Technology companies are utilizing new option strategies to deal with the economic and stock market realities that have developed over the past year. Many, if not most, technology companies are struggling with flagging stock prices and “underwater” stock options (i.e., the company’s stock is currently worth less than the strike price of option grants). The economic and stock market downturns have led to many significant problems for investors and HR professionals alike.
While investors lick their wounds over losses in technology shares, HR professionals have to deal with the day-to-day psychological impact of poor financial results, underwater options and layoffs. Technology companies are utilizing a number of strategies to try and combat the morale busting impact of the dramatic drop in technology shares, especially of those in the Internet sector. The reality for many public (post-IPO) companies is that large portions of employees hired in the past year or two are now holding onto worthless underwater options.
One word of caution is worth mentioning, however. Much criticism, some of it quite justified, has been leveled against companies for re-pricing and replacing stock options and for using other methods that effectively take much of the “at risk” element of variable compensation out. While many dislike these practices in general on a philosophical basis, much of the criticism is particularly directed at executives who effectively re-set the bar for their own incentive compensation and thus removing much of the executives risk in being compensated for creating long-term shareholder value. Thus, while many of the practices below are effective strategies for reducing employee turnover and reinvigorating the general workforce, they are often viewed as anathema for senior executives.
Here’s a brief overview of what some companies are doing:
- Restricted Stock – A small but growing number of companies have chosen to give restricted stock instead of, or in addition to, stock options, to insure that employees receive some ownership value for their service to the company. Of course, the primary reason for doing so is retention, and in that sense, Restricted Stock may be the best option, although one that many VC, investors and other outsiders like the least. The reason is because Restricted Stock is essentially a guarantee (unless the company goes under or never has a “liquidity event” such as an IPO or buy-out) of some monetary benefit, since Restricted Stock is actual stock (assuming certain service or performance requirements are met), not an option that must be worth more than its initial strike price to have any intrinsic value. In a stable public company, Restricted Stock is essentially a guarantee of some benefit. Many investors believe that options holders should at least take the same upside risk that real investors do; with Restricted Stock, the employee recipient of Restricted Stock is likely to receive a monetary benefit in all but the worst-case scenario.
- Supplemental Options – Rather than go through the financial and psychological pain of re-pricing stock options, many companies simply issue new (and often previously unplanned) stock options to their employees at reduced valuations. Supplemental options take a variety of forms. Some firms just issue new options after a large drop in their firms’ stock price. Some do it at their normally scheduled granting time, but many don’t wait for that time to arrive. Many firms have also started to offer supplemental grants more regularly (see below). Of course, supplemental options are not “free.” The additional shares dilute the holdings of existing shareholders and often anger non-employee shareholders and the investment community. They also increase the company’s “overhang,” which is the percentage of outstanding shares that have been optioned to the company’s employees. Supplemental options do, however, offer an improved opportunity for employees to achieve some future economic benefit from their employers’ business success.
- More Frequent Option Grants – Several firms have started offering options on a more frequent basis, to address the issues of flagging morale and lower stock prices. Some companies are just offering options on a more frequent basis, rather than issuing larger or “extra” supplemental option grants. Many companies that offered options annually are now doing so semi-annually or quarterly. By offering more frequent grants, employees get the opportunity to take advantage of lower option prices and get more frequent reminders of the stock holdings they have in their employer.
- Re-priced Options – It used to be a lot easier to re-price options than it is today. Re-pricing is the practice of canceling previously-issued stock options, and re-issuing new options at the current lower price of the stock. The arguments against re-pricing options are many and persuasive, but many executives still feel compelled to re-inject financial viability into the their employees (and their own) stock options. For the reasons stated above, executives are often excluded from stock re-pricing programs.New accounting rules implemented in 1999 have made re-pricing a very expensive proposition. Companies must now take a charge against earnings to re-price their options, and the cost is prohibitive enough that until recently, instances of re-pricing had dropped dramatically. However, with many public technology companies now trading 50 percent or more (some a lot more) below their 2000 peaks, some companies have decided to take the hit and re-price their options anyway.
In January 2001, Amazon.com announced an option re-pricing program. After its shares sank below $15, it allowed employees holding options with an exercise price of $23 or more to receive new options with an exercise price of $13.38 that begin vesting in August of that year. To reduce the potential financial impact, the options must be exercised within two and a half years.
- Replacement Options (also known as “6+1” programs) – By canceling and re-issuing options in the future (a minimum of six months and one day in the future, to get around re-pricing rules and avoid having to take a charge to earnings, hence the name “6+1”), some firms are getting around the re-pricing regulations.Replacement options offer some risk as well, but may be a better strategy than re-pricing for some firms with a severely depressed stock price. One risk is that the options issued at a future date could recover in price, and therefore have to be offered at a similar or even higher price in the future. Like re-pricing, though, this strategy is reserved mainly for firms with severely depressed stock prices and little likelihood of the stock’s return to its formal glory at any time in the near-to-intermediate future.
In February 2001, RealNetworks) went the replacement options route. The company announced a replacement options plan that would allow employees to replace their options in August of 2001, but employees had to agree to the plan in February. While there is some risk in the plan for employees, many options are so far out of the money that the risk seems quite small that the stock price would recover or go above the much higher strike prices of options issued before the middle of 2000.
According to a study by iQuantic (now part of Buck Consultants), more than 80 percent of the companies surveyed reported they had at least some portion of their outstanding stock options underwater. The Underwater Options Flash Survey of over 100 “new economy” companies reported that over one-third of the respondents had over 50 percent of their options underwater. The survey revealed that the most commonly used strategy was issuing supplemental options, and over 90 percent of the respondents cited the ability to attract and retain staff as the most important reason for taking actions to address underwater options.
Regardless of the choice of strategy, one often-overlooked element of getting the most positive impact for employee stock options is developing an effective communication strategy. Stock options, while they have become an expectation in the high-tech world, are not a gift, not a free lunch or an automatic ticket to riches (as just about everyone knows by now). What they are is a chance to create economic value for their holders when their employer achieves business success in the marketplace. A lot of things have to happen right, not the least of which is having solid products, strong management, a sound business strategy and good execution.