Managing Stock Options in a Volatile Market


Until recently, few people outside the investment community understood the value of stock options. But the explosion of entrepreneurial companies in the 1990s, spurred by a raging bull market, changed all that. Today, nearly all employees of growing companies, from the top executives to the mailroom staff, are looking at success stories like Netscape and Dell and asking for a piece of the action.

For the most part, companies have been happy to play the game, adopting a liberal attitude about doling out stock options. With the company's stock climbing (and seemingly nowhere to go but up), stock options represent a low-risk, no-cash way to attract and retain talented employees at all levels of the organization, particularly in a tight labor market. Plus, by giving employees an ownership stake, companies create a tangible incentive to keep the staff focused on growing the value of the company.

The results have often been spectacular for companies and employees alike. At Silicon Valley software firms and Minneapolis medical device manufacturers, employees have reaped payouts in the tens and hundreds of thousands of dollars. As a result, at many companies, the staff now tracks the company's daily stock value with the passion of a fantasy football game.

Hidden Dangers

It's the ultimate "win-win" scenario. Employees get rich, shareholders get rich, and the company grows on the value of its human and financial resources. But if it sounds too good to be true, it is.

The volatility of the stock market in recent months has jolted many companies back to reality, with a timely reminder that stocks can go up and down. So-called "small cap" companies, with a relatively modest market capitalization, have been particularly hard hit, as institutional investors shuttled their capital to "safer," more established companies. In a short period of time, many small businesses have seen a sizable chunk of their paper value vanish - and watched in frustration as once-valuable stock options sank underwater.

Suddenly faced for the first time with a down market, many companies have discovered an ugly fact: the same stock options that serve as golden handcuffs for top employees when the market is going up actually serve as incentives to leave the company when the market is going down. In such circumstances, many business owners feel pressure to "re-price" options downward to reflect the lower stock value, in order to keep key employees on board - a step most institutional investors vehemently oppose. As a result, companies face a delicate balancing act.

By doing nothing - and forcing employee shareholders to assume the same downward risk as ordinary shareholders - companies risk losing top performers. The incentive to stay and "grow the company," after all, is significantly reduced when employees realize that their stock options - often given as an alternative to higher cash compensation - may be worthless for several years.

Most key staff are also smart enough to realize that they can effectively re-price their own stock options simply by jumping to a new position at a new company. Assuming the new company's stock has been similarly depressed, employees can land stock options at bargain basement prices and watch their value climb. (The downside for employees, of course, is that most options take several years to be fully vested, and so they often end up walking away from vested options in favor of new options that may not be fully realized for several years.)

Following the major correction of 1987, and again in the more recent dips of the mid-1990s, companies responded with a wave of stock option re-pricings. But companies contemplating the same route today face complicated and risky legal and business issues. In a true bear market - as opposed to a temporary correction - shareholders may be quick to seek legal remedies for any business decision that looks like corporate waste.

Internal Struggle

Board members who granted and re-priced stock options autonomously in the past, with little outside dissent, now face a vocal and sometimes hostile constituency. Institutional investors, representing a growing percentage of outstanding shares, have begun to wield their clout by challenging company leadership and taking a strong stand against special deals for insiders. Dissatisfied shareholders have shown an increasing willingness to sue for breach of fiduciary duty, prompting board members and their advisors to tread carefully on re-pricing for fear they will end up in court. In addition, companies that re-price options must comply with recent strict changes to the proxy rules, requiring additional public disclosures. Many institutional investors now also hold any new options plan hostage unless the company includes an affirmative prohibition against re-pricing.

The opposition of major shareholders to re-pricing isn't hard to understand, since they have no comparable cushion against the eroding value of their investments. However, most shareholders also aren't anxious to watch the company's leading executives walk out the door, depressing the company's performance further. On the other hand, companies that automatically re-price options risk removing much of the incentive for employees to avoid a decline in the company's stock price in the first place.

Important Considerations

In the midst of these mixed signals, what's a growing company to do?

Unfortunately, there aren't any hard-and-fast rules. But any company considering re-pricing as a response to a market slide should follow several guidelines:

  • Re-pricing should only be considered in the event of a sustained, significant decline in a company's stock price. It's not a solution for a temporary drop - even a large one - but only when the stock value seems unlikely to recover in the near future.
  • A company that re-prices options should only do so if it requires compensating benefits from the employees in return, such as an extended vesting schedule or tighter restrictions on exercise.
  • Re-pricing should be optional, giving individual employees the choice to retain their vested options at the original price.
  • Options should only be re-priced if they are significantly underwater - and if options represent a substantial portion of top employees' compensation. If a company can afford to increase cash compensation, doing so may be a better alternative to re-pricing.
  • If the Board chooses to re-price, it should document the process thoroughly, including a record of the facts and figures backing up the decision. Proper documentation is essential for the Board's defense in the all-too-likely event of securities litigation.

Above all, companies contemplating re-pricing should map out a comprehensive strategy before acting. Consider the example of Company X, whose stock falls to $5.00 a share from its prior trading range of $11.00 to $13.00. Seeking to retain its top executives, the company quickly re-prices all options to the new, lower market price, without changing vesting requirements or putting a moratorium on exercising options after the new valuation. A month later, the stock abruptly rebounds to its old trading range. Suddenly, the re-pricing plan - intended to create incentives for key employees to stay - instead gives them powerful reverse incentives to exercise their options by leaving the company. Adding insult to injury, the Board may also face a lawsuit from its shareholders.

Conclusion

To re-price or not to re-price? It's a question with no easy answers - and significant risks regardless of the path a company chooses. For companies accustomed to using stock options as a "magic bullet" for growth, the volatility of today's market can be especially frustrating. But finding a way to retain talented staff, whether times are good or bad, is usually the test of a company's long-term strength.