What Is Repricing?
Repricing involves the exchange of worthless employee stock options for new options that have intrinsic value. This is a common practice for companies to keep or incentivize executives and other highly valued employees when the value of the company's shares falls below the exercise price or break-even point for the options issued in the original incentive program.
Key Takeaways
- Repricing occurs when a company retires employee stock options that have become quite out-of-the-money with new options that have a lower strike price.
- This is done when a company's share price falls well below the exercise price of the original employee stock options issue.
- By repricing, the company effectively replaces now-worthless options with those that have value to keep top managers or key employees.
- Repricing may have tax implications for both the issuing firm and recipients.
Understanding Repricing
While repricing is not new, it became a common event after the Internet bubble burst in 2000 and again following the financial crisis of 2008-09 as many stock prices experienced a deep bear market. As company share prices dropped sharply, employee stock options found themselves underwater, meaning that their strike price was higher than the current market prices.
Many start-up companies offer employee shares of stock as a hiring incentive.
For instance, a company may have issued employee stock options that could be exercised at $30 after a vesting period, when the shares traded at $35. This option effectively granted holders the right to buy shares at $30 regardless of the market price in the future. However, nobody will agree to buy the stock at $30 if it falls to $25 a share in the open market.
Therefore, companies essentially took back the worthless stock options to retain and incentivize executives and highly valued employees and issued new ones. The newer options would likely be struck near or just below the current share price. This, in effect, is equivalent to a standard option being at the money (ATM). This is an important issue as many valued employees agreed to substantial pay cuts from previous jobs when joining new companies. This is true, especially for start-ups. The hope is that the employee will make up the difference many times over as the company's stock price increases.
Implementing Repricing
Some companies changed their incentive programs to grant restricted stock instead of stock options. Others issued options that converted immediately into shares to eliminate uncertainty in the future. Which route the company takes depends on its unique tax and reporting issues. Repricing will increase the option expenses a firm must deduct from net income.
Also, the new stock options granted must use the current fair market value of the underlying stock as their "strike." For privately held companies, the board of directors must determine a new value on the company's common stock, which directly impacts all existing shareholders.
Under the Financial Accounting Standards Board (FASB) rules, when the company cancels an existing stock option and grants a new option "six months and a day" later, it is technically not a reprice. Therefore, it avoids variable accounting treatment. For that period between cancellation and new granting, the employee only has a promise that they will get the new options.
Another approach is called a “restricted stock swap,” the company cancels the underwater or worthless stock options and replaces them with actual restricted stock. Finally, the company may issue additional stock options, leaving the original options in place. This is called a “make-up grant.”
Can You Reprice Stock Options?
Yes, stock options can be repriced. There are many ways to reprice stock options, including lowering the exercise price to the current market price for outstanding options. Another method would be to entirely cancel the outstanding options and replace them with at-the-money options.
Why Do Companies Reprice Stock Options?
Stock options are considered incentives to attract high-quality talent to a firm, as well as to retain high-quality talent, and in many cases, motivate employees. When the value of stock options becomes worthless due to adverse changes in the economy, companies will reprice the stock options to bring value back to them.
Can You Exercise Underwater Stock Options?
Yes, technically you can exercise underwater stock options but it is not recommended to do so, because you will pay more for the shares than the current market price. For example, if your exercise price is $15 and the current market price of the stock is $12, you would pay more for the shares than they are worth if you exercised them. Furthermore, exercising underwater options does not allow for any tax-loss benefits.
The Bottom Line
Repricing is a company's action to retire stock options that have become quite out-of-the-money with new options with a lower strike price. The company effectively replaces worthless options with those with value to retain top managers or key employees. Repricing may have tax implications for both the issuing firm and recipients.
