The issue of underwater share options arises each time there is a downturn in the market. The term is used when an option is ‘out of the money’: the agreed price at which an employee can acquire shares under an employee share scheme is lower than the current market value of the shares. Where this is the case, an employee will not wish to exercise their option. Employees are disincentivised and majority shareholders are unlikely to want to make a ‘giveaway’ in order to provide them with a further incentive.
There are no easy solutions to problem of underwater share options, but the choices are likely to be as follows:
Employees wait for the situation to improve
Most employees should understand that the point of share options is to align their interests with those of the shareholders. As such, they may be willing to wait for the situation to improve for everybody, when the economic climate recovers.
Change remuneration arrangements to provide an incentive
If companies are keen to retain the employees, they may consider amending the overall remuneration package to compensate for the loss of incentive from the share option scheme. The appropriateness of this will depend on the extent to which the decline of the company’s fortunes was attributable to the employee’s performance.
Parallel phantom options
A phantom option can be granted, based on the current market value of the shares, whereby the employee receives an agreed amount upon increase of the share value. This is capped at the exercise price of the actual option, to prevent double reward.
Sell the options
This is not usually a consideration because options cannot generally be transferred. The EMI legislation specifically requires that options are not transferable.
Surrender for cash
The employee could be offered the opportunity to surrender the option for cash. Where this occurs, amounts received will be subject to PAYE and NICs in the usual way.
Reprice the options
Care must be taken here, particularly with EMI. Amending the terms of an EMI option can be a disqualifying event, meaning that the option must be exercised within 90 days to avoid the loss of tax advantages.
A repricing is likely to be considered by HMRC to be a change to the fundamental terms of the option and so will be classed as a new option. This means that the EMI conditions must be met at the time of the new grant and the two-year holding period for Business Asset Disposal Relief (formerly Entrepreneurs Relief) starts again.
Surrender and regrant
This can be a useful option when the statutory limit on the value of share options (calculated at the date of grant), has been reached.
An alternative to maintaining a share option scheme would be to allow employees to purchase shares immediately, at the current low market value. Employers and employees should note that any discount on market value will be liable to income tax immediately.
The advantage of this is that it allows employees to obtain shares at a lower value than they may have been expecting, especially if an EMI scheme was not available to the company. Where there is no upfront income tax charge, the employee will benefit from the entire future growth in value being subject to capital gains tax.
From the employer’s point of view this can be a valuable retention tool although the majority of shareholders must be willing to accept dilution of their holdings. The shareholders’ agreement and Articles of Association must be reviewed to ensure that protection is in place for majority shareholders.
All of the above will require clear communication with shareholders and option-holders to obtain buy in from all parties. HMRC has a non-statutory clearance process, which can be used for queries relating to the amendment of tax advantaged share plans.
The considerations when deciding how to deal with underwater share options can be summarised as follows:
- Check plan rules
- Check whether shareholder approvals are needed
- Check tax implications
Dixcart can work with you to determine the best way to deal with underwater share options while continuing to incentivise your employees. Please do get in touch for an informal discussion: firstname.lastname@example.org.