What is Stock Option Repricing?

Stock options are a popular form of startup employee compensation. Options give employees the right to buy company stock at a predetermined price, known as the exercise price or strike price.

If a company grows and becomes more valuable, the stock value also increases. This typically makes the value of the shares subject to an option more valuable than the exercise price. This is commonly referred to as an option being “in the money”.

However, if the value of the underlying stock decreases—as is common in rapidly changing macroeconomic landscapes—the exercise price can become higher than the stock’s current valuation. This is commonly referred to as options being “out of the money” or “underwater”.

An employee who exercised underwater options would receive shares worth less than the price they paid to exercise them. This is a demoralizing realization for any employee who holds underwater options, and it’s one reason why down markets make it challenging to keep top talent motivated through the value of existing option grants.

One solution is option repricing: a process in which a company lowers the exercise price of existing employee stock options.

For example, if a company’s stock has a current fair value of $1 per share, an option with an existing exercise price of $1.50 per share might be repriced to have an exercise price of $1.00 share. As a result, the employee’s option would be in the money if the company’s value increased by any amount following the repricing.

The most common time for startups to reprice options is after an event that prices the company's stock at a decreased value—such as a round of financing with a lower valuation than the prior round. In fundraising environments marked by a large number of decreasing valuations, startups naturally reprice options more often.

How Does Option Repricing Work?

The repricing process starts by working with legal counsel to structure the key terms of the repricing.

Some key economic terms include:

• Deciding which options are eligible for the repricing. The core term in a repricing is a reduction in the exercise price for options.Some companies reduce the exercise price for all options. Others only include the underwater options—or even a subset of the options that are most underwater. The main decision point is the expected impact on employee motivation and retention weighed against the cost to the company of reducing the exercise price.
  
• Deciding on vesting schedules.While not present in many repricings, it sometimes makes sense to also adjust option vesting schedules as part of a repricing event. Unlike the reduction of an option price—which typically can be done unilaterally by the company—lengthening an option’s vesting term will typically require the explicit agreement of the option holder.
  
• Setting an exchange ratio.In some repricing events, the original options are exchanged for new options instead of simply having their exercise price amended. While it’s not the norm, there are sometimes exchange rates that are not 1:1—for example, an employee might receive 0.75 new options for each old option in order to help align shareholders with a repricing decision.

Some key tax and accounting considerations in a repricing include:

• Section 409A. In order to avoid the penalties under 409A, the new exercise price of a repriced option generally must be at or above the fair value of the stock at the time of the repricing. Usually this means obtaining a fresh 409A valuation which sets the minimum exercise price for the repricing.‍
• ISO Impact. Repricings can have complex and non-intuitive impacts on ISOs. For one, the repricing can restart ISO holding periods. In addition, the $100k annual limitation rules for ISOs typically require double counting the value of the grant when it is repriced (essentially treating the repricing as though it is a new grant). As a result, in some cases a repricing can lead to part of an ISO being reclassified as an NSO. If you’re considering repricing ISOs, it’s worth investing some extra time to understand the impact based on your specific facts.‍
• Accounting.The accounting rules for compensation expense under ASC 718 generally treat the reduction to an exercise price as a compensation benefit to the employee who holds the option. In order to account for this benefit, accounting rules typically look at the value of the option immediately before and after the repricing using option valuation methods such as Black-Scholes.

How to Execute an Option Repricing

Once you’ve determined your repricing structure, you’ll work with your attorney to draft the documents for updating the options and/or offering new options to employees.

Next, you’ll work with a cap table software provider to plan the repricing event and ensure compliance with regulations and accounting standards.

Some key steps to execute the repricing:

• Obtain board consent.Almost all repricings require board consent. If you’re making additional changes to the equity compensation plan itself, you may also need stockholder approval.‍
• If required, obtain option holder consents.Most company equity plans allow options to be repriced for a lower exercise price without obtaining consent of the option holders. However, some changes—such as vesting terms or exchanges—may require optionholder consent. It’s best to confirm what consents your proposed structure will require with your attorney before executing a repricing.‍
• Draft and execute changes. Most companies use cap table software to issue new grants and stage the adjustments to existing grants. When ready, cap table software can also automatically record the changes.
• Satisfy reporting requirements.Once the repricing has been executed, work with tax and accounting advisors to ensure the repricing is accounted for. Most cap table software includes ASC 718 reporting tools to help process the repricing for financial accounting purposes.

It's also important to effectively communicate your option repricing internally. Here are some steps you should take when executing your communication strategy:

• Provide context. Companies should be transparent with employees about why they are repricing options. This could include explanations of the current market conditions, the impact on the company's financials, and how repricing can help retain top talent.
• Outline the changes. Companies should provide clear and concise information about the changes to the options, such as the new exercise price, vesting schedule, and other key terms.
• Address concerns. Employees may have questions or concerns about the repricing process, so it is important for companies to provide a channel for employees to ask questions or voice their concerns.
• Follow up. Companies should follow up with employees after the repricing to ensure that they understand the changes and are satisfied with their updated compensation package.
• ‍Satisfy reporting requirements. Once the repricing has been executed, work with tax and accounting advisors to ensure the repricing is accounted for. Most cap table software includes ASC 718 reporting tools to help process the repricing for financial accounting purposes.

AngelList Can Support Option Repricing

Option repricing can be a powerful tool for startups looking to retain top talent and align incentives. But it must be executed properly to avoid unexpected pitfalls.

With the help of legal and finance teams combined with cap table software, companies can execute a successful option repricing that supports their growth.

AngelList Equity offers support for option repricing and ASC 718 reporting. We partner with company law firms as well as tax and accounting advisors throughout the process.

Visit AngelList Equity or contact startups@angellist.com to learn more.