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Stock Options Repricing: Keeping your Employee Equity afloat ⛵
Learn how to conduct stock options repricing, why startups do it and what are the legal watch-outs
In the current economic environment, it is not rare for stock options granted by private companies to their early employees to be seen as less attractive compared to cold, hard cash.
This is particularly true in the tech sector where down rounds are no longer the exception they could seem to be let’s say 2 or 3 years ago. As one can expect, going from a wave of mega rounds to a drop or stagnancy in valuations has obviously several consequences on the attractiveness of employee stock options: 🌊
- There are fewer employees who exercise their options
The number of employees exercising their options has gone down. According to Carta 2022 Employee Stock Options Report, the average exercise rate of “in-the-money options” - that is, whose current fair market value is higher than the strike price - went from an all-time high of 55.9% in October 2021 to 41.7% in December 2022.
Most employees are now in a “wait and see” mode with respect to their options, unless they have been let go as part of the latest reduction in force where they usually have no choice but to make a decision within the three months of post-termination exercise period that typically follow termination of their contract.
- More employees now have “underwater” grants 🤿
<aside>💡 Some employees now have to pay more to buy their shares than the current fair market value of the shares. They now hold what we call “underwater” or “out of the money” options.
You may say that it makes little difference for the true believers in the company’s long term purpose and success. Those who, come hell or high water, will stay onboard until the end of the journey, will for sure weather the storm and eventually exercise their options when the economic climate gets clearer. In practice though, most employees can easily feel demotivated by the lack of attractiveness of their equity package, which is why employers can be tempted to do a repricing of underwater stock options in an attempt to help retain and incentivize employees.
In this article, we’ll give you some information that could help private companies navigate a repricing process and answer a few frequently asked questions. This is not legal advice
But before diving into the FAQ:
What is a repricing?
A repricing is a reduction in the strike price or exercise price option holders have to pay, to align it with the current fair market value of the shares (which is typically determined on the basis of a new 409A valuation).
Now let’s dive 👌
Can every team member participate in a repricing?
Most private companies will reprice the options of all their team members. Team members are to be understood as service providers in the broad sense, i.e. not only employees but also contractors for instance.
Some companies could consider only repricing the options of their C-level executives, or only the options that are twenty thousand leagues under the sea and not the ones near the surface.
In practice, most companies would reprice all underwater grants of active service providers.
💡 The goal of a repricing is to try to keep motivation intact for those who have to contribute to the company’s success. What no company would normally do is to reprice the options of people who are no longer active (e.g. service providers within their post-termination exercise period).
What are the legal reefs to avoid ? 🪨
ISO status
(only applicable to US employees)
Although repricing seems like a simple modification of an existing grant, from a tax perspective, repricing an option comes down to making a new grant, and this has two consequences for ISOs:
- 100k rule
To qualify for ISO treatment (and thus favorable tax treatment), the maximum fair market value of the stock with respect to which ISOs at first become exercisable in any calendar year should not be higher than 100k$.
When an ISO is repriced, the 100k$ limitation must be recalculated for the year of the repricing, including with respect to stock options that became exercisable and counted against the 100k$ limit in a prior year, leading to higher probability to exceed the 100k$ limitation and therefore that the number of stock options being deemed NSO increases.
If you’re considering repricing large ISO grants, it’s worth investing some extra time to understand the impact based on the specific facts of the grant.
- Holding period for long term capital gain tax treatment
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 previously granted higher-priced ISOs will cause that 2 year holding period to start again.
International service providers
In some countries (e.g. Australia, Belgium, Ireland, Canada) taxation can, under certain circumstances, take place at the time of grant of the options (depending on whether the options have been granted to an employee or a contractor, the specific terms of the option agreement or the grantee’s taxation choice).
Since repricing an option amounts to a new grant, there could be tax consequences for the company and the service provider.
There can also be consequences when you have offered tax-favored instruments such as EMI, CSOP, or BSPCE.
⚠️ Specific attention should be paid to the impact of tax-favored instruments such as ISO, EMI or BSPCE, or to international employees whose options could be taxed at grant.
Accounting
For most companies, a repricing of options will result in an incremental accounting charge under accounting rules (e.g. FASB ASC Topic 718). The incremental charge for repriced stock options is generally fixed at the time of repricing and typically equals the increase of the fair value, if any, of the repriced stock options over the original stock options. These accounting consequences should particularly be assessed by later-stage companies.
Do shareholders need to be involved?
Not necessarily, but some documents (e.g. equity plan, certificate of incorporation or investor right agreement) may - even though it will rarely be the case - impose some restrictions and require shareholders to approve a repricing of options. In private companies, it’s usually only the board who will have to be involved in the process.
Does the initial grant documentation need to be amended?
Not necessarily, because repricing is normally in the interest of the grantee.
There are cases where it is required, for instance if the company decides to not only reduce the exercise price, but also keep the initial grant’s expiration date, or have a longer vesting schedule than the initial one. There are also borderline cases when ISOs are repriced and loose (part of) their ISO status, where it could be prudent to obtain the grantee’s consent.
How to communicate a repricing?
To investors
Before carrying out a repricing, management should carefully explain the benefits to the investors, as some of them may not see it as necessary or useful.
Ultimately grantees have to pay less if they exercise, meaning less incoming money for the company, make sure you communicate a repricing to your investors in advance. Management should stress the positive impact on employee morale and company culture of fairness.
To employees
Repricing communication is a touchy topic. On the one hand it is good news for those whose options are repriced, on the other hand it can be perceived as unfair by employees whose options are “in the money” and therefore not repriced.
In addition, maybe some of the employees didn’t even realise that the fair market value of the company had gone down. In other words, you’re making employees a “gift” but the flip side of the coin is that it could raise doubts as to the company’s ability to perform, thereby demotivating employees and having the opposite effect as the one initially sought.
Eventually, we think that each company should communicate a repricing in a transparent way and underline this it is a precious perk they are giving. The format doesn’t matter, the most common approach is to give a one-page notice that informs the grantees about the repricing and the lower exercise price that now applies to their options.
👋 How can Easop help?
At Easop, we’re helping you identify underwater options via our equity insights tool, here more about it.
We have automated the process of issuing new equity grants to US and non-US team members, and edit the existing grants (waiving the cliff, extending the post-termination exercise period (PTEP) or accelerate the vesting). Companies can now perform these basic tasks at a fraction of the time and cost required if those had to take place manually.
You can’t change the direction of the wind but you can adjust your sails, and this goes also for our product roadmap. That’s why even if it would be more exciting to ship 🚢 a feature around liquidity, we’re now working on the automation of repricing workflows, to help you navigate it more serenely 🧘♀️ and cost-effectively. We also partner with the best law firms out there to make sure nothing falls through the cracks.
📣 If you'd like to learn more about how Easop could help your organization, request a call with our team. Try easop
