Many private companies are having to grapple with the realities of lower valuations. When a new Section 409A valuation values the company’s common stock at a lower price than any past Section 409A valuations relied on to grant prior stock options, the company may want to consider repricing the stock option held by its service providers. Where an existing stock option has an exercise price higher than the company’s current valuation, the result is an “underwater option.”
While repricing can restore some of the incentive and retention value of employee equity, it raises a host of valuation, perception, legal, tax, and accounting considerations that a company must manage.
Is a repricing necessary?
If the decreased valuation is a temporary situation that is expected to shift and change in a short period of time, or the long-term value is expected to be significantly greater than the current price, a repricing may not be necessary. This is particularly true if the value that is added to the option as a result of the repricing is not significant from a long-term perspective (i.e., the adjustment in price is relatively small). For example, if an employee held 1,000 company stock options that were currently priced at $2 per share, but that could be repriced to $1 per share, it may feel like making this change would be a significant repricing. However, if, a few years later, the company were to have a liquidity event where the shares were sold at $100 a share, this repricing only added an additional $1,000 to the total sale amount of $99,000 which is an increase of only 1 percent. Contrast that to a situation where the shares are ultimately sold at $3 a share where this represents the same dollar increase of $1,000 to the total sale proceeds of $2,000, but effectively doubles the holder’s proceeds.
While companies may not be able to predict the ultimate sale price, it is useful for a company to look at what a healthy potential exit will look like and how significant this repricing would be in that context, to ensure there is material value being added as a result of the repricing.
Negative Aspects of a Repricing
On first blush, most people would expect employees would be happy to have their options repriced as it gives them additional potential equity value; however, repricing options can introduce worry about the long-term value and prospects of the equity and, as a result, impact employee morale. Repricing can, and often does, have a positive impact on employees, but employees may also interpret it to mean the equity they hold is decreasing in value and that they are less likely to get the hoped for upside. This can be particularly true where there are multiple repricings over a period. Repricing can also impact employees’ trust in management, especially if the message coming from management is about how well the company has been doing during that same period. If the future value of the shares is perceived to be weak, it create jitters among the service providers and can negatively impact retention and hiring. The impact is exacerbated if the company is in an industry where most companies are doing well, as opposed to general market downturns impacting all similar companies. Finally, a company repricing can be a signal to investors that the company does not perceive as much long-term value in the shares and can actually lead to low-ball investment proposals, creating a self-fulfilling prophecy. Companies need to carefully weigh both the long-term and short-term impact of a repricing and its perceptions by service providers and investors.
Repricing Terms & Participation
If the company has decided that a repricing is necessary to properly incentivize its employees, the next consideration is what terms the company should offer in connection with the repricing. While a private company may be tempted to use the repricing as a chance to add vesting or other terms favorable for the company, anything other than a simple repricing (e.g., changing only the price) adds considerable cost and complexity for the repricing and could trigger the tender offer rules as discussed in more detail below.
Generally, only current service providers can participate in a repricing. This is because the repricing is effectively treated as a cancellation of the prior grant and a grant of a new award at the new price. All new awards need to be granted pursuant to a valid securities law exemption thus the repricing is generally limited to service providers that satisfy compliance under Rule 701 (discussed more below). If a significant number of former service providers are impacted by underwater stock options, the company should consult with counsel to determine the best path forward.
Tax Considerations
Any time a company wants to do a repricing, it needs to consider Section 409A compliance and Incentive Stock Option (“ISO”) tax issues.
Section 409A Tax Compliance: Section 409A governs deferred compensation, including stock options, and imposes severe tax penalties options granted with an exercise price below fair market value. Section 409A penalties include an immediate income inclusion plus a 20% extra tax for the option holder. Any option repricing must therefore be done in compliance with Section 409A. In practice, this means the new exercise price cannot be less than the then-current fair market value of the underlying stock as of the repricing date. To ensure this, companies generally obtain an updated Section 409A valuation before repricing options. The board will use this valuation to set the repriced exercise price at or above fair market value, preserving the options’ exemption from 409A. Furthermore, a single repricing is usually not a risk under Section 409A, but successive repricings may be. While market volatility may tempt companies to repeatedly adjust option prices, serial repricings can be seen as the company not having a fixed price for options (e.g., the repeated repricings are seen as chasing a price to the bottom) which could be a Section 409A violation. Each modification should be carefully considered and tied to a material change in value (not minor fluctuations), and any subsequent repricings should be analyzed for their impact under Section 409A.
