Overview

Engaging and retaining key employees is a central concern for emerging companies in the biotechnology and life sciences field. However, lack of available cash often serves as a barrier to hiring the right people to take the company to the next level. In order to incentivize performance, increase retention and maintain a competitive compensation program, life sciences companies frequently grant stock options to directors, executive officers, other employees and service providers.

Typically, when stock options are granted, the exercise price of the options will be equal to the current trading price of the shares of common stock underlying the options. The excess of the current trading price of the shares of common stock underlying such stock options as measured against the exercise price of the stock options represents the profit that can be made by the holder of the option.

Conversely, when the exercise price of a stock option is higher than the current trading price of the shares of common stock underlying the stock options, the stock option is said to be "underwater" or "out of the money." In such a situation, stock options no longer retain their traditional benefits because the holder of the option is not able to generate a profit by exercising the option and selling the underlying shares.

In addition to the loss of traditional benefits, stock options that are "out of the money" can pose additional problems, including:, (i) causing an "overhang" of equity, and (ii) hindering the issuance of additional equity instruments by the company.

Life Sciences Bear Market

Recently, national stock markets have experienced sustained periods of volatility and unpredictability for many reasons – including, among others, the COVID-19 pandemic, the Russian invasion of Ukraine, historically significant levels of inflation, and political and social issues.

Life sciences companies, in particular, have been in a bear market for close to two years now. The volatility and unpredictability of the stock market has caused the stock prices of many publicly-traded life sciences companies to decline rapidly, resulting in an increasing number of stock options that are out of the money. Companies that have issued stock options that are now "out of the money" may consider repricing them in order to restore the traditional benefits of stock options that have been lost. This article is intended to serve as a resource for companies that are listed on the New York Stock Exchange (NYSE) or The Nasdaq Stock Market (Nasdaq) which may be considering repricing stock options that are "out of the money."

Solutions for Underwater Stock Options

A publicly-traded company that is evaluating whether to reprice its underwater stock options should keep in mind the following issues:

  • Is stockholder approval required for an option repricing?
  • Which of the below repricing methods is most appropriate?
  • Which stock option holders will participate in the repricing?
    • How do U.S. Securities and Exchange Commission ("SEC") tender offer rules and SEC disclosure requirements apply to a potential stock option repricing?
    • Is the company able to implement a stock option repricing under the terms of its equity plan?

Alternative Methods of Repricing

One-for-One Repricing (Straight Option Repricing)

The company unilaterally (i) amends underwater stock options to lower the exercise price to the current market price of the underlying stock, or (ii) cancels underwater stock options and replaces them, on a one-for-one basis, with stock options having a reduced exercise price.

Pros +

Cons –
  • Easily communicated and understood by stock option holders (assuming no other changes to the stock option terms)
  • Allows stock option holders to maintain control over the taxable event (i.e., tax at exercise)
  • Not likely to trigger SEC tender offer rules or require stock option holder consent
  • Often considered a "windfall" for stock option holders and likely to face stockholder resistance because stockholders do not benefit from the same treatment as stock option holders.
  • NYSE and Nasdaq require listed companies to obtain shareholder approval of option repricings, unless the plan specifically permits repricing. However, most forms of equity plans would require shareholder approval
  • Likely to face negative recommendations from proxy advisory firms unless (i) vesting is changed to include additional requirements, (ii) the exercise price is reset to the current market price or a premium to the current market price (thereby causing the options to remain out of the money), or (iii) directors and officers are not eligible for the repricing
  • Repriced stock options remain susceptible to going underwater in the future

Option-for-Option Exchange (Value-for-Value Exchange)

Underwater stock options are replaced with new stock options that are exercisable for a smaller number of shares with an exercise price equal to the current fair market value of the underlying stock. The exchange occurs on a "value-for-value" basis, where the value of the exchanged stock options, based on a commonly accepted valuation method (e.g., Black-Scholes or binomial lattice model), is equal to, or less than, the value of the underwater stock options being cancelled, resulting in an exchange ratio of less than one-to-one. The newly issued options will typically have a different vesting schedule than that of the prior underwater options. Directors and officers will usually be ineligible for such a repricing in order to avoid the appearance that management is sheltered from declines in stock price while other shareholders are not.

Pros +

Cons –
  • Allows stock option holders to maintain control over the taxable event (i.e., tax at exercise)
  • Viewed more favorably by institutional stockholders and proxy advisory firms than a one for-one exchange
  • Reduces dilution and equity overhang and preserves the equity plan's share reserve
  • Avoids an accounting charge if the value of the new stock options is equal to or less than the value of the exchanged underwater stock options
  • More difficult for stock option holders to understand than a one-for-one exchange and may require more employee communication efforts
  • Requires shareholder approval unless the plan specifically permits repricing. However, most forms of equity plans would require shareholder approval
  • Requires determination of proper exchange ratio to use
  • Will likely trigger SEC tender offer rules
  • Repriced stock options remain susceptible to going underwater

Option-for-Cash Exchange

Cancellation of underwater stock options in exchange for cash based on a Black-Scholes or similar valuation technique.

Pros +

Cons –
  • Reduces issued equity overhang and preserves share reserve under the equity plan
  • Easily explained and understood by employees
  • Eliminates the possibility of future underwater stock options
  • Provides immediate value to participants
  • Shareholder approval is not required
  • Requires determination of proper exchange ratio to use
  • Immediately taxable upon payment Will likely trigger SEC tender offer rules
  • Requires a cash outlay, which may not be prudent for a company looking to conserve cash
  • The long-term incentive and retention features of equity awards are lost
  • May present a number of tax related issues unless done in a very careful manner.

To determine which stock option repricing method will be most beneficial, a company will need to consider: (1) its compensation philosophy, (2) what it hopes to achieve through a stock option repricing, (3) alternatives available under any equity plans, and (4) the company's cash on hand. The one-for-one, option-for-option and option-for-stock methods are most common. The option-for-cash exchange is much less common – especially in situations of volatility where a company may need to retain cash. Given the views of proxy advisory firms and institutional stockholders, a value-for-value stock option repricing in the form of either an option-for-option or option-for-stock exchange is likely to be the best repricing method for public companies.

Considerations For Companies Contemplating Stock Option Repricings

Participation in the Stock Option Repricing

Proxy advisory firms strongly disfavor director and officer participation in stock option repricings. Because of this, if stockholder approval is required, companies should decide whether to exclude directors and officers from participating in the option repricing.

Terms of Replacement Stock Options

If new stock options are issued in place of existing underwater stock options, the company must consider whether such new options will retain the same vesting terms or whether additional vesting terms and conditions will be imposed.

Cancelled Stock Options or Shares

Companies should confirm whether their equity plans allow for cancelled stock options or shares to be returned to the plan's share pool for future issuances. Additionally, companies may choose to permanently retire any cancelled shares because such retirement will increase the likelihood of receiving proxy advisory firm support and stockholder approval.

Actions Requiring Stockholder Approval

NYSE and Nasdaq listing rules require stockholder approval for any stock option repricing unless a company's equity plan expressly permits repricing without stockholder approval. Companies should review their equity plans to determine whether such a provision is included. Often, companies' equity plans do not permit stock option repricings without stockholder approval because institutional stockholders and proxy advisory firms prefer that stockholders have approval rights of such actions.

Unless allowed by a company's equity plan, the following repricing actions are considered material amendments that require stockholder approval under NYSE and Nasdaq rules:

  • Reducing the exercise price of a stock option after it is granted;
  • Canceling stock options and issuing replacement equity awards when the exercise price of the original options exceed the fair market value of the underlying stock, unless such cancellation and exchange occurs in connection with a merger, acquisition, spin off or other similar corporate transaction;
  • Any other action treated as a repricing under generally accepted accounting principles (e.g., the grant of replacement stock options close in time to the cancellation of underwater stock options).

Under NYSE and Nasdaq listing rules, stockholder approval is not required for the cancellation of underwater stock options in exchange for cash. However, many equity plans prohibit cancellation of underwater stock options for cash without stockholder approval because proxy advisory firms consider it be a "problematic pay practice."

SEC Tender Offer Rules

SEC tender offer rules apply when the holder of a security must make an investment decision with regard to the purchase of a new security or the modification or exchange of an existing security for a modified or new security. A one-to-one repricing of stock options which results in a lower exercise price will generally not trigger SEC tender offer rules because there is virtually no investment decision required. However, a value-for-value exchange implicates tender offer rules because stock option holders must decide whether to accept a new option to purchase fewer shares or to exchange their existing stock options for other forms of equity awards or cash. Additionally, the SEC considers a repricing of stock options requiring the consent of stock option holders to be a self-tender offer by the issuer of the stock options.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.