Trying to Raise Sunken Stock Options Can Be a Murky Business
Repricing options when shares tank a questionable move
Kathleen Pender Friday, April 28, 2000
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As the ranks of dot-com paupers grow, companies are coming under pressure to do something about their employee stock options that have become temporarily worthless.
But their own options are limited now that the accounting poo- bahs and institutional investors have clamped down on the most popular solution -- repricing options at a new lower, price.
This week, Microsoft took a different approach. All 35,000 full- time employees will get an extra, one-time stock grant equal to the grant they received in July -- about 70 million options in all.
While that may be a good alternative for many companies, it won't be possible for all those whose stock prices have plummeted.
Of the 159 Bay Area companies that have gone public this year or last, 53, or one-third, are trading below their initial public offering prices. That means people hired since the IPO -- and possibly before -- may be sitting on options that have no immediate value. Many newer workers at older companies are in the same boat.
Stock options let you purchase a certain number of shares at a fixed price, known as the strike or exercise price, during a certain time period, usually 10 years. Generally, high-tech workers get a passel of options when they join a company and another clump once a year.
The options vest, or become available, over time. Typically, one- eighth of the options from each grant can be exercised every six months over four years.
The exercise price is usually the share price on the day the options are awarded. If the share price subsequently goes up, employees pay for stock at the exercise price, sell it at the market price and pocket the profits.
But if the stock price goes below the exercise price -- known as going underwater -- the options can't be sold at a profit and employees may become disgruntled.
The easy solution to this morale problem is to lower the exercise price so that the options are ``above water'' or ``in the money.'' This is often accomplished by canceling the old options and replacing them with new ones at a lower strike price.
Either way, this practice usually doesn't require shareholder approval or prior notification. And until recently, it had no impact on a company's earnings.
But in March, the Financial Accounting Standards Board changed the rules. Starting July 1, companies will have to increase or decrease their earnings for all options that have been repriced since Dec. 16, 1998, or that are repriced in the future.
Here's an overly simplified example: Say a company issued options at $10 per share but the stock tanked and the exercise price was lowered to $5.
Now the stock recovers and at the end of the quarter is trading at $13. The company will have to reduce its earnings for that quarter by the difference between the new exercise price and the current market price -- or $8 per share -- for all repriced options.
On the flip side, if the stock sinks to $2 per share, the company would increase its earnings by $3 per share.
Each quarter, the process is repeated with all options that have been repriced but not yet exercised. The big danger is that there is no limit to the charges a company would take if its stock keeps going up.
Another drawback is that big investors don't like repricings -- especially when they're done without a shareholder vote.
``We are very strongly opposed to repricing,'' says Keith Johnson, general counsel with the State of Wisconsin Investment Board. ``Basically, it undermines the rationale for having put options in place, which is creating an incentive'' for employees to do things that will boost the share price.
Companies often warn that without repricing they will lose valuable employees. But Johnson believes those fears are ``overblown'' and unjustified.
``If you're just one company, you'll do anything you can to avoid losing talent,'' he says. ``But shareholders like SWIB have a large and diverse portfolio of companies, many of which are stealing employees from each other. When that happens, we still have the same talent in the portfolio, we're just paying more for it. We look across the board and say, `at some point, this has got to stop.' ''
Although institutions usually can't stop a company from repricing, ``if a company does reprice, particularly for top executives, it inclines us to vote against future option plans, which is where we have some leverage,'' says Ken Bertsch, director of corporate governance for TIAA-CREF, the nationwide teachers pension fund.
Bertsch says one problem with stock options ``is that many employees do not recognize the value they're receiving. It's like paying them in yen.'' If the option goes underwater, they might think it's worthless, even though the stock could easily rebound. ``It makes us question whether this is a good way of compensating employees.''
Bertsch says companies will continue to reprice, but ``you're not going to see knee-jerk repricings. These accounting charges can be considerable, and most companies will be unwilling to put up with open-ended charges.''
He says corporate directors also fear that class-action lawyers will automatically sue companies that reprice options without shareholder approval.
The companies most likely to reprice are those in desperate situations and those that don't worry about the impact on earnings because they don't have any.
In the past few weeks, Barnesandnoble.com, CDnow and MyTurn.com have all repriced options, and Iomega has asked shareholders to approve a repricing plan.
More-established companies are expected to follow Microsoft's lead and issue additional options without canceling old ones. Microsoft's new options will be exerciseable at Monday's stock price -- $66.63.
Issuing new options does not affect earnings like a repricing would, but Microsoft was only able to do so because it had a huge number of options in a shareholder-approved plan that had been authorized but not yet used. Many companies, especially newer ones, don't have that luxury, because they've already doled out most of their approved options.
These companies might be able to set up a new plan without shareholder approval, but this can have negative tax implications and raise the ire of institutions.
``If you already have 20 percent of your outstanding shares in a stock option plan, and you go up to 25 percent, it's going to get people's attention very quickly,'' an analyst said.
Carl Schmitt, vice president of Westward Pay Strategies in San Francisco, says many of the companies his firm advises are considering repricing or other alternatives.
Some are accelerating annual options grants. ``If normally they're made during the summer, they're making them earlier so they can capture the low (stock) price and send a message to employees,'' he says.
Others are making supplemental grants, perhaps equal to half of what a new hire would get. Some companies are ``identifying key talent and making targeted grants of any size to the top 25 or 30 percent of employees.'' If they have enough cash, some are raising salaries or bonuses.
Another option is to give employees restricted stock that, unlike stock options, does not require employees to make an investment.
Restricted stock, which also vests over four to five years, ``can be a stronger retention tool, especially during a crisis situation,'' Schmitt says. But it does reduce corporate earnings by the amount vested each year, and institutions don't like it because it's seen as a giveaway. ``As long as you stay living and breathing, you can have it.''
An article about alternatives to repricing, ``After the Dot.Com Fall,'' is on Westward's Web site (www.westwardpay.com).
Schmitt wouldn't name which companies are taking action, so I called 15 Bay Area companies whose shares have fallen significantly below their IPO prices. Most wouldn't comment or didn't return calls.
Of those who did talk, none had repriced options. They all emphasized that the decline in tech stocks is a recent phenomenon, that many employees who came in before the IPO are still above water and that they're trying to keep workers focused on long-term strategies.
``We're very early in the game,'' says Todd Hagen, CFO of Salon.com. ``I think options are an important part of the reason why people join Salon. But it's only one facet of why they come in the door every day.''
Marleen McDaniel, CEO of Women.com Networks, says ``our shares only started falling at Christmas, so it's only people hired this year who are affected.''
She says she would not consider repricing options because it's ``too complicated and unnecessary.'' But she would consider granting new options for employees who are underwater.
Nora DePalma, a spokeswoman for ImproveNet, says options are not an issue because her company never hyped them. ``Our CEO, Ron Cooper, came from the home improvement industry. He was very strong during the recruiting process that options were not to be presented as the be-all and end-all. If options even came up early in the interview process, (job candidates) were eliminated,'' she says.
As time goes on, expect more companies to be taking that approach.
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