The COVID-19 pandemic has disrupted nearly every daily norm and has caused extreme market volatility that is likely to continue for the foreseeable future. There are countless ways that high volatility and depressed stock prices can impact the success of your company’s equity plans; here are ten items to keep in mind during these turbulent times.
#1 Stock Options May Be Underwater for A While
An underwater stock option exchange or even a straight repricing may be appropriate to contemplate if a company grants broad-based stock options. Some key considerations include estimating exchange ratios and incremental expense and strategizing the message to shareholders. Access our underwater option exchange tool to perform your own preliminary modeling: https://models.infiniteequity.com/underwater (email us for registration code)
#2 Options Expiring Underwater will Negatively Impact the Income Statement
Because a company’s deferred tax asset (“DTA”) is based on the grant date fair value and there is no more APIC pool, stock options that expire underwater trigger a reversal of the DTA that goes straight to a company’s income statement. Depending on the materiality of stock options granted, the impact could be significant. Companies should review upcoming option expirations and moneyness levels to determine to what extent they will be impacted. While companies can’t change the outcome, they can model various stock prices that will trigger options to expire in or out of the money over at least the rest of the year so that they aren’t surprised by the outcome.
#3 Consider Granting Auto-Cancel or Indexed Stock Options
Stock options may not be viewed as an effective form of long-term compensation in these volatile times. Auto-Cancel Options (which automatically expire if their moneyness dips below a certain threshold for an extended period of time) or Indexed Options (which have a variable strike price dependent on a market index) could be considered as a solution. Both features help to automatically adjust your options from prolonged periods of being underwater. Familiarize yourself with these new features and concepts to determine if one is right for your equity strategy.
#4 ESPP Withdrawals Are NOT the Same as ESPP Forfeitures
Companies will likely observe extraordinary participant behavior over the next few months, including an increase in ESPP withdrawals due to financial hardship or generalized fear about market outlooks. However, it’s important to distinguish that a voluntary withdrawal is not the same as a forfeiture that results from termination of employment – the original estimated expense must stay on the books, and cannot be reversed out like estimated ESPP expense for forfeitures.
#5 ESPP Purchases May Hit Share Limits
In addition to the $25k share purchase limit for Section 423 Qualified plans, most ESPPs also mandate a plan-specific purchase share limit; often the limits are outlined per participant, other times they are defined as an aggregate share maximum. It is critical to confirm plan provisions so the impact of low stock prices can be planned for and communicated to participants as share limits can result in refunds or rollovers of excess contributions.
#6 Volatility Is Volatile
This period of heightened volatility will now be included in the historical lookback period if a company utilizes historical or peer volatility in its equity valuations, increasing fair values. Additionally, if a company relies on implied volatility to develop volatility valuation assumptions, it will likely observe that this market-based measure is wildly volatile in the near-term; this will in turn cause the equity valuations to be volatile. It is unlikely companies will be able to exclude this period unless we receive new guidance from the SEC, but companies can neutralize the impact by evaluating their methodology to consider a longer look-back period.
#7 Performance Awards May Have to Be Modified
Performance goals, such as stock price hurdles or revenue goals, may seem impossible to achieve with the recent market volatility and global economic impact of Covid-19. Ultimately a company issues PSUs to motivate, retain, and incentivize, so it is important to consider whether the plan is still aligning with these goals. However, expense and governance implications from a PSU modification should be contemplated in the decision-making process. While it is too early to tell, this may be one scenario where investors and proxy advisors may be more understanding of the need for revising a performance goal.
#8 Relative Plans Can Be More Responsive to Conditions in a Down Market
Different equity vehicles vary in responsiveness to market volatility. Relative performance measures (e.g., relative internal metrics or a Relative Total Shareholder Return (“TSR”) award) rather than absolute measures, eliminate many of the challenges with goal setting, ensure competitive behavior even in a down market, and appease shareholders and proxy advisors alike.
#9 Anticipate Disruptions to Your Peer Group
If a company already has a Relative TSR award in place, whether it uses a custom peer group or the constituents of an index, the peer group will likely change in the months ahead. For administrative ease, the appropriate inactive peer treatment can be confirmed in advance. For example, should bankrupt companies be excluded for the final ranking, or kept in the peer group at the very bottom? Will acquired companies be ignored, or will their ending price be determined based on pre-acquisition prices? Now is the time to nail down those details in order to have the clearest line-of-sight into current relative TSR performance.
#10 Mitigating Dilution
At lower share prices, it will be easier to burn through the available share pool both for omnibus plans and ESPPs. However, there are many ways to slow down this share churn for omnibus plans, including thoughtful grant sizing techniques, payout caps, and cash-settled awards. For ESPPs, companies could consider implementing or lowering per person share or contribution limits for future purchases to help preserve the pool for the intended duration. Typically, these limits can be set by the plan administrator, without requiring shareholder approval.
The world has experienced unprecedented events in a matter of weeks, and it’s natural to want to respond quickly in turn, in order to help employees and help the company be prepared; however, take your time to be thoughtful and assess alternatives before making decisions. Be prepared for barriers too. A company may need shareholder approval before executing a stock option exchange, or employees may be personally impacted by the virus. Expect the unexpected during these times, and to maximize your success, keep all necessary teams continually informed of all changes being considered.