How do you improve workers’ compensation at a minimal cost? The sharp declines in technology stocks make it possible to reprice options granted to employees; who can it benefit? What are the consequences? And are there any pitfalls to watch out for?
The current market conditions appear concerning compared to recent times, particularly for the technology sector, which had previously lifted the markets but now weighs on them. Amidst geopolitical tensions around Ukraine and escalating interest rates, technology companies are grappling with persistent chip shortages, fueling a downward trend that has persisted for over six months across public markets.
Declining multiples of technology company shares, coupled with rising interest rates elevating discount rates, are driving down the value of technology shares in private markets as well. In times of uncertainty, investors tend to halt investments and adopt a wait-and-see approach. Despite significant drops in global stock markets, such as the Nasdaq index falling approximately 30% since November, technology firms may find opportunities amid the turmoil. The devaluation of companies allows for reassessment of valuations, including the repricing of options granted to employees.
Repricing entails reducing the exercise price of options to align with current stock values, sometimes even altering vesting period terms. While this has tax and financial implications, its primary significance lies in personnel management. With the decreased value of technology firms, options granted to employees, initially intended as rewards and retention tools, have lost their effectiveness as the options move further out of the money and the chance of them being exercised decreases. To counteract this, companies may consider leveraging the devaluation to their advantage by granting options at lower exercise prices, thereby revitalizing employee incentives and increasing the likelihood of their exercise.
- Who can do repricing?
In principle, any company can reprice the options for employees. If it is a public company, the procedure is simpler compared to a private company, and there is no risk in terms of Section 409A (for the purpose of granting options to employees who pay taxes in the US), as long as the options are granted at a fair value. In private companies, on the other hand, it is necessary to estimate the value of the company in some cases, to ensure compliance with tax rules such as 409A.
Alternatively, companies may opt for a strategy akin to repricing, which involves canceling existing options and issuing new ones. From an economic standpoint, this approach essentially achieves the same objective as repricing, albeit through a different method.
- What is the significance from a tax perspective?
It’s important to note that following the repricing of options, both Israeli and US tax authorities consider this as resetting the two-year holding period necessary to qualify for reduced tax rates. This means that the countdown begins anew from the date of repricing, impacting the eligibility for paying capital gains tax instead of higher marginal tax rates.
- What is the effect on the financial statements?
As soon as the conditions of the options granted to employees are changed, there will usually also be a change in the value of the options. If the value of the options after the repricing is higher, then it is a benefit that is recorded in the financial statements as an expense immediately.
- How do you calculate the value of the benefit?
In assessing the value of the benefit, the initial valuation of the options based on the original grant date becomes irrelevant. Instead, the value of the options is reevaluated, typically utilizing the Black-Scholes model, as of the repricing date. This evaluation is conducted twice: once under the original conditions concerning exercise price and vesting period, and once again following the repricing, reflecting the new exercise price and vesting period. The difference in value between these two sets of options determines the value of the benefit.
- Possible pitfalls
Before initiating a repricing, it is important to pay attention to several issues. Firstly, the message conveyed by the company’s management to both employees and investors holds major importance. Particularly amidst broader market challenges such as a financial downturn or prolonged negative trends in the technology sector—akin to what we’ve observed since November of the previous year—the management must communicate that repricing aims to leverage adverse market conditions for the benefit of employees. The goal is to fortify employee-company relations with minimal investment.
If repricing is intended to deal with a cash flow crisis of a specific company, and not as part of broader market downturn, then the message to employees and investors can cause damage, since it will be perceived as a distress signal and this must be taken into account. Of course there are situations, such as after cutting a third of the company’s employees and a substantial cut in expenses, in which it is clear to everyone that the company is in a cash flow crisis.
The Bottom Line
The repricing of employee-granted options stands as a valuable tool for employers to benefit their employees with minimal financial outlay. Against the backdrop of challenges in the technology sector, characterized by economic uncertainty and layoffs, many employees have also experienced erosion of their compensation in the form of reduced option values. Repricing presents an opportunity for employers to rectify this decline in option values, thereby fostering stronger employee-company relationships and long-term commitment.
Repricing necessitates diligent attention to tax implications. Proper application to tax authorities by company representatives is essential to avert potential tax liabilities and uphold the tax-favored status of such grants under Article 102 capital regulations. This proactive approach ensures compliance while maximizing the benefits accrued to both employees and employers alike.
What is said in this article is provided for informational and general purposes only. The aforementioned does not constitute “investment consulting” and/or “investment marketing” as defined in the Law on the Regulation of the Practice of Investment Consulting, Investment Marketing and Investment Portfolio Management, 1995 and/or a substitute for the above and/or a substitute for legal, financial, taxation advice, financial or any professional and personal advice. The S-CUBE company and/or the IBI group and/or any of the group companies will not be responsible for any loss or damage caused to any third party due to reliance on the above information.