If you’re listening to industry chatter, you’ll know that experts are weighing up whether the recent drops in many stocks signify a correction, or a bear market? A bear market has various definitions, but symptoms can be a drop of 20% in worth from a stock’s highest value point, or investors who are making risk-averse decisions rather than risk-seeking ones.
With a lot of uncertainty in the market, heavy talks of hyper-inflation, and political tensions a’plenty, what should companies do if recent high valuations don’t last, and the market turns a sharp corner leading to stock options that take a tumble?
Understanding the depth of the problem for today’s businesses
It’s clear that whether we’re in a bear market or not, a lot of stock options and 409a valuations are dropping in price in the current climate. However, while 409a valuations aren’t based on market demand, stock options certainly are. If employees are granted the ability to purchase their share options at $10, but by the time they exercise them they have dropped 20% in worth to $8, they are what’s called underwater. That means the exercise price is greater than the market value, making it unlikely an employee would want to exercise at that price at all.
While of course a company can educate their employees that stock options have inherent risk associated with them, and that they may increase, or in this instance, decrease in value – in reality this is obviously going to lead to frustration, lack of morale and buy-in from the employee. With stock options that suddenly become worthless, the financial tie to the company becomes less evident, and you might find that employees feel less invested (no pun intended) and you’re left watching talent walk out the door.
Instead, here are some ideas that companies can use to work around the drop in stock value, starting with a choice that has become popular for supporting employees who have left the company – extending the exercise period.
#1: Extend the exercise period after termination
Stock options typically expire after ten years, and most companies offer a 90-day period where employees can exercise their options after they leave a company. Extending this “safe zone” means that ex-employees could hold onto their options while they are underwater, and exercise them without the pressure of the 90-day window once the price rises again.
In the past, this kind of arrangement would only be done for employees with a certain amount of longevity or seniority at the company, or for “good” leavers rather than those who were terminated from employment. However, with this approach, the extended exercise period would impact everyone equally.
There is definitely some added administrative burden to the company in extending the exercise period, as traditionally options would simply expire after the 90-day period was up. In this case, administrators would have to account for and manage the process for each employee for far longer, and the ball would be in the previous employee’s court as to when to exercise the stock.
However, it’s not all sunshine for the employees either, as there are tax issues to watch out for. In the US for example, you can receive preferential tax treatment for stock options with the use of Incentive Stock Options (ISO), but if you exceed the 90-day window to exercise your stock options, you will lose that benefit, as the stock options become what’s known as non-qualified. Even if employees have already paid alternative minimum tax on their ISO, income tax will become payable, which can cause added expense and administration for the employee.
Additional ideas for turning the tide when it comes to underwater stocks
If increasing the exercise period doesn’t work for you, or you’re looking for a solution that impacts a wider contingent of employees, and not just those who have left the company, here are some other choices that could be a better fit:
#2. Convert stock options to RSUs
Though they may increase and decrease in value, Restricted Stock Units do not have the same risk, as they are gifted to the worker without obligation to purchase. Receiving RSUs in lieu of or in addition to stock options can relieve some of the employee tension if stock options are expected to be underwater long-term. You’ll need to consider what a fair amount of RSUs is for the relative number of stock options.
Employees may need to take into account that they are getting less RSUs, but at a fixed price so with more stability over their equity. There will be some administrative overhead involved in changing the original agreement, and sorting out what each employee will be given. An added benefit of this approach is that you’ll have more shares available to issue in the future.
#3. Interim appeasement
This approach involves giving your employees cash or shares to get them over the hump of the stock slumping. The value of the reward may vary depending on the business requirements, but of course won’t exceed the value of the original stock option. This choice limits administrative burden for the business, as you don’t need to change the original agreement, so might make more sense for your specific company.
You might also choose to cancel existing stock options and replace them with a cash bonus or reward. Your employees should recognize they will need to pay full income tax on this kind of benefit.
#4. Reprice the stock options
This is definitely the most onerous route, and involves repricing the original grant price which can mean obtaining consent from each employee to make those changes. A last resort, this is usually only considered when there is no expected turnaround for your stock, and you can’t see them returning to their former glory days. Remember, you have no guarantee that these new repriced stock options won’t also fall underwater over time.
Do something or do nothing – it pays to know your options
Whether you take the gamble of losing employees due to underwater stock options, or change the way you approach equity with a reprice, one thing is for certain – there’s a lot of uncertainty in the market right now.
Understanding the different options you have for underwater stock options, with or without a bear market breathing down your neck is an important part of offering equity to your employees. Educating teams and employees on the benefits they have available to them or simply advocating for long term improvement can be enough to hold back the tide.
Got a specific question about equity or employee rewards anywhere in the world? Papaya Global offers a complete global equity management advisory service so we’re best placed to get you the answers you need. Reach out to schedule a consultation.
