United States: Repricing Options: What Every Private Company Needs To Know

Stock options are typically a critical component of a private company's ability to recruit, incentivize and retain key talent. Particularly for early-stage companies, rewarding equity packages can help make up for the gap between the cash compensation a startup can offer against the more significant cash compensation their larger competitors can afford to pay. However, when stock options have exercise prices that are higher than the fair market value of the underlying stock (i.e., when the options are "underwater") they lose most, if not all, of their incentive and retentive value. And where there is a competitive market for talent, the lack of effective equity incentives may make the departure of key employees more likely. As a result, a company may determine that a repricing of underwater options is necessary to retain executives and other employees who are instrumental in the company's future success.

While the term "repricing" can cover a variety of structures, private companies usually opt for a simple options-for-options approach in which the exercise price of underwater options is reduced to an exercise price equal to the then-current fair market value of the underlying stock. While there are other repricing structures—options-for-restricted stock, options-for-restricted stock units, or event option-for-cash—in this alert, we focus solely on the options-for-options structure because it is the least administratively complicated, avoids undesirable tax consequences and preserves cash. Even so, there are number of business and legal considerations that a private company must balance as it evaluates whether and how to implement a repricing, including the (often surprising) consideration that the consent of option holders may be required, as discussed below.

Repricing Structure Considerations

Terms of the Repricing. For many private companies, a repricing can be as simple as reducing the exercise price of all outstanding underwater options held by current service providers to the current fair market value of the underlying stock but leaving the other terms and conditions of those options unchanged. Such a simple approach may be the beginning and end of what they seek to accomplish. Indeed, private companies generally demand little or no "giveback" from participants in exchange for the reduction in their option exercise price: they do not require that option holders participating in the repricing receive a reduced number of options or have a portion of their vested options made subject to vesting again. However, in some cases additional changes to the repriced options may be necessary or appropriate to achieve the goals of incenting and retaining employees via the repricing. Specifically, a company may wish to consider one or some combination of the following terms:

• Repricing Threshold: Should all underwater options be repriced or should the company choose a threshold above the current fair market value of the underlying stock in identifying which options may be repriced? While private companies generally allow options having an exercise price that is in excess of the then-current fair market value to be repriced, choosing a higher threshold could limit the number of options being repriced and avoid repricing options that are only modestly underwater.
  
  
• Number of Participating Options: Depending on the number of options outstanding, the company may wish to limit the size of the repricing. If so, in addition to (or in lieu of) setting a repricing threshold that is higher than the then-current fair market value of the underlying stock, the company could consider either setting a limit on how many underwater options each eligible participant may reprice in total or setting an exchange ratio (for example, providing that every 3 underwater options may be exchanged for 1 repriced option). Setting such an exchange ratio would also generally have the effect of returning shares to the equity plan that could be made available for new awards.
  
  
• Repriced Option Exercise Price: The new exercise price of the repriced options must be at least equal to fair market value of the company's stock at the time of repricing to comply with Section 409A of the Internal Revenue Code ("Section 409A"). While companies generally set the new exercise price to exactly fair market value, a company could choose to set the new exercise price higher instead.
  
  
• Vesting Schedule: Typically, existing vesting schedules are carried over to the repriced options without change; however, the company may wish to reset vesting schedules in whole or in part so that the repriced options provided greater retention.
  
  
• Expiration Date of Repriced Options: Repriced options typically have the same expiration date as the original underwater option. The company may instead provide each repriced option with a new 10-year term in connection with the repricing.
  
  
• Tax Characterization of Repriced Options: Repriced options will generally retain their character as incentive stock options ("ISOs"), subject to the rules regarding ISOs (described below), or as nonstatutory stock options ("NSOs"); however, the company could structure the repricing so that the repriced options are either ISOs (to the extent allowed under the Internal Revenue Code) or NSOs, even if the original option had a different tax character.

The more extensive the changes to the terms of the repriced options, the more likely it is that option holder consent will be required to effect the repricing. But even a repricing that only reduces the exercise price of the underwater options may require option holder consent if the underwater options are ISOs or the form of award agreement requires it.

Eligible Participants

Within the United States. The company must determine who is eligible to participate in the repricing and can be as selective or broad as best accomplishes the goals of the repricing, absent any constraints imposed by the company's stock incentive plans or award documents. Typically, companies allow all current service providers (employees, consultants and directors) to participate, though it is permissible to offer the repricing to a small group of key employees. Former service providers who still have time left in which to exercise vested options are generally excluded from repricings both because the company no longer needs to incentivize or retain them and because their inclusion raises securities laws concerns.

Outside the United States. An option repricing for employees who are tax residents outside the United States may be subject to local securities, tax and other legal requirements that differ from those in the United States. Compliance with these requirements—and providing descriptions of the securities and tax consequences in all applicable jurisdictions to the relevant eligible participants— can become burdensome. Unless the company is willing to incur the expense of complying with all local law requirements, foreign employees will need to be excluded from any repricing. If the company does wish to include foreign employees, it will be necessary to consult with foreign counsel in any applicable jurisdictions. While some jurisdictions may be quite straightforward and similar in approach to the U.S., others may require compliance with complicated administrative regimes or present adverse tax consequences.

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