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Reprice (Stock Options) Definition
Repricing is a strategy of replacing the worthless stock options held by employees with new options. Companies use this strategy to deal with “underwater” stock options. Underwater stock options are those whose exercise price exceeds the fair market value of the underlying stock.
A Little More on What is Repricing Stock Options
Repricing became popular during the internet bubble burst in 2000 and then again during the economic crisis in 2008. Traditionally, many companies rely on stock options to attract, retain, and incentivize their valued employees. Repricing allows the companies to retain those employees during the economic crisis by taking back the worthless stocks and issuing new ones having intrinsic value.
Repricing becomes necessary during the economic crisis as the price of the stocks experience a sharp decline and employee stock options become worthless. Otherwise, the employees may take up a new employment with another company.
In such situations, the companies often tweak their incentive program and grant restricted stocks instead of stock options. Others might issue stocks that can be converted into shares immediately avoiding any future risks.
The board of directors of a company has the authority to make decisions regarding repricing stock options, as it is a matter of corporate governance. Repricing directly affects all the existing shareholders. Repricing increases the option expenses which must be deducted from net income. The strike price of the newly issued stocks must be based on the current fair market value of the underlying stocks to avoid a tax consequence to the employee recipient.
According to the rules of the Financial Accounting Standards Board (FASB), if the new stocks are issued more than six months after the cancelation of an existing stock, it is not a repricing. Companies may avoid variable accounting treatment by following this. In such cases, the employees get assurance from the company that they will be granted new stocks after that period of time.
The companies may also swap the worthless stocks of the employees with restricted stocks.
Another approach of dealing with this issue is called a “makeup grant”. In this case, the company keeps the original options in place and issues additional stock options for the employees. This tactic puts the existing shareholders at risk of additional dilution. If a future hike in stock price puts the original underwater stocks back in money, then that would lead to further dilution of existing shareholders.
The management of a company needs to make the decision of opting for any of these approaches with utmost care and caution avoiding any further risk.
References for Repricing Stock Options
Academic Research on Repricing Stock Options
An examination of executive stock option repricing, Carter, M. E., & Lynch, L. J. (2001). Journal of Financial Economics, 61(2), 207-225. This study compares a sample of firms which reprice stock options in 1998 to a control sample of firms possessing out-of-the-money options in 1998 that don’t reprice. The results indicate that the possibility of repricing increases for young high-tech firms and the firms whose options are out-of-the-money. The study also finds no evidence suggesting that repricing is associated with agency problems.
Executive stock option repricing, internal governance mechanisms, and management turnover, Chidambaran, N. K., & Prabhala, N. R. (2003). Journal of Financial Economics, 69(1), 153-189. This research analyzes the features of the firms that reprice their executive stock options and documents that these repricings are economically important compensation events. The evidence provided in this research presents little support for the opinion that repricing mainly reflects managerial entrenchment or ineffective governance in firms.
Repricing executive stock option in a down market, Saly, P. J. (1994). Journal of Accounting and Economics, 18(3), 325-356. This paper examines the repricing of employee stock options after a market-wide crash using a model that determines sufficient conditions for renegotiation to be optimal and for optimal compensation to be a fixed salary together with stock options. The empirical results support the renegotiation prediction. However, the stock options grants increased in value and numbers after the crash of 1987.
Executive option repricing, incentives, and retention, Chen, M. A. (2004). The Journal of Finance, 59(3), 1167-1199. This article investigates the determinants of the repricing policies of firms and the effects that such policies have on executive turnover and retention. The results indicate that those firms which restrict repricing are more vulnerable to voluntary executive turnover following the decline of stock prices. When these declines are significant, the restricting forms award vast numbers of new options.
The timing of option repricing, Callaghan, S. R., Saly, P. J., & Subramaniam, C. (2004). The Journal of Finance, 59(4), 1651-1676. This paper examines whether executive stock options repricings are systematically timed to coincide with the favorable movements in the stock prices of the company. The findings suggest that the dates of repricing either precede the release of good news or follow the announcement of bad news in the quarterly earnings announcements.
The effect of stock option repricing on employee turnover, Carter, M. E., & Lynch, L. J. (2004). Journal of Accounting and Economics, 37(1), 91-112. This study uses a sample of firms that reprice stock options in 1998 and another sample of firms with underwater stock options that choose not to reprice to examine whether repricing underwater stock options decreases the executive and overall employee turnover. The results present no evidence indicating that the relationship between turnover and repricing is distinct between high-tech and non-high-tech firms.
Stock market liberalizations and the repricing of systematic risk, Chari, A., & Henry, P. B. (2001). (No. w8265). National Bureau of Economic Research. This paper studies the situation where countries open their stock markets and firms which qualify for purchase by foreigners are repriced depending on the difference of the covariance of their returns with the domestic and international market. The results from the study suggest that the CAPM has predictive power for the cross-sectional repricing of systematic risk when barriers to capital movements are removed.
Proxy advisory firms and stock option repricing, Larcker, D. F., McCall, A. L., & Ormazabal, G. (2013). Journal of Accounting and Economics, 56(2-3), 149-169. This is an investigation of the existing relationship between firm performance recommendation and those recommendations presented by proxy advisory firms in the US on shareholder votes in stock option exchange programs. The findings are in line with the conclusion that proxy advisory firm recommendations regarding stock option exchanges increase the value for shareholders.
Managerial Risk‐Taking Incentives and Executive Stock Option Repricing: A Study of US Casino Executives, Rogers, D. A. (2005). Financial Management, 34(1), 95-121. This paper investigates the relationship between managerial incentives from holdings of company stock and options and stock option repricing. It examines the repricing activities by US firms in the gaming industry and finds that risk-taking incentives from options are directly related to the incidence of executive option repricing.
Options, option repricing in managerial compensation: Their effects on corporate investment risk, Ju, N., Leland, H., & Senbet, L. W. (2014). Journal of Corporate Finance, 29, 628-643. This article indicates that stock options can create serious incentives to distort the choice of investment risk even though they are commonly used in managerial compensation to provide desirable incentives. It shows that the inclusion of lookback call options in compensation packages has beneficial countervailing effects on the managerial choice of corporate risk policies and can induce risk policies which lead to the growth of the shareholder wealth.
Stock option repricing and its alternatives: An empirical examination, Kalpathy, S. (2009Journal of Financial and Quantitative Analysis, 44(6), 1459-1487. This paper examines the possibility of CEO stock option repricing and its alternatives. Multinomial legit results indicate that firms reprice options to increase the sensitivity of pay to stock price and also to decrease the sensitivity of pay to volatility. They also suggest that repricing is not encouraged by agency cost considerations but by incentive alignment and retention.