With an ever-changing business environment, sustained stock price declines might be a new thing for you or your employees. Whether you’re experiencing market volatility or customer pains, you may be wondering, is it the right time to consider a new common stock valuation?
The answer is: maybe. And it all depends on circumstances. Regardless, as a private company, you have control.
Stock options are an additional form of compensation. When used appropriately, they can serve as a morale booster and give employees a greater stake in the future of the company. By executing a new valuation, companies may be able to reduce the price of their stock, thereby distributing options to employees at a lower cost — providing them with valuable assets with more upside potential.
Remember that valuation experts use information that is known or knowable as of the valuation date. So, a new valuation in the trough of the market could make your company more attractive if you are hiring.
Of course, if the value has declined, you must also be sensitive to giving new employees options below existing employees. What this means and how you communicate this is important. You might even consider repricing existing underwater options to further incentivize current employees (keep reading as we will dive deeper into this shortly).
If you have a new round of financing with new investors, this is a well-known reason to update your valuation. Even if you have taken on more money from existing investors either as a follow-on or an extension of an existing round, you may want to consider a new valuation. Existing investors are already well apprised of the health, viability and roadmap of your company, so this may not be a true indication of fair market value. Further, you may have to give up some additional preferences or warrants as part of the transaction, which would impact the value.
Any time you do an “internal round” there can be complexity in the next valuation, so it’s important to discuss structuring decisions with a valuation expert in advance so you understand the impact.
If it is appropriate to do so and will not disrupt or endanger an ongoing M&A process, a potential decline in value may be an opportune time to execute a new valuation (and repricing or issuance of new options). This allows employees to receive equity compensation at an advantageous price before the company is acquired, as opposed to them having underwater options during a closing and getting minimal or no return as well as missing out on future upside with the acquirer. It is important to have the employees and company aligned on strategic initiatives and for employees to participate in the company's growth and value.
If you’re doing a new funding round, this is not the time to try to lower the stock price. Ultimately, the new round will likely be the best indication of value, so it is generally not fruitful to do a valuation close to raising a new round. Although investors (and acquirers) do their own valuation, it may draw unnecessary questions from potential investors as to why you are revaluing the company for compensation purposes prior to the round.
Additionally, it is usually a poor data point from a tax perspective to have a valuation done right before another with differing values. The value derived from the funding round is a market-based input and will carry more validity from a valuation perspective. Any conflict between two such valuations could do more harm than good.
Sometimes the process of going through a new valuation simply isn’t worthwhile. If it only manages to lower the stock price by an insignificant percentage, it may not be worth the effort. For example, you may not be willing to reprice your underwater options if the price went from $1.10 to $1.03, and you expect to rebound in three to six months (although some companies do).
Ultimately, this comes down to understanding the qualitative and quantitative factors of how your business has been and is expected to be impacted. The valuation considers not only the macroeconomic factors, but also your future forecast and expectations. These can be potentially compounding elements that might negatively impact the valuation.
Generally, the longer your expected road to recovery, the more beneficial it is to get a new valuation now. If the runway to reaching old highs is a year or more off, a valuation now may be more beneficial than if that’s three to six months away.
These are all important considerations when thinking about a new common stock valuation. Each company has its own unique set of factors to weigh.
Within the context of a lower valuation, the question then is whether you should address your underwater stock options or stock appreciation rights (SARs) for existing employees — we’ll address these collectively as “underwater options.” To answer this question, you have four main options which we’ll explore below (the last two may not be as well received by employees):
You could make an immediate replacement of the underwater options with a new option or SAR that has an exercise price equal to the market value at the time of the new valuation date. All remaining terms (vesting, expiration date, etc.) will generally remain the same, but these could also be modified to help offset investor concerns.
Advantages:
Disadvantages:
You can exchange the underwater options for a different type of equity-based award, for example, restricted stock units (RSUs). Since these are considered “full value” awards, the number of shares in the new award is usually less than the number of shares from the cancelled options. The ratio is generally between 1/4 and 1/2. Other terms such as additional vesting could be added.
Advantages:
Disadvantages:
Potential negative perception by investors is a common disadvantage between both alternatives. (Although, we have rarely seen this in practice. In fact, we have seen some investors pushing for it because they understand the importance of employee retention.)
Instead of repricing underwater options, you could simply grant more options or SARs at the new price.
Advantages:
Disadvantages:
You could simply wait and see if the stock price will recover and attempt to reassure employees that the market volatility does not reflect the company’s true long-term value.
Advantages:
Disadvantages:
For tax purposes, if you reprice ISOs, some of the new options may be converted to non-qualified stock options (NSOs). Additionally, the qualifying disposition clock gets reset.
Under ASC 718, a repriced or exchanged option is considered a modification. Incremental compensation expense is recognized to the extent that the replacement grant’s fair value is greater than the fair value of the cancelled options. On the positive side, your pool of shares available for future grants may increase significantly if you choose an RSU exchange program.
As a private company, you have various considerations when looking to complete a new valuation or stock option repricing. We encourage you to think about your long-term business goals and short-term employee morale. Often, a reset of the stock price and stock option exercise price can be beneficial in balancing both. Whatever route you take, make sure to consider the pros and cons holistically and include your team of advisors (including those who specialize in employee communications).
Contact our equity management experts for questions or help with determining whether now is the right time to do a new common stock valuation or stock option repricing, or to explore more ways to take control of your business operations and stabilize your future.
