It's too soon to make changes to any stock options or profit interests your management team has as part of its compensation package, financial advisors say. But once lockdowns lift and the economy stabilizes, there are ways to make changes to these equity awards to maximize executives' interest in the business.
"My advice is to do nothing, at least for right now," Howard Klein, a partner at Dechert LLP, said in a webcast on equity-based compensation for executives at private-equity sponsored companies. "Until you can assess the new normal for your business financially, it's difficult to accurately reset performance goals or stock options strike prices. Valuations are still very much an open question."
In a more normal economic environment, stock options and profit interests are seen as a good way to give executives an incentive to maximize company financial performance, but as market valuations plummet, the equity awards in many cases have turned negative.
For executives whose compensation is largely tied to the awards, the sudden loss of value can create an incentive for them to find a position elsewhere, although that might be difficult in today' climate, said Eric Rubin, a Dechert partner.
"Retention may not be as much of a challenge now, because of the job market," he said.
Revising equity awards
When markets settle enough for you to make a clean valuation of the underlying assets, the most common way to change the equity awards is to do a straight repricing, said Rubin.
Start by amending the terms of the awards to reduce the exercise price or distribution threshold to reflect fair market value of the underlying security or by canceling the awards and granting new ones, he said.
Or you can reprice by reducing the exercise price or distribution threshold while at the same time reducing the number of underlying securities to limit dilution to shareholders. Together, those would work to preserve the original value proposition for the holder, he said.
Another way is to cancel the award, assuming it is underwater, and instead grant new options or other appreciation awards, or grant new full-value equity based awards like restructured or phantom stock.
Phantom stock is an agreement giving the holder the right to a cash payment at a designated time, with the amount tied to the market value of an equivalent number of shares of the company’s stock.
Granting new options reduces the risk to the employee of further reductions in value as compared to appreciation awards because restricted and phantom stock can still have value to the employee even if equity values continue to decline. Appreciation awards, by contrast, become worthless from an intrinsic value perspective if the equity value drops below the exercise price or distribution threshold.
If you reprice the equity awards, you have to think of the change as the grant of a new award and recognize an incremental accounting expense, at least for accounting purposes, said Sarah Burke, a Dechert associate.
If modification of the equity award involves an investment decision, such as lowering the exercise price or the threshold amount, then you might have to treat it as a tender offer and meet those rules or comply with other securities disclosure rules, she said.
You also have to see how the change should be treated under Section 409A of the tax code. The section governs nonqualified deferred compensation and imposes an excise tax when its rules are violated.