Repricing Underwater Stock Options –

Stock prices of high-technology companies have continued to decline precipitously as a consequence of increasing investor uneasiness in the wake of the recent terrorist attacks. Increasingly, the market drop has pulled many stock options underwater, meaning that the exercise price of the options has fallen below the current market price for the underlying securities. Many option holders, typically employees who have accepted less compensation in the form of salary in order to participate in the potential upside of a New Economy business, are pressuring management to reprice these underwater stock options or grant new options at reduced strike prices. At the same time, many stockholder groups are expressing their displeasure with attempts to reprice stock options, stating that repricing is unfair and removes the incentive to increase stock prices and improve the company’s financial performance. Additionally, the Financial Standards Accounting Board (FASB) has issued FASB Interpretation Number 44 (FIN 44), restricting the manner in which companies may reprice stock options without incurring significant accounting charges. These factors have combined to make stock option repricing one of the most-discussed topics related to compensation to emerge in some time-a topic of particular relevance to venture capitalists who invest in, or sit on the boards of, publicly traded companies.

The Employee Perspective

From the employee perspective, repricing is the surest way to revive the original incentive and retention value of the underwater stock options, particularly those options that are severely underwater, as the employee has no confidence that the options will ever be in the money. When a significant portion of an employee’s total compensation consists of stock options that the employee believes are worthless, the reasons to remain with the company decrease substantially. This is particularly true in instances where an employee could receive stock options at a depressed price from another company as part of their compensation package and would thereby be more likely to benefit from even a modest increase in the new employer’s stock price.

Related to the issue of retention is the potentially unfair treatment afforded by granting options to new employees at the reduced current strike price. While a new employee would receive the benefit of the reduced strike price, the incentive for a loyal employee to remain with the company and help reverse its fortunes would be greatly diminished. As a result, experienced employees may flee in order to receive fresh options from other companies, many of which may be direct competitors. The failure of a company to reprice its underwater options and therefore lose valued employees may cause its stock price to decrease even further.

Employees may also feel unfairly penalized as a result of general declines in the stock market that are not necessarily an indicator of poor performance by the company. Additionally, it may be argued that the efforts of the average employee have much less of an impact upon the company’s stock price than competent and efficient management by the top executives and therefore, while perhaps management’s stock options should not be repriced, repricing the stock options of the rank and file should be undertaken.

The Stockholder Perspective

From the perspective of a company’s stockholders, repricing stock options severs the fundamental link aligning stockholder and employee interests, which justifies the issuance of stock options in the first place. Stockholders invest in a company expecting an appreciation in the company’s stock price over time and, to that end, they may approve stock option plans that provide employees with an additional financial incentive to maximize the profitability and stock price of the company. Stockholders tend to see the issuance of stock options pursuant to these plans as a contract between themselves and the employees. Should the employees perform well and should the stock price rise as a result, the stockholders will share some of the upside with the employees. Should the stock price falter, stockholders feel justified in stating that the employees have not held up their end of the bargain and, as a result, the company should not reward the poor performance of the employees at the expense of stockholders by changing the rules of the game.

Increasingly, stockholders are voicing concerns that repricing enables employees to avoid the risk of loss inherent in any investment. After all, stockholders cannot reprice their depreciated shares in the event that the company performs poorly and, accordingly, there is a strong belief among venture funds and other institutional investors that employees should not be insulated from sharing the risks associated with poor company performance by having their options repriced.

Further, stockholders may believe that stock option repricing sends a clear message to the capital markets that management does not expect the company’s stock price to rebound to its previous level in the near term. Frequent repricing could also create a sense among employees that performance is not crucial, as the company will always take steps to bail out underwater stock options.

Stockholders may also find unconvincing the argument that stock option repricings are necessary in order to retain key employees. Stockholders have argued that, instead of repricing underwater options, the company should continue to grant options at the current reduced price in accordance with its usual granting schedule, or even accelerate its option-granting schedule. Additionally, certain key employees could be provided with additional stock options for retention purposes.

