Underwater Stock Options & how to address them in the current climate

Content Team July 3, 2020 mins read

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Global Shares’ Content Team comprises a dynamic and talented team of writers and experienced professionals who strive to deliver useful equity insights and simplify complex equity information, all with the aim of helping you to better understand equity management.

Underwater Stock Options & how to address them in the current climate

This Academy post is by Jon W. Burg, CEP, FSA – Infinite Equity

Headshot of Jon Burg Vice-Chairman of the Global Equity Organizations Board of Directors

Jon has a passion for equity compensation with over 20 years of experience guiding companies from initial idea to full execution of plans.  He previously held roles at leading global equity compensation teams and recently served as the Vice-Chairman of the Global Equity Organization’s (GEO) Board of Directors. Jon has a Bachelor of Science in Mathematics and Economics from the University of Washington, is a Fellow of the Society of Actuaries, and is certified equity professional. He is based in San Francisco. Infinite Equity is a trusted Global Shares partner.

Stock prices go up, stock prices go down… and sometimes way down, leaving a significant portion of a company’s outstanding stock options deeply underwater. The COVID-19 pandemic has had a profound impact on certain industries, plunging the share price of these companies by 40% or more. Consequently, many of the employee stock options granted by companies over the past few years are now underwater.

To address these problems, some companies will likely explore re-pricing the options or an exchange program whereby employees can trade-in underwater options for at-the-money options, restricted stock, or cash.

There has been no shortage of publications recently about addressing underwater stock options. Most can be characterized as either a regurgitation of articles written 10+ years ago in the wake of the Great Recession or a summary of proxy advisor policy which takes a myopic view on the design and rationale for programs. While helpful reminders for dusting off the cobwebs on program design, they often miss the mark on conveying the bigger picture of whether a company is a good candidate and whether proxy advisor policy is even the right lens in which to evaluate investors’ perspective.

In this article, we take a step back from these generic summaries to provide perspective on what is important in assessing whether to consider a re-pricing or exchange program.

A Brief History of Stock Option Re-pricings and Exchanges

To better understand whether a re-pricing or an option exchange program is the right response for your company, it is informative to look at the history of these actions over the past couple of decades. Options have been re-priced for nearly as long as they have been issued, but the first wave of employee stock option exchanges came following the burst of the dot-com bubble in the early 2000s.

Dot-Com Bubble

After the dot-com bubble era, these had a few key characteristics:

  • The initial stock market downturn primarily impacted the technology sector in 2000, but eventually expanded to a broader range of industries with the market declines accelerating following 9/11.
  • Straight re-pricing of options (i.e., 1 for 1 basis) was the preferred methodology.
  • The re-priced options were granted 6 months and a day after the underwater options were cancelled to avoid recording any expense.
  • Accounting rules were governed by APB 25 (FAS 123R adopted in 2005), which did not require expensing of stock options at grant but modifying them would trigger variable accounting.
  • Conducted without shareholder approval as the exchanges (NYSE and NASDAQ) did not enact rules bestowing the right to vote on equity compensation matters until 2003.

In the aftermath of all these changes, new accounting rules for equity compensation were finally adopted. Shareholders won the right to vote on equity proposal matters, and the stock option backdating scandal was exposed.

At this point, there was less shareholder scrutiny of re-pricing and fewer rules surrounding the accounting for employee equity. Most notably, companies did not have to accrue compensation expenses for employee stock options. Consequently, companies simply cancelled the underwater options (with no adverse accounting implications) and granted new, at-the-money options to employees six months and a day later to avoid mark-to-market accounting. Fewer regulations meant companies could react quickly to address any retention or overhang concerns, at the expense of accountability to shareholders.

The second wave of programs emerged following the housing bubble burst, which triggered a global financial crisis now known as the Great Recession when stock prices again fell precipitously.

The Great Recession

During the Great Recession, equity and the market underwent further changes:

  • The stock market impact was widespread, affecting all industries and companies.
  • “Value neutral” exchange programs emerged, where the underwater stock options are exchanged for a reduced number of awards (e.g., 2 underwater options for 1 at-the-money option).
  • Exchanges required a month-long tender offer period in which employees could make an election.
  • Accounting rules were governed by FAS 123R (now ASC Topic 718), which required expensing of options. Option repricing and exchange programs were treated as a modification of the original award, which was an improvement over the APB rules.
  • Both the NYSE and NASDAQ required shareholder approval for most underwater option programs unless the plan explicitly stated it was not required. Vote recommendation from proxy advisors increased in importance, resulting in more shareholder-friendly design elements.

