Why Not Reprice Your Stock Options?
In 2008, the stock market collapsed under the weight of bad loans by banks and lenders. Then, in 2009, the IRS rolled out its rules for IRC 409A. Back then, many of today's leaders were just entering the early stages of their careers—some were even in college or university. It was a very different time. Both the markets and roles have changed significantly since then.
The challenges start-ups are facing today are unprecedented. We have never had a market downturn while 409A was in place.
409A values have evolved from "a way to make the IRS happy", to a method that is used to show employees the value of their options and RSUs.
We have weathered a global health pandemic that has changed the way we work.
The stock market has been on a bull run that exceeds even the "Golden Decade" of 1988–1999.
The amount of money invested in start-ups has never been higher. In 2020 and 2021 alone, venture capital firms invested almost 60 billion dollars in start-ups.
Now we are staring at a future that includes stagflation and a potential recession. Late-stage pre-IPO companies are proactively laying off staff. Capital providers have become far more cautious with their investments. Most importantly to employees at these start-ups, 409A figures are decreasing while investors' interests have remained unchanged.
Most pre-IPO companies still grant stock options. However, the options these companies grant depend on 409A values continuing to increase to create value. So, when the 409A value drops, it creates several interesting challenges:
Older stock options are viewed as "underwater," even though the 409A value was generally not intended to be used as a "hard" value.
"Underwater" stock options, while still having upside potential, are a demotivating force.
New employees will likely get stock options with a lower price and a potentially greater future value.
The potential future value challenge demotivates and upsets legacy staff who hold "underwater" options.
Capital providers (investors) are annoyed at granting more options at lower prices, further diluting their position when their investment price is locked in.
The concerns above are amplified at the companies that adopted the practice of determining grant sizes based on the difference between the most recent funding round price per share and the most recent 409A value. When using this spread, grant sizes drop when the 409A value goes down. This is counterintuitive since a lower stock price usually results in a larger grant. You could require a skilled staff to assist you with your retention strategy for employees through rewards and benefits.
*At FutureSense, we have consistently recommended against this practice since it tends to benefit ONLY the investors, while delivering equity to employees that is generally not market competitive.
Why not reprice?
There are many methods for fixing underwater stock options. These include cash for option buy-outs, RSU for option exchanges, and laying off staff or canceling outstanding grants to return the unvested equity to the pool. They all require compromises, most of which are driven by accounting rules and shareholder concerns for publicly traded companies.
409A values do not reflect the value investors place on their investments. Recent market conditions have made these values lower for many companies. If this is your company, addressing this issue early and proactively is the best way to continue toward a future liquidity event.
Investors care more about dilution than they do about employee strike prices. They also know that granting more, or new, equity to make up for devalued legacy equity generates higher dilution.
"Repricing" is precisely what it sounds like. You change the grant price from the old higher 409A value to the new reduced 409A value. This method does not impact dilution or impact the future shares available to grant.
Repricing cannot be done without fully thinking it through. Strong communication is required for success. There are potential accounting concerns that must be addressed. Investors need to be informed and approve the action. There may be unintended tax consequences for employees. Additionally, your grant size methodology may need to be changed to reflect the new reality. This is where the experts at FutureSense can help.
We have one of the world's strongest teams of equity compensation experts. For more than 20 years, we have helped companies successfully get through the gauntlet of market corrections. Contact us today to learn more about our pre-IPO equity compensation consulting services.
About FutureSense
FutureSense is a management consulting firm that provides integrated solutions to build and sustain human capital capacity. The firm can work with you by offering support and guidance to manage your workforce. To learn more about FutureSense, please visit FutureSense.com.