Stockholder groups are also using the debate about repricing in order to more closely scrutinize the compensation policies of the companies in which they have invested. In the recent past, stock options were granted primarily to top management -those individuals within a company who had the opportunity to have a direct impact upon the fortunes of the company, and who, presumably, received stock options in addition to and not in lieu of a large salary. When the technology-driven New Economy was booming and all of the options were in the money, no one complained about the issuance of stock options to all levels of employees. Now that the stock prices have declined, stockholders are claiming that the use of stock options as a form of compensation for rank and file employees diluted the original intent of providing incentives to those individuals who could raise the stock price through the use of their expertise. Stockholders argue that the repricing dilemma, which many companies now face, is a direct result of instituting these indulgent policies.

Accounting Issues and 6&1 Plans

The FASB rules relating to stock option accounting treatment, which became effective on July 1, 2000, have the potential to make stock option repricing very costly. Briefly, FIN 44 requires that a company that reduces the exercise price of an option must treat the repriced option according to variable (rather than fixed) accounting rules. The switch to variable accounting will require a company repricing options to include the increase in the price of the shares underlying the options as a compensation expense and, therefore, a charge against earnings. In short, the appreciation in the value of the stock is subtracted from the company’s profits, a negative outcome for the company and its investors.

In order to avoid this accounting charge, many companies have followed the example set by Sprint Corp. in November 2000 and adopted what has come to be known as a 6&1 plan, basically allowing employees to exchange underwater stock options for new options to be granted six months and one day from the date of the exchange. Placing the new grant date six months and one day into the future enables companies to reprice underwater stock options while retaining fixed accounting treatment under FIN 44. Several dozen companies have put a 6&1 plan into effect since Sprint introduced the concept.

The 6&1 plan has its drawbacks, however. The incentive for an employee to attempt to increase the stock price during the six month waiting period is eliminated and some have argued that an employee may actually reduce the stock price during the waiting period so as to increase the potential upside benefit when the replacement options are granted.

A Middle Ground

Regardless of the form of the plan that a company undertakes to reprice its underwater options, there are certain steps a company can take to make the option repricing more palatable for investors.

Adjust vesting provisions for new grants. In order to ensure that the new options serve to retain employees, companies should restart the vesting period for the repriced options at the time of the grant, or even extend its typical stock option vesting period.

Adjust options on a tiered basis. Companies should consider repricing only those options with strike prices above a certain fixed level between the current strike price and the current fair market value of the stock in order to ensure that some stock price appreciation is realized before many of the options are in the money.

Adjust option grant frequency. In order to reduce average exercise prices, companies should begin granting options in smaller share quantities on a monthly or quarterly basis, rather than annually. This practice is similar to the dollar-cost averaging method employed by many investors in connection with 401(k) and IRA plans.

Reprice on value, not share numbers. A company which determines that repricing is warranted should avoid providing an identical number of options at a reduced per share exercise price, and instead focus on the value of the equity compensation as a whole that is being provided to employees under the repricing plan.

Readjust compensation components. A company should take advantage of the opportunity afforded by repricing to consider its current mix of compensation components, particularly between fixed amounts given in the form of salary and variable components in the form of stock options and performance related bonuses.

Avoid repricing for executives or directors. Repricing stock options for the rank and file but excluding management is one way in which a company can retain valuable employees while assuring stockholders that management is being held responsible for the poor stock performance of the company.

Obtain stockholder approval. Perhaps the best way to ensure that stockholders are in agreement with repricing plans is to seek their approval in advance of instituting the repricing plan. However, attempts to obtain stockholder approval with respect to repricing stock options for executives and directors are meeting increasing-and justified-resistance from the investment community.

Until stock prices rebound, issues concerning stock option repricing will continue to plague companies. With a creative thinking, careful planning and a fair amount of institutional will, companies can find common ground between employees and stockholders to ensure that the needs of both constituencies are addressed.

Mr. Sutton and Mr. Donohue are associates at Kirkpatrick & Lockhart LLP’s Boston office, concentrating on growth company organization and financing, technology licensing, product development collaborations and venture capital.