This is the last post of a three-part series about repricing of employee stock options. It summarizes a webinar I hosted with two experts: Ali Murata, a partner in the Compensation & Benefits group at the law firm Cooley, and Kristin O’Hanlon, special counsel in Cooley’s Compensation & Benefits group.

Part I  discussed the factors involved in deciding whether and when options that have fallen underwater should be repriced. Part II covered four approaches for dealing with underwater options, with certain advantages and disadvantages for each. This part walks through the process of options repricing (which, for shorthand throughout this summary, may include an exchange).

How to Reprice Underwater Options

First, we will discuss the issues and decisions relative to implementing a repricing.

Designing the repricing plan

Several factors affect the structure of a repricing program.

• • Option eligibility
    Which underwater options are going to be eligible? This might be an easy decision if all the options have been significantly underwater for an extended period. But what if you have some options that are just a little underwater or were recently granted? It’s not uncommon for companies to exclude options that are underwater by, say, less than 20 percent or were granted relatively recently. That said, this is not as common as including all underwater options. And as we said in Part I, you should not be repricing options that you expect to be above the strike price relatively soon.
  • Participant eligibility
    Will executives and board members be excluded from the repricing? One line of thinking behind this is that executives are most responsible for the company’s trajectory and should not be rewarded for a decline in stock price. Another alternative is that they are included but on different terms than those granted to the options of rank-and-file employees (e.g., reprice to exercise price that is at a premium to the then-current fair market value).
  • Exchange ratio
    Will it be 1:1, or something else (generally fewer shares in a value-for-value exchange)?
  • Vesting schedule
    Are you going to extend the expiration date, or maybe shorten it? New vesting is considered a best practice, but that would trigger tender offer rules. So, this is another case in which the company needs to think about how employees will react.
  • Contractual term
    Will the term of the awards be retained, shortened, or extended? (It is not common to extend the term if there is no new vesting.)
  • Exchange vehicle
    Will an exchange be for options, RSAs, RSUs or cash? If options, will all options be incentive stock options (ISOs) to the maximum extent possible? (Alternatives to options were discussed in Part II.)

Understanding the legal and tax subtleties

Whatever plan you adopt, there will be financial, legal, and tax implications for both option holders and the company. Here are a few of the most common.

ISO status

“The potential benefits of ISO status may be impacted in an option repricing or exchange, for two reasons,” Kristin noted. “The first is that ISOs are subject to what’s called the $100,000 ISO limit. This limit is based on the fair market value of the stock on the grant date. The maximum value of options that can become exercisable in any given calendar year as an ISO is $100,000. If you exceed that limit, the excess will become non-qualified stock options (NSOs), which are taxed very differently.”

“The second reason is the holding period. To fully benefit from ISO status, one of the requirements is that the shares issued must be held for at least two years from the date the option is granted. Any new ISOs granted in exchange for the higher-priced ISOs will cause that two-year holding period from the option grant date to restart.”

Fair market value

For a private company whose shares are not yet publicly traded, the fair market value of stock is generally determined by an independent party – what’s known as a 409A valuation. Kristin observed, for a simple repricing or an option-for-option exchange: “If you’re going to enter into a repricing program, you want to make sure you have a solid valuation in hand. If the valuation shows that the fair market value has gone up, maybe you don’t have as big an issue as you previously thought, and that might help reduce the need do a repricing. In any case, you need to make sure that whatever valuation you have, it’s a good one.”

You need to make sure that whatever valuation you have, it’s a good one.

Rule 701

Rule 701 allows private companies to issue equity to employees without the time and expense of registering securities with the SEC. This saves companies a lot of time and expense. However, among other limitations, Rule 701 limits the amount of equity issued to no more than $10 million in a given 12 month period before robust disclosures need to be delivered (including financial statements, risk factors and a summary equity plan description). So, if options are to be exchanged or repriced and the exchanged or repriced grants, plus the new grants, exceed $10 million for the applicable 12 month period, the company will need to provide robust disclosures in accordance with the Rule 701.

Tender offers

You might have noticed that some of the alternatives referenced in Part II included among the disadvantages, “Consent of option holders required; could mean tender offer.” These are instances where optionees must agree to the proposed changes. When is such consent needed?

Kristin: “It is a fair summary to say that anything that is not obviously to the option-holders’ benefit probably triggers some sort of tender offer process. Why do we care if a tender offer is needed? It’s for two reasons. First, it can be expensive and time-consuming. Second, it requires information – like financial statements and risk factors – that are generally considered sensitive information that private companies prefer to avoid making public.”

Tender offers can be expensive and time-consuming.

“To give you an idea of the costs involved, I’m working with a late-stage private company whose plans involve a tender offer. They got a bid from a third-party provider for $250,000 just to manage the process.”

Ali: “And here’s another complication: a tender offer needs to be left open for 20 business days. And if you’ve got incentive stock options, any offer that’s open for more than 29 days automatically disqualifies your ISOs. So, you need to carefully thread the needle on complying with the tender offer rules, while not inadvertently disqualifying all of your ISOs in the process.”

Tax consequences

Kristin: “A simple repricing sounds like just an amendment to an existing option. Unfortunately, from a tax perspective the repriced option is deemed to be a new option grant. This means there is a greater likelihood of at least some portion of the repriced option becoming an NSO due to application of the $100,000 ISO limit.”

From a tax perspective the repriced option is deemed to be a new option grant.

The Bottom Line:

Ali: “What you should not do is simply conclude that your value clearly is lower than it was based on your last 409A and undertake a repricing without a new 409A evaluation in hand. Doing so will trigger questions from every investor who comes along down the road and will be very messy to fix. So, valuation first and then repricing.”

“You need to be very careful how often you reprice. This is a conversation that Kristin and I have with some frequency because there is no fixed guidance as to how many times is too many. If the IRS deems there is no fixed exercise price on the date of grants, the options will then be deemed to be granted at a discount, thus violating 409A. The advice I give to clients is that the only thing worse than repricing is to reprice more than once.”