to be more straightforward for all concerned, whereas bear markets pose more challenges and therefore demand more of those looking to navigate the choppier waters, including companies offering equity compensation. There are several courses of action that companies can consider as they look to buttress their equity compensation strategy against the more demanding circumstances associated with a bear environment.

Extend exercise period post-termination

Once options vest, individuals – assuming they remain with the company – can exercise them at a time of their choosing, as long as those options remain valid. Typically, options expire after 10 years. The 10-year window offers some leeway in terms of riding out any storms in the market, but, again, this timeline applies to individuals who remain with the company.

The situation tends to be different for former employees with options. It is not uncommon for businesses, particularly startups, to allow a 90-day window for ex-employees to exercise their options after leaving the company. In the context of a bear market, if options are underwater, extending that 90-day limit would give those individuals the prospect of being able to exercise their options down the line.

While this can be beneficial for the individuals involved, there are potential downsides associated with extending this “safe zone.”

For the company, this policy brings with it an additional admin burden. When options held by ex-employees remain valid beyond 90 days, administrators need to oversee and manage that process for a longer period.

For the individuals, holding options for more than 90 days after departing can have adverse tax consequences.

Reprice stock options

When companies reprice options, they effectively exchange options that have become worthless – i.e., underwater – with new options that have value to those holding them.

Repricing can be a complicated process and is usually only considered if it is felt that the relevant stock valuation is unlikely to bounce back in the medium or even longer term. It can be deemed necessary in those circumstances as underwater options lose their effectiveness as an incentive for recruitment and retention.

When repricing options, companies don’t get to just think of a number and go with that. There are specific rules and guidelines in place that will lead companies towards the new valuation. For example, companies must be guided by the fair market value at the time of the repricing when setting the new exercise price.

It is important also to note that repricing may not be a magic bullet solution, as there is no guarantee that repriced options might not also go underwater over time.

Interim awards

With an interim award, a company acknowledges that existing options are underwater and gives employees either cash or stock, with a view towards easing absorbing that hit.

This approach does not require any change to the original agreement and therefore doesn’t create any admin headaches for the business.

Convert stock options to Restricted Stock Units (RSUs)

RSUs do not have the same risk attached to them as options. Another plus from the employee perspective is that RSUs are received as a gift and without any purchase obligation.

The trade-off here is that while employees gain certainty and stability, they may end up with fewer RSUs than options.

From the company perspective, there are admin implications involved, as this approach involves changing the original agreements and decisions must be made around what number of RSUs would be fair to assign relative to the number of options held by individuals.

Another relevant consideration for companies is that when they convert options into RSUs, it means they will have more stock on hand to issue at a later time.

Stay the course

Depending upon the circumstances, companies may choose to batten down the hatches, wait out the market storm, and hope to emerge on the other side with options back “in the money.” As pointed out above, it is impossible to predict with certainty how long a bear market will last, so choosing to stay the course or make no adjustments may or may not prove practical. If the bulk of options granted to employees are not due to vest for 1-2 years, then it is possible that no corrective action may be required in the short-term. If bear market conditions persist, then management might need to revisit that decision over time.

On a similar point, if companies make performance-related annual stock awards to key individuals, they may choose to continue to do so, without altering the terms, even in a bear market. This is relevant to the current discussion because typically, companies link a dollar figure to such awards as opposed to a specified number of stock, e.g., a senior executive may be in line for stock to the value of $100,000 per year, assuming conditions are met. When the company stock price falls, more stock will need to be granted for the company to hold up its end of the deal.

This may not prove to be a massive concern if the stock price decline proves to be short lived. However, the viability of this approach would be called into question if either a) the stock price falls drastically or b) that decline continues beyond the short-term.

In closing, we have entered a challenging period in the stock markets. This bear market may prove to be short-lived or stay with us into the medium term. No-one knows which it will be at this point. This poses challenges for companies on many levels, and one such challenge relates to equity compensation. Businesses can respond to the bear market in many ways, including those outlined above. There is no single solution to dealing with the complications that a bear market brings with it. Whether the right choice is to, for example, reprice options, convert options to RSUs, or hold steady and make no adjustments to your equity awards strategy while you watch the situation evolve, will depend upon your individual circumstances.

Contact Global Shares today to speak to our experts on how best to manage your equity compensation needs in a bear market.

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