In the aftermath, Dodd Frank ushered in a new era of executive compensation governance. Performance awards emerged as part of the long-term compensation for executives, and migration began, from stock options to RSUs as the favoured vehicle for broad-based equity programs.

At this point, FAS123R had been implemented, requiring companies to estimate the fair value of employee stock options at the grant date and to accrue compensation expense based on that grant date fair value regardless of the value recognized by the employee. Additionally, shareholder approval was now required for most companies to modify or exchange underwater options. Proxy advisory firms laid out stringent option exchange requirements that needed to be met to receive a favourable recommendation. An era of more balanced, shareholder-friendly option exchange programs emerged, with the majority designed to receive proxy advisor support.

Proxy Advisor Lens and the Period After

Following the financial catastrophe fueled by corporate greed and loose regulations, shareholder concerns regarding addressing underwater options were not unfounded or unjustified. Shareholders asked, “Why should employees (particularly executives) have their equity value restored while non-employee shareholders suffer massive losses?”. Proxy advisory firms and large institutional investors provided specific criteria for companies to receive support for an option exchange program. While there was some variation between them, programs generally needed to comply with the following 6 criteria:

  1. Provide a clear company-specific rationale
  2. Exclude the Board of Directors and Executive Officers
  3. Exclude any options recently granted or with a strike price below the 52-week high
  4. Exchange options on a value-for-value basis
  5. Include vesting for new awards
  6. Contractual period for new awards not longer than average for exchanged options

Some companies that completed an options exchange program following the Great Recession received shareholder approval without following all these guidelines. However, it is fair to say that all were influenced by these considerations in some manner and that shareholders possessed a stronger voice and healthy scepticism towards addressing underwater options.

After the deluge of exchanges in the wake of the Great Recession, options exchanges were relatively few and far between for several reasons. First, broad-based option programs fell out of favour, with many companies shifting towards RSUs. Secondly, a ten-year bull market meant that most companies saw their share prices rise and their employee options sit comfortably in the money. However, broad-based options remained popular in the start-up tech and life sciences industries, in which share prices can be subject to extreme volatility due to product or drug successes or failures. In general, options exchanges in this period hewed towards the proxy advisor guidelines.

Proxy advisory firms’ underwater stock option policies are certainly shareholder-friendly. However, strict adherence to their exchange related guidelines may not be optimal for many companies, and, in some cases, their shareholders.

They are Employees, not Investors

One primary concern surrounding option exchanges has always been the discomfort with one stakeholder (employees) benefiting by having the value of their equity holdings restructured while another stakeholder (investors) does not. On the surface, this may seem unfair, but there are key distinctions between these two groups of stakeholders.

  1. Employees receive equity as compensation for services provided: The value of equity compensation ultimately recognized by the employee is intended to vary with the share price, but too large of a disconnect between the target value and the realizable value can be demotivating.
  2. Employee equity awards have retentive value: The last thing a company with a struggling share price needs is an exodus of key talent and individual contributors. Restoring the retentive aspects of underwater employee equity (even executive leadership) can absolutely be in the best interests of shareholders when measured against losing talent and the cost of hiring and training.
  3. Companies ultimately do something: To address concerns that occur when the share price drops significantly, companies inevitably take some action even when a re-pricing or exchange is ruled out. This commonly takes the form of retention grants, key performer awards, or a variety of other creative incentives that add to the total issued overhang.
  4. Equity can be optimal over cash: Equity does dilute the value of future earnings, but it also preserves cash at times that may be critical to a company. The cash can be preserved to service debt, pay obligations, or otherwise avoid seeking funding at a greater cost of equity.

When considering the items above, it becomes clear that an equity re-pricing or exchange can be an effective way to achieve an array of objectives with limited accounting charges, cash expenditure, and, in some situations, less dilution to shareholders.

Key Questions to Ask When Considering an Option Exchange Today:

The facts and circumstances that surround potential option exchanges today are fundamentally different from those that surrounded exchanges in the wake of the Dot-Com Bubble and Great Recession. As such, it is important for each company to evaluate a potential exchange in the current environment.

Here are a few questions, along with what you need to consider, and the implications.

Why has the stock price declined?

Considerations: A government-mandated shutdown and change in consumer behaviour is outside of management’s control and likely not an indication of management’s leadership or performance.

