Exploring the Pros and Cons of Different Approaches
Pulling Forward Future Grants
When discussing the alternatives at hand, a lot of the decision-making rests on timing — how quickly can the company remedy the situation. Often, underwater equity presents with a rapidly depleting share pool due to the depressed stock price, making some alternatives less attractive than others or even impossible to execute in a meaningful way. Pulling forward future grants is a way for companies to retain employees by denominating the grants and fixing a new lower exercise price to the grants to articulate value, ideally without overextending the share pool reserves. In theory, the company provides no additional cost and minimal shareholder dilution using this alternative. For UK-listed companies, any accelerated grants should be checked against the Investment Associations’ 10-year rolling period dilution caps and annual executive director policy limits.
Part of this pull-forward might also include a discussion of changing the mix of the traditional annual grant, whereby the weighting on options could decrease and the weighting on RSUs could increase. This would typically be considered to provide downside protection that options do not intrinsically have and would prevent the company from facing a similar situation if the pulled forward option grant ends up underwater and thereby loses retentive value.
The downside of this approach is the reporting ramifications and the potential for a lower or non-existent annual grant the following year, depending on how aggressive the company gets with pulling forward the grants. From a reporting standpoint, this could result in two annual grant values being presented in the present year’s Summary Compensation Table in the annual proxy statement, which would need significant narrative to explain the rationale to shareholders and may result in a negative shareholder say-on-pay vote.
With this approach there is also the potential perception of “spring loading” (i.e., timing grants at a historically low share price). Proxy advisory firms ISS and Glass Lewis may take this practice as a reason to recommend voting against the company’s say-on-pay vote and possibly even a future share request. Spring loading is a greater concern with options because the value will be grants.
Making an Additional Grant
Granting additional equity can be a more effective way of using equity compensation to retain employees without causing the double-disclosure issue that pulling forward future grants presents. It also eliminates confusion among employees when the annual grant cycle rolls around and they didn’t understand their annual award was already granted the previous year. However, companies must first determine if they can afford from their share pools to make grants in addition to their next planned annual grant.
The key decisions surrounding making an additional grant include:
Whether to make the grant in options since there is a potential that these options could end up underwater depending on how long the bear market lasts, where the company is in the market and other macro- and microeconomic factors.
Whether to switch the entirety of the grant or part of the grant to full-value shares like RSUs that would still vest over time but have downside protection in an uncertain market.
And whether to include a performance condition on the RSU such that it becomes a PSU and requires something more than years of service at the employer to vest the award.
A company should consider how each alternative would impact their burn rate, dilution, remaining share pool and employee retention before deciding which vehicle to grant. Particularly with the PSUs, the company should be ready to set long-term goals, articulate goals, and track and measure them to ensure the performance conditions incentivize the right behavior and strike a balance in being achievable but challenging.
An Option Exchange or Repricing
Companies with share pool constraints can consider an underwater stock option exchange (UWSE) or one-for-one unilateral repricing. This approach is controversial from a governance standpoint, but it is also efficient in addressing outstanding underwater equity and bringing immediate value back to employees’ shares. For public firms in the UK and Europe, a repricing under any structure will not be supported by investors. Private firms, however, may have greater flexibility to reprice awards if the major private equity investors are supportive.
A UWSE allows employees that hold underwater options to trade them for an at-the-money (or less underwater) stock option that often has reset vesting conditions that require employee service, thereby attempting to guarantee retention of the employee once the trade is complete.
The balancing act of injecting value back into the existing options and retaining and motivating performance to benefit the shareholders and company is done via:
Setting the exchange ratios to be value-neutral whereby the aggregate fair value of the underwater equity is equivalent to the aggregate fair value of the at-the-money grants
Resetting vesting to a minimum of one year in order to require continued service and performance
Reducing overhang by returning options to the company
Determining eligibility to participate (both for employees and for option grants) in the most shareholder-friendly manner
Most equity plans require shareholder approval to enact a UWSE. The makeup of a company’s investors will influence whether such a program is attainable. Additionally, there are resources and cash needed to conduct shareholder outreach, drafting the filing, related administration and more.
Some companies express interest in a unilateral repricing with no exchange or extension of vesting terms. This involves reducing the exercise price in order to “reprice” the options to no less than the current fair market value of the stock. This approach is a pure windfall to the employee and includes none of the balancing act that a UWSE has to benefit the company and shareholders. It is significantly more costly from a non-cash expense but has no cash costs outside of normal administration of the plan. The issue here exists with shareholder approval because not many investors are amenable to such a program.
In instances where a company’s plan does not require shareholder approval for either a UWSE or a repricing, companies should consider the long-term ramifications of not getting shareholder approval. This can include ISS and Glass Lewis recommending against the say-on-pay resolution and/or the compensation committee members or against any new equity plan proposals (i.e., an entirely new plan or share increase to a current equity plan).