ISOs: Repricing an ISO is deemed a grant of a new ISO. This means that the regular limit on ISOs ($100,000 per year in which the option first becomes exercisable) must be recalculated, and some holders of repriced options may end up with fewer ISOs and more non-qualified stock options (“NSOs”) as a result of these recalculations. Also, since the repricing of ISOs is deemed a grant of new ISOs, the ISO holding periods (specifically, the prong requiring the ISO be held for two years from date of grant) will restart from the repricing date. Whether these changes are sufficiently material to require the consent of the option holder or a company tender offer should be analyzed by the company in consultation with its counsel under the terms of the plan (such as plan limitations on ISO grants and changes to existing grants) and applicable securities law.
Securities Law Considerations
A repricing raises securities laws issues under Rule 701 and could trigger tender offer issues.
Rule 701. Rule 701 of the Securities Act of 1933 is the primary federal exemption that allows private companies to offer stock options and other equity compensation to employees without registering shares with the Securities and Exchange Commission. Repriced options count toward Rule 701 limits and disclosure thresholds. Importantly, as noted above, a repriced stock option is generally treated as issuance of a new security which must qualify for an exemption at the time of repricing. Therefore, the company must ensure that the repriced options, taken together with other equity compensation issued in the same 12-month period, do not exceed Rule 701’s size limits (the greater of $1 million, 15% of assets, or 15% of outstanding securities). Moreover, if the value of the repriced options, taken together with other equity compensation issued in the same 12-month period at the time of repricing, exceeds $10 million, the company must provide the required disclosures under Rule 701 (financial statements, risk factors) to all participants. Companies should keep in mind that, because Rule 701, by its terms, covers offers to current employees, directors, consultants, and advisors, it is generally not available as an exemption for repricing options to former service providers.
Tender Offer: An issuer tender offer under Rule 13e-4 and Regulation 14E of the Securities Exchange Act of 1934 (the “Exchange Act”) encompasses an offer by the company to security holders to exchange securities, which offer is open for a limited time and involves decisions by the holders. Importantly, a “simple” unilateral repricing that changes only the exercise price to the new Section 409A valuation while leaving the other terms the same is generally not thought to rise to the level of a tender offer. However, an option repricing where the option holder’s consent or action are needed may require compliance with tender offer rules, which are triggered because the option holder is making an investment decision over whether to accept the proposed terms of the repriced options. To comply with tender offer rules, the company then must observe a host of requirements under the Exchange Act. Also note, if the option is an ISO, keeping an exchange offer open more than 30 days might affect ISO status, so companies with ISOs will sometimes limit the offer window to 29 days to be safe.
Corporate Governance Considerations
A repricing will also raise a number of corporate governance issues, including approval requirement and fiduciary duties.
Board Approval: In almost all cases, repricing will require approval by the company’s board of directors (or a committee with delegated authority). The board should formally approve the repricing terms (who is eligible, new exercise price, timing, etc.) via a resolution. This is both a governance requirement and a key part of the board fulfilling its fiduciary duty (documenting that it considered the repricing and found it in the company’s interest to retain talent). The board should also be mindful of any conflicts of interest that may arise, particularly if grants to the directors are implicated.
Stockholder Approval: For private companies, stockholder approval of a repricing is typically not required unless the company is contractually obligated pursuant to agreements with investors. It is crucial to review the stock option plan documents, the company’s charter or organizational documents and any investor agreements (such as an Investor Rights Agreement) before proceeding. Credit agreements or other contracts might also restrict modifications of equity incentives.
Fiduciary Duties and Legal Risk: A company’s decision to reprice options should also be evaluated through the lens of fiduciary duties and fairness to all stockholders. While repricing is aimed at benefiting employees (and, by extension, the company, through improved retention), it does effectively transfer potential economic value from existing stockholders to the option holders. Directors must justify the repricing as a reasonable, informed, and fair decision. To withstand scrutiny, the company’s board should document the business purpose, such, for instance, maintaining team morale and productivity during a downturn. Additionally, to the extent any holders benefiting from repriced stock options are directors, officers or controlling stockholders of the company, the company should be mindful of the safe harbor requirements under Section 144 of the Delaware General Corporation Law and obtain the appropriate approvals.
