Should Companies Reprice Underwater Stock Options?

Last Updated Apr 10, 2009 2:29 PM EDT

Given today's market conditions, most employee stock options are underwater and therefore worthless. The same thing happened when the dot-com bubble burst 8 years ago. At that time, about 10 percent of tech companies repriced underwater options by trading them for new ones at a lower strike price. That led to all kinds of shareholder revolt.

Times are different now and there are new factors to consider, but the debate's the same: should companies reprice underwater options or not? I think the answer's relatively straightforward, and it might be a welcome remedy for many underwater option sufferers.

The big debate
Stock options are widely used to incentivize managers and employees while aligning their interests with shareholder's. As of two months ago, executive compensation firm Equilar estimated that about three quarters of options held at Fortune 500 companies were underwater. I assume the percentages are now even higher.

To date, the argument between repricing pros and cons has been something of a standoff: The pros say they can't retain and incentivize employees with worthless options. The cons say shareholders don't get bailed out when share prices plummet, so why should employees? Doesn't that reward failure?

But that old debate misses a number of key points:

  • When the Internet bubble burst, shareholders could argue - right or wrong - that companies did it to themselves. That's certainly not the case today, since the vast majority of companies with underwater options had nothing to do with our current economic crisis.
  • The rules have changed. New regulations require companies to account for stock options as corporate expense and get shareholder approval for repricing options.
  • Key employees can indeed take matters into their own hands by jumping companies - a common practice in the tech sector - and getting new options at the current market price. Employee churn is bad for business and productivity. It affects everyone, including shareholders.
  • A rarely discussed issue is the growing disparity between lower-priced options that newly hired employees get and those of existing employees. The problem gets much worse when new managers or executives are hired with lower-priced options than employees. Think about it.
The solution
The solution - espoused by eBay, Intel, Starbucks, and a growing number of companies - is relatively straightforward. A new repricing method - "value-for-value exchange" - exchanges underwater options for fewer options at the current, lower market price. Since this exchange is actually less dilutive and does not result in additional compensation expense, there's not much for shareholders to gripe about. Everyone wins.

That's how I see it. What do you think; should companies reprice stock options or not?