Option Repricing and Exchanges
Many companies faced with underwater employee stock options outstanding are considering option repricing or exchanges. Our unsurpassed valuation expertise and deep understanding of equity compensation accounting can prove essential in meeting the challenges of decision-making in this important area. Please contact us to discuss how we can help.
Types of Option Repricing and Exchanges
In a repricing or exchange, a company offers to cancel (effectively repurchase) original underwater options of employees and issue new options or stock. Less commonly, a company repurchases options with cash. Option repricing and exchanges typically require (i) filing proxy materials to obtain shareholder approval where needed, (ii) compliance with the SEC's tender offer rules to allow option holders to make investment decisions with respect to an exchange, and (iii) modifications under FAS 123R.
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Value-for-value Option Repricing: In this case, a company cancels the original underwater options and issues fewer new options at-the-money. The .exchange rate. of original options for new options is determined by equalizing pre-modification and post-modification fair value. As a result of the equalization, there is no incremental FAS 123R expense. Notwithstanding the value-neutrality, employee perception is generally positive. Shareholders and proxy advisors generally approve.
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Value-for-value Option Exchange for Stock: Rather than repricing options, a company issues new stock. Again, the exchange rate is determined by equalizing pre-modification and post-modification fair value, and again, there is no incremental FAS 123R expense.
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One-for-one Option Repricing: In this case, a company cancels the original underwater options and issues the same amount of new options at-the-money. This will result in an incremental FAS 123R expense.
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Value-for-value option exchange for cash: Here a company repurchases underwater options for cash based on the fair value of the original options.
Historical Context
There have been three different accounting regimes providing the framework for repricing and exchanges.
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Under the original APB 25, companies were free to reprice with no adverse accounting consequences. In the 1990.s companies frequently reset the price of options without offsetting changes in the awards. The investment community began to pressure companies to seek shareholder approval.
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FIN 44, released in 2000 (retroactive to 1999) subjected traditional repricing to variable accounting, and likely accounting charges. In response, companies canceled grants and issued new grants six months and 1-day later to retain fixed accounting.
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FAS 123R has now removed the prospect of variable accounting. The key challenges now are shareholder relations and legal issues.
Shareholder Approval and SEC Reporting
Any broad offer to employees to exchange options is treated as a tender offer by the SEC. Companies are required to file a Schedule TO giving employees up to 20 days to consider participation in a repricing or exchange.
NYSE and NASDAQ rules require shareholder approval. Occasionally, cash-out of options is expressly permitted by the Plan averting the need for shareholder approval.
Less significant legal and tax issues are the treatment of ISO.s, the disclosure for named executive officers in a proxy, treatment under Sections 162(m) and 409A. Although, these are not typically material obstacles, they should be discussed with legal counsel.
Because of the need for shareholder approval for most repricing and exchanges, the attitude of the shareholder advisory services such as RiskMetrics (ISS), Glass Lewis and PROXY Governance becomes significant for many companies. These firms look at each transaction on a case-by-case basis, but generally they favor the exclusion of executive participation and they favor value-for-value treatment. However, companies can frequently obtain shareholder approval, notwithstanding an adverse recommendation from a proxy advisory service. Factors such as additional retention enhancements, such as vesting extensions, will typically make shareholders more inclined to support a proposal.
Accounting Perspective
Under FAS 123R, an option repricing or exchange is a modification. In the case of vested options, or .likely to vest. options, the modification will never reduce a company.s original compensation expense for those options. If the modification increases the fair value of the options as of the exchange date, the incremental expense is expensed over the remaining vesting period of the new instruments. Any remaining unamortized expense for the original options is also amortized over the new service period, although in certain situations where vesting is extended the company can elect to amortize it over the remaining original service period instead. If the exchange does not increase fair value, in the case of a value-for-value (or value-for-less-than-value) exchange, there is no additional compensation expense. In cases where the vesting schedule changes as part of the transaction, a value-for-value exchange can alter the amortization schedule of the remaining unamortized expense.
In addition to exchanges for plain vanilla options and stock, a company can offer more complex instruments in exchanges, such as market-based awards or options with a variety of structures such as a cap on payoffs that allow for more options in the exchange.
For the bulk of outstanding options, a repricing or exchange will typically be a Type I probable-to-probable modification. However, any change to the vesting schedule as part of the modification, will generally trigger improbable-to-probable or probable-to-improbable treatment for a portion of the options because of the interplay with the projected forfeiture rate. Standard stock option administration programs do not handle these scenarios; thus, additional off-line analysis is required.
The Essential Numbers: Modeling Repricing and Exchanges
There are typically three stages of modeling work in connection with a repricing or exchange. In the first stage a company performs preliminary analysis of all options with potential eligibility for the exchange program. The centerpiece of this analysis is the fair value. Due to the dependency of option fair value on .moneyness. (stock-to-strike ratio) and remaining term, each grant must be valued. The products of this work are preliminary arrays of fair value and expected term as well as relevant exchange rates:
Option Exchange Ratios as a Function of Moneyness and Remaining Term Under Specific Volatility and Risk Premium Assumptions
A company can use the analysis as part of a report to HR for each optionee:
Report by Optionee
A company can model scenarios based on type of exchange, uncertain market parameters, and participation in the offer:
Option Exchange Model
Underlying the option exchange model is detailed grant-by-grant analysis:
Once a company has finalized the terms of the offer, a formal preliminary valuation is performed for the proxy. The final phase is the formal valuation in aggregate as well as grant-by-grant for FAS 123R expensing purposes.
Company Filings to Date
