Managing Equity in Volatile Times
One year ago, the Nasdaq was trading near an all-time high of ~16,000. As of the time of this publication, it is trading at ~11,800.
This ~30% market value reduction, coupled with ongoing macroeconomic challenges (e.g., resetting of the workforce, higher cost of capital, sustained inflation) is creating a lot of discomfort and uncertainty as companies try to figure out how to keep their current employees calm (and in their seats); and how to consider an appropriate strategy to address their equity programs.
IDENTIFYING THE RISKS
Determining the right response starts with the ability to identify the risks. While each company’s business situation and needs differ, there are universal indicators that help companies determine if they might have a problem (and how significant that problem is):
Low share pool availability. Equity plan funding dictates the degree of flexibility companies have to maneuver when things don’t go to plan. When the equity pool starts running low, it means its time to take stock in how to prioritize spend and to confirm the planned sources and uses of equity. Where are new shares coming from? How quickly will they hit the plan? What granting activity do we need to cover between now and then (and beyond)?
Underwater stock options. Stock options are arguably the most shareholder aligned LTI vehicle in the toolbox, but their Achilles heel is that they don’t always have value. Underwater options are part of the business cycle, but companies must dig deeper to assess risk. How far underwater? For how long to we expect to be trading in this range? How isolated or systemic is the problem? More than 30% underwater tends to be the danger zone.
Significant de-valuation. Think RSU users have it better? Not necessarily. While there is a benefit to have having downside protection, a problem still exists in that a $100K grant date value could now be more like $70K. To achieve that same level of delivery at the current price, it requires 40% more shares being issued! In general, tolerances of +/- 15-25% are considered acceptable, but beyond that it can be a flag to get ahead of this issue.
Unsustainable equity use. Many companies take the view that each year is “unique” and requires specific actions to deal with the challenge-du-jour. However, when this starts to become a trend (i.e., more than two years in a row), it creates other issued around accelerated pool consumption and excessive dilution that can inadvertently limit future flexibility.
POTENTIAL STRATEGIES TO CONSIDER
Unfortunately, there is no one-size-fits-all solution, however there are several strategies that can be considered to stabilize your equity program during this period of uncertainty.
Admin & Mix Changes. Often overlooked, there are tools that exist within the current plan that can make a difference. For example, take our earlier RSU example of $100K in intended grant value that is now valued at $70K today. What if we reduced the vesting from 4 years to 3 years? We could maintain a similar level of annualized vesting value without granting more shares. And for stock options users, consider introducing RSUs as part of the equity mix. This will allow for more efficient value transfer that will alleviate pressure on the equity plan and provide some downside protection to participants while they wait for options to get “in the money”.
Cash in Lieu of Equity. When companies go through extended de-valuation cycles, it is natural to have the mindset that we should give more options given favorable strike prices and upside potential. The problem often becomes that employees may not understand – or worse, may not value – stock options if they have not experienced past value creation. At a certain point, the cost and ROI can become more favorable for a cash-based program, if feasible from a cash-flow perspective, compared to the incremental dilution and pressure on the equity plan – particularly for mid and lower-level employees.
Taking Near-Term Action. For many companies, there is a feeling that action must be taken “now”, prior to the annual grant cycle in Q1 (another 6 months away). There are two techniques to consider:
1. Pulling Forward a Future Grant. For example, if I typically receive 10K units in Feb, I could grant 3-5K now, and provide the balance (5-7K) on-cycle. This can be a “quick hit” at a lower price, while maintaining overall plan dilution. Caution: the price can still slide between now and Q1, so that must be considered as a potential outcome.
2. Providing a Supplemental Award. Rather than borrow from the future, we load up employees through an award now AND the full award on-cycle. This can be very impactful but can also be very dilutive. Affordability is a key consideration here, as well as identifying the potential recipients. Caution: executive participation could result in 2 grants in a given year, creating potential governance exposure.
More Dramatic Strategies. Underwater Stock Option Exchanges and Repricing’s are receiving a lot of press in the market right now. Why? Because they are extremely powerful tools that can restore outstanding equity value in a very short period of time. They also bring with them significant risk and potential exposure from a governance perspective.
1. Underwater Stock Option Exchange (“UWSO”). In the case of an Underwater Option Exchange, employees voluntarily surrender (“tender”) underwater stock options and get new (generally fewer) shares at the current market strike price. This can restore value to a large number of outstanding options, but brings with it a higher level of complexity, cost and a requirement of shareholder approval, which may eliminate this alternative if the proposed plan design can’t achieve the required shareholder votes. 2. Repricing. Unlike an UWSO exchange that cancels old shares and grants new shares, a repricing leaves all outstanding awards unchanged except for the strike price, which is lowered from the underwater price to the current fair market value. Sound too good to be true? In most cases it is… a lot of things need to line up to make this strategy viable. The specific provision needs to exist within the Equity Plan, the Board must be supportive of the action (despite losing significant value on their investment) and the company must be prepared to take on public criticism which may have a hangover effect in future years. Oh, and then there is the expense. A sizeable non-cash equity expense is trigged upon modifying the awards.
In times of volatility and uncertainty, companies need to be open minded and flexible to stay ahead of the curve. Start by understanding your company’s business situation and evaluate the risk indicators that might prompt deeper analysis and discussion. Consider what strategies are right for your company’s situation and be sure the solution is fit for purpose.