United States: The Pros And Cons Of Repricing Stock Options

With the downturn in Internet stocks, millions upon millions of dollars in employee stock options have evaporated. Many dot-com employees took substantial pay cuts from their former jobs, with the hope that they would get rich from stock options. Many holders of these options are now deciding to pack it in and leave - either moving to other Internet companies when they can get pre-IPO option packages at a time where the stock is at a low valuation, or leaving the Internet world to find a job in the more traditional corporate world.

In order to try to stem such defections, Internet companies sometimes decide to reprice their stock options. Repricing options may seem to be the perfect quick fix to the problem. If employees were granted options when the stock price was at $80 and now that same stock is at $40, companies see a solution in simply repricing the option at $40. The employee is happy because he or she is in the same situation economically as before the stock lost half its value. The company is happy because it can retain its employees with little or no cost incurred.

Unfortunately, earlier this year this simple solution became substantially more expensive to implement. In March 2000, FASB (Financial Accounting Standards Board) issued Interpretation No. 44 of APB (Accounting Principles Board) 25. Under this interpretation, companies can be forced to record an expense when they reprice options. This new rule may be enough to deter public companies from repricing options. After all, companies anticipate what the financial statements will look like for the quarter, and the market has certain expectations as well.

Companies that decide that they would rather issue new options to employees at the current stock price than reprice the existing options need to make sure they have enough shares reserved under their stock option plans. Because a cancellation followed by a reissuance within six months would be deemed a repricing under Interpretation 44, companies must keep the existing options outstanding while issuing new options.

The issuance of new options to a large number of employees while the existing options remain outstanding may necessitate amending the existing stock option plan or adopting a new one. Companies should review their existing stock option plan to determine whether or not they have enough shares reserved under their plan to issue additional options.

Interpretation 44 has made the decision whether or not to reprice options more complex. However, even before the new accounting rule was implemented, there were reasons to avoid repricing options.

The following section provides insight into some of the positive and negative aspects associated with repricing options.

• Repricing options could help ensure that employees are not punished for the downturn in the stock that may have had little to do with their performance.
• Repricing options will help retain employees. If the options are so underwater that they may never be of any value, the employee may have no incentive to remain at the company until they vest.
• Options are a cheap way to increase employees' compensation. If options are of no value, employees may demand higher salaries.

• Stockholders have been hurt by the decline in stock prices. Since they are not able to simply reprice their stock to soften the blow of the downturn in the market, they may resent that employees are getting a special deal.
• Stock options are granted in order to give employees an incentive to work hard, as they will share in the successes of the company. If employees have their options repriced when the stock does not perform well, the incentive factor is diluted.
• Companies should be confident that they would be able to drive their stock prices higher. Repricing gives the impression that the company does not think the stock price will recover over time.
• The new FASB accounting rule provides that companies must take a charge against earnings when they reprice options. This accounting charge could make repricing very expensive to companies.

Together with the traditional arguments against repricing stock options, Interpretation 44 is putting Internet companies in an uncomfortable position. Some companies may feel that the only way to retain their key employees is to reprice employee stock options. These companies should weigh the accounting risks against the employment benefits to determine if repricing is the best course of action.

If a company does decide to reprice its employee stock options due to the downturn in the technology sector, the company should make it clear to its stockholders that this decision is a one-time event due to an extremely inflated exercise price on the options, rather than a routine action that will be taken from time to time when the stock price falls.