Stock Options

Incentive stock options (ISOs) have long been a favored form of equity compensation for companies, particularly startups, to attract, incentivize, and retain employees. When properly structured, ISOs offer two key federal tax benefits: (i) ISOs are not taxed as income when granted by the company or exercised by the employee, and (ii) subject to applicable holding periods, any gain on stock acquired from the exercise of an ISO is taxed at a more favorable capital gains rate (however, the spread at exercise may be subject to the alternative minimum tax (AMT)).

But the regulatory framework that gives ISOs potentially advantageous tax treatment comes at the price of their flexibility once granted. What companies may view as a “minor” change to the terms of an ISO may be treated as a “modification” under the tax regulations, which can have significant, unanticipated consequences and, in some cases, cause the ISO to lose its preferential tax treatment altogether, and in the worst-case scenario, become subject to Section 409A and the 20% additional tax thereunder. In such instances, the option no longer qualifies as an ISO and is thereafter treated as a nonqualified stock option (NSO) for tax purposes, meaning that it is taxable upon exercