The NASPP Blog

Underwater options; they’ve been a problem that companies have faced before, but companies are seeing a much larger impact right now. Not only has equity pay become a larger percentage of executive salaries, it is also making its way down the operational chart of companies. Stock prices have been on a decline. In August, Financial Week reported that 40% of the Fortune 500 companies had options that were then underwater; these numbers can only have increased with our recent financial crisis.

Stock options and other equity-based compensation are a great way to provide incentive for employees. They provide employees with a path to ownership in the company even if employees are selling their shares as soon as they vest. The benefit of shares is still tied to the success (or lack of success) of the company. The obvious problem is that when the whole market is sliding down, companies will find their individual stock prices sliding right along. Employees may feel particularly disenfranchised, since there is little they can do individually to impact the success of their own company, let alone the entire market. They may begin to feel underappreciated and, as their income level falls, undercompensated.

Fortunately for many employees, we have also seen a trend toward greater shareholder acceptance of option exchange programs. What once was an ideological battle is now a tangible issue, as both NASDAQ and the NYSE now require shareholder approval for most option exchange programs. Part of this greater acceptance is that FAS123(R) has made it possible to create an option exchange program that has less of an accounting impact than before. An option exchange program allows a company to take worthless stock options from employees and exchange them for new options, restricted stock or RSUs (with reduced share amounts) or cash. The upside for the company is reduced dilution and overhang as well as restored employee ownership, satisfaction, and alignment with shareholder interests.

Engaging in an option exchange program to deal with underwater options is not a decision to be taken lightly. It requires intense employee education; and any communications sent to employees about the exchange must be included in the Schedule TO filing required by the SEC. Companies will need to structure the option exchange in a way that shareholders are most likely to approve. This means paying special attention to the ratios of the exchange as well as determining who may participate. Shareholders will be more likely to feel an option exchange is in their best interest when it involves only the rank-and-file employees. There is an increased negative focus on executive compensation recently, with growing resentment of arrangements that allow executives to profit when the company declines. If you are struggling over how to handle your company’s underwater options, check out these articles from our Practice Alerts:

Addressing Underwater Options: Measured Responses to a Contentious Problem

Dealing with Underwater Stock Options: Some New Twists on a Timeless Quandary.

Stock option exchange programs may help limit the impact of the market downturn in the short run, but companies must start thinking now about how to design stock plans that can better withstand market volatility. Don’t miss your opportunity to get valuable tips and information on redesigning equity compensation plans in at our 2008 Annual Conference session In the Thick of the Storm: Compensation Redesign in a Turbulent Environment.

-Rachel

Now – check out our new Underwater Options portal!