How companies can deal with ‘worthless’ staff stock options

Since February 2015, the market has lost over 70 percent of its value. Year-to-date losses have claimed 22.6percent, 8.2percent and 18.1percent for NASI, NSE 20 Share Index and NSE 25 index, respectively.

With the long-term decline, it is possible many employee stock options (ESOP) awards have turned underwater - there are about eight ESOPs by listed companies operated as part of their management compensation package.

ESOPs being an appreciation-based incentive instrument, lose complete value if the price of the underlying share falls below the exercise price (or the price at which the option was granted).

It not only nullifies the value for the option holder (leading to loss of morale) but is also a sunk cost for the company since the expense recognised is irreversible according to accounting standards - a “lose-lose” scenario for the company as well as the employee.

With no foreseeable market revival in sight, boards may need to deal proactively with the issue of underwater options. Here are a few suggestions.

One, the board can alter the terms to use “look-back” options - meaning the employee can exercise the option at any underlying price that has occurred during the ESOPs life instead of the price at the time of option granting.

In that case, the employee can choose the lowest price. Two, they can simply cancel the original ESOPs and re-grant them using the lower exercise prices.

Three, the board can use “average strike options” where the strike price at the expiration date is set at the average rate of the underlying over the life of the vesting schedule.

Four, they can consider extending the vesting schedule to give more time for the ESOPs to be “in the money.”

Five, re-price the original ESOPs to reflect current low prices so that when the market recovers, they can quickly become “in the money” options.

That said, what’s uncertain is how the taxman would treat such suggestions.

I am not a tax professional, but my reading (per Section 5(5) and (6) of the Income Tax Act) is that the tax position of ESOPs states that the benefit will be based on the difference between the market value, and the offer price, per share at the date the option is granted by the employer.

In addition, benefits are deemed to accrue to the employee at the end of the vesting period. More importantly, what will the shareholders say?

Will companies accept to pick up the added cost associated with the above actions? Anyway, if bailing out these worthless options fails, companies can still think of alternative reward mechanisms to keep their high-performing employees.

Worse, do nothing.

Granted, bailing out “worthless” options is a hot-button issue. In a market that has destroyed more wealth than create it, it’s bound to be a touchy issue.

That notwithstanding, keeping high performers will always be any board’s priority.

Besides, management employees typically have a lot of expectations. So, if a stock option goes underwater, it shatters dreams.

Hence, there's a need to strike a balance between these two positions.

Mwanyasi is the managing director at Canaan Capital.