Implications: If the stock price drop is due solely to COVID-19, it may be prudent to include executives in an exchange program.

Is the stock price expected to recover? If so, when is recovery anticipated?

Considerations: Some companies may expect to bounce back in the next few months as the country and the world reopens. The share price of other companies may take longer to reach pre-pandemic levels or may never fully recover.

Implications: The expectation and timing of recovery may inform the decision about what type of equity award to grant in an exchange.

What would the objectives of an exchange program be?

Considerations: The main objectives can range widely, from recapturing dead equity overhang back into the shared pool to increasing retention to restructuring the value function of employee equity (e.g., move from options to RSUs).

Implications: The objectives will help the company decide whether to conduct an exchange and how to design it.

Does the benefit of an exchange outweigh the cost and effort?

Considerations: Option exchanges require significant effort from several departments and are not inexpensive to conduct.

Implications: Plan for three to six months to thoughtfully design and implement.

Thoughtful and Creative Exchange Program

If a company decides that an options exchange program is the best path forward, it should be empowered to design a program that successfully achieves its goals. Ultimately, a thoughtful and creative exchange program will be more beneficial to shareholders than strict adherence to proxy advisor requirements.

Option Eligibility

The proxy advisor guidelines for option eligibility are to exclude options granted last year or with a strike price within the 52-week high.
It may be important to include options granted recently if COVID-19 has fundamentally altered the long-term prospects of the business. Exchanges are a one-time restructuring of overhang and it may be pragmatic to cast the widest net possible.

Employee Eligibility

The proxy advisor guidelines for employee eligibility are to exclude the Board of Directors and Executive Officers.

Consider including Executives if stock price decline is not a reflection of poor stewardship and if continuity among leadership is important. Any new awards granted could contain performance conditions to further align leadership with shareholders.

Exchange Ratios

The proxy advisor guidelines for exchange ratios are value-neutral.

If granting RSUs, post-exchange awards could have less value than exchanged awards to counteract the guaranteed nature of an RSU vehicle.

Vesting Periods

The proxy advisor guidelines for vesting periods are no awards vested upon exchange.

Combine longer vesting periods with post-vest holding periods to further align employees with shareholders.

Companies should consider adding performance conditions to executives’ awards received in the exchange. These conditions can be based on new strategic objectives, traditional financial goals, or stock price performance (on an absolute basis or relative to peers). The main concern shareholders have regarding option exchange programs is that employees are “bailed out” while they suffer losses.

By adding performance conditions, the company recognizes this concern and guarantees that executives only receive value if they deliver tangible results that help create wealth for shareholders. It is worth noting that performance awards were not widespread when the proxy advisory guidelines were established, and these guidelines may be due for revision in an equity landscape in which performance awards are widely accepted and promoted.

A post-vest holding period is another tool in a company’s utility belt that can further align employees with shareholders in the event of an option exchange. Post-vest holding periods are simplest to apply to RSUs and are most logical to apply to executive awards since these high earners often have less need to liquidate value in the short term. By creating a longer period between the exchange and the time an award holder can realize value, post-vest holding periods ensure that employees are thinking about long-term company health and long-term value creation for shareholders.

Companies will ultimately need to design an option exchange program that receives shareholder support. However, that does not necessarily mean complying with any or all of the guidelines laid out by proxy advisory firms. The option exchange design process should be both thoughtful and deliberate, and companies should also remember there is flexibility to design a program suited towards its individual goals, as long as it can make the case to shareholders for why the program is the most effective way to achieve those goals.


Since the turn of the century, option exchange programs have evolved to fit changing circumstances and regulations. However, option exchange programs have looked fairly similar over the last fifteen years, mainly due to proxy advisor guidelines and the impact of the Great Recession on corporate governance and shareholder oversight. The COVID-19 pandemic has led to an increase in the number of companies considering option exchange programs. These companies should feel empowered to tailor the design of an exchange program to achieve objectives while keeping the best interests of shareholders front and centre.

Infinite Equity is a trusted Global Shares partner and expert in the establishment of employee stock plans for US companies of all sizes.

Please Note: This publication contains general information only and Global Shares is not, through this article, issuing any advice, be it legal, financial, tax-related, business-related, professional or other. The Global Shares Academy is not a substitute for professional advice and should not be used as such. Global Shares does not assume any liability for reliance on the information provided herein.

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