‘Underwater’ stock options: Whether to stay put or swim out

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SummaryAs a result of the stock-market dip, employees of many companies now hold stock options that have little retention incentive or motivational value because their exercise price far exceeds the current fair market value of the underlying shares.

As a result of the stock-market dip, employees of many companies now hold stock options that have little retention incentive or motivational value because their exercise price far exceeds the current fair market value of the underlying shares. These options are commonly referred to as being ‘underwater’. There are two schools of thought on navigating this issue.

Leave the current underwater options unchanged. The argument for this approach is that the option holders feel the same pressure as an owner of the company, and will be keen on the rapid growth of the company’s performance to ensure wealth creation. Thus, if option holders know that their existing options are going to remain unchanged, they will put in greater hard-work to ensure some value from the options before they expire.

Provide alternatives to swim out. A flip side to leaving the current underwater options unchanged is that it will not be able to achieve its general objective of retaining and motivating the employees and the company is running the risk that the most-prized talent will leave. Further, the stock prices may have been artificially gravitated due to the general downturn and, thus, they may not reflect the correct picture of company performance and the true value of the work of their employees.

An alternative to swim-out can take any of the following forms:

* Underwater options may be bailed out by options that have an exercise price equal to the current market price. One key downturn to such an alternative is that employees may view the new options skeptically as they have seen the previous options go underwater.

* Underwater options may be replaced with a restricted stock award, wherein the award could be issued at a discount based on the current market price, thereby ensuring to hold some value even if the stock price declines. Also, the restrictions for exercise of awards could be in the form of continuation of employment and specific level of performance.

* The underwater stock options may be replaced with a cash award, which would ensure immediate benefit to the employee and reduction in equity dilution. However, there is higher cash outflow for the company and, unlike stock options, the employees are not motivated by any future share price appreciation.

* A fusion plan can also be explored, wherein it can be decided that if the options still remain underwater as on the exercise date, the company

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