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Underwater share options
Practical Law Legal Update 7-384-6677 (Approx. 3 pages)
Underwater share options
by Peter Talibart and Monique Fry, Norton Rose LLP
| Published on 26 Jan 2009 • United Kingdom |
Some practical solutions for companies that have granted share options to employees, the exercise cost of which now exceeds the price of the shares.
Speedread
Because of the economic downturn, many share options granted by companies to their employees may now cost more to exercise than the shares are in fact worth (that is, they are "underwater"). Companies have a number of options to address this problem.
During an economic downturn, long-term share awards can decrease in value to such an extent that they cease to incentivise employees or facilitate their retention.
This is particularly the case for "underwater" share options, which have exercise prices greater than the current share price. For many companies, options granted before the current downturn will now be underwater.
Set out below are some practical solutions to underwater options that companies may wish to explore as part of their annual review.
Change from share option plans to performance share plans
Many listed companies already operate plans which provide for performance-related free share awards (typically called long-term incentive plans or performance share plans) instead of, or in addition to, option plans. Those that do not may wish to consider adopting a performance share plan.
Performance share awards will never be underwater and investors are normally supportive of them on the basis that they provide a better alignment of the interests of executives and shareholders than options.
Replacement or re-pricing of underwater options
Share plan rules normally provide that cancelled or lapsed awards cease to count against dilution headroom limits. This means that new options can be granted (following the cancellation of underwater options) up to the relevant limits based on the new lower share price.
In the past, investors have on the whole been unsupportive of cancellation and re-grant or re-pricing programmes, which the Association of British Insurers' (ABI) guidelines state are "not appropriate". However, in the current climate investors should be willing to work with companies and may consider that such programmes are the best solution.
Creating more dilution headroom
Typically, share plan rules will provide that only awards capable of being settled with newly issued shares will count against the dilution headroom limits recommended by the ABI.
Boards could therefore create additional headroom by resolving that certain awards will only be settled using market purchased shares.
Share dilution can also be reduced if options are settled as stock appreciation rights. When an option is settled as a stock appreciation right, the option holder receives free shares equal in value to the net gain the option holder would otherwise have made on exercise.
To read more about underwater share options, click here.