In light of the COVID-19 pandemic and subsequent economic slowdown, many corporations face unique and complex issues in addressing outstanding equity awards.
For a large majority of companies, the pandemic has resulted in significant disruption to company operations, leading some firms to file for bankruptcy. In addition, 2020 financial forecasts have been completely upended for most companies, which now find themselves falling short of year end performance targets. Given the uncertainty of when this crisis will end (and the forecasting difficulties it brings), combined with the need for companies to retain and incentivize employees, most companies are reevaluating total reward strategies.
Although most proxy advisory firms are not expecting changes to outstanding awards, any adjustments should include clear disclosure on the rationale for doing so. In addition, the decision to change outstanding equity awards should take into consideration any lost value of current equity awards, the type of equity vehicles, share usage and dilution, as well as shareholder and other governance concerns.
Addressing Underwater Stock Options
With outstanding stock options significantly underwater in the current economic environment, companies have a few choices to counteract the negative effects of underwater stock options:
Additional Equity Compensation
Rather than adjusting or replacing underwater options, a company can elect to grant additional equity compensation. While this strategy may provide short-term retentive value and allow outstanding awards to remain intact, shareholders may view this approach negatively, since it could result in a windfall to employees (should stock prices rebound to pre-COVID-19 levels). In addition, companies will need to assess whether their equity plans have sufficient share capacity to accommodate any additional awards.
Option Repricing
With option repricing, the existing award is amended to provide for a lower exercise price - the exercise price of the existing award is reduced to a price at or above the stock price on the date of repricing. However, due to restrictions imposed by the NYSE and NASDAQ, along with the negative perception of shareholders, companies are typically reluctant to reprice options.
Option Exchanges
Under an option exchange, the existing award is cancelled and exchanged for a new equity award (e.g., option, restricted stock, RSUs, etc.), or cash.
- Stock Options-for-Stock Options: With this approach, the underwater options are cancelled and replaced with new stock options with an exercise price equal to or greater than the market price at the time of the new grant. A value-for-value exchange ratio is often used in this situation, where the value of the new option is equal to the value of the cancelled option. Terms, vesting and forfeiture conditions may also differ with new grants.
- Stock Option-for-Other Security: In a stock option-for-other security exchange, underwater options are exchanged for a different type of equity award, typically restricted stock or RSUs. A value-for-value exchange ratio is typically used to determine the new equity award value, and additional vesting and forfeiture conditions typically apply.
- Stock Options-for-Cash: With this exchange, underwater stock options are purchased by the company for cash. The value of the options would be determined by a valuation method such as Black-Scholes or binomial, and the cash payment may be subject to future vesting or forfeiture conditions.
Option repricing or exchanges are often more complex than additional grants, but can be effective in addressing retention concerns. However, for most companies, repricings or exchanges require shareholder approval, and are also subject to heightened scrutiny by institutional investors and proxy advisory firms. In addressing underwater stock options, companies should consider:
- ISS and Glass Lewis Guidelines: Companies should be cognizant of the applicable ISS and Glass Lewis guidelines with respect to any repricing or exchange programs. Both ISS and Glass Lewis will: (1) Recommend against an equity plan that permits option repricing or exchanges without shareholder approval; (2) Recommend against members of the compensation committee, and potentially the entire board, if the company conducts a repricing or option exchange without shareholder approval; (3) Require companies to clearly articulate why the company is seeking a repricing or option exchange; and (4) Consider each repricing or option exchange proposal on a case-by-case basis based on factors disclosed in the respective guidelines.
- Clear Communication and Investor Outreach: Facilitating support from institutional investors, shareholders, and proxy advisory firms for any repricing or exchange program will require a compelling rationale, clearly articulating the company’s unique circumstances and reasons for such a program. Engaging directly with investors through outreach campaigns could also help mitigate any negative perceptions, and provide the company an opportunity to illustrate why such a program is necessary.
Performance-Based Awards
In light of current economic challenges, stock price volatility and business uncertainty surrounding COVID-19, performance goals and corresponding targets established in early 2020 or prior will likely not be achieved for many companies. Accordingly, companies may wish to consider modifying performance plans and subsequent awards to enhance retention, and ensure goals are challenging, yet achievable in the current economic environment.
Companies considering such actions should be cognizant of:
- Institutional Investor and Proxy Advisor Views: Negative reviews from institutional shareholders could lead to negative recommendations on Say on Pay votes or a “no” vote on the election of company directors at the next stockholders meeting. Companies that modify performance goals that were previously set for 2020 should provide robust disclosure describing the rationale for any changes to performance metrics.
- Accounting Considerations: Depending upon the nature of the original award, accounting for any modifications can be complex and the impact to a company’s compensation expense can often be significant. As such, companies should assess the accounting impacts of potential modifications before they are finalized, and discuss all options with their accounting firms.
Time-Based Restricted Stock
Using full value awards (e.g., restricted stock) could help offset some of the negative impact of underwater options, as full-value awards maintain at least some value, even in an economic downturn. However, with suppressed stock prices in today’s environment, companies may wish to use supplemental grants to offset some of the lost value. Moving forward, companies may rely more heavily on full-value awards for retention purposes rather than stock options, at least in the near term.
Supplemental Equity Grants
Instead of modifying outstanding performance awards, companies may wish to consider supplemental grants to offset any lost value in outstanding awards. This approach could be an ideal option for companies, as shareholder approval is not required. However, companies must have sufficient share capacity to accommodate any supplemental grants.
When considering this option, companies should take into account the following:
- Share Usage and Dilution: When using supplemental grants, companies should to be aware of their existing share pool, as supplemental grants will increase dilution, and may require some companies to request additional shares from investors. Companies should also be cognizant that burn rate levels remain in line with guidelines from proxy advisory firms and institutional investors.
- Award Windfalls: Supplemental grants not only increase the equity plan’s burn rate, but may also create a windfall and deliver more value than intended if stock prices rebound in a short period of time. Such circumstances could lead to increased scrutiny and criticism from institutional investors and proxy advisory firms, as employees may realize outsized compensation as a result of a quick market downturn instead of in recognition of extraordinary performance. To help mitigate this, companies should consider adding performance vesting criteria to any supplemental grants, ideally using relative performance measures given the current economic environment, and stock price volatility.
- Accounting Considerations: Since supplemental equity grants do not require any modifications to existing underwater agreements, companies can offset any loss in value with additional grants, while also keeping outstanding equity awards intact. However, companies should be mindful that they will incur the full cost of the new supplemental grants, in addition to any existing underwater programs.
Conclusion
Given the market volatility associated with the COVID-19 crisis, companies should consider all available strategies for addressing outstanding equity programs. An option repricing or exchange program may make sense for some companies, if the decline in stock price is solely due to market conditions, and not a result of management’s performance. However, companies should be mindful of the unintended windfall for awards, should stock prices rebound, and conversely (in the case of repricing), if the stock price continues to decline. Alternatively, supplemental grants may be better suited for other organizations, provided there is sufficient share capacity, and the ability to absorb the additional accounting expense.
In any event, companies will want to consider utilizing all available tools and resources in addressing outstanding equity programs, while also taking into account the optics of shareholders and proxy advisory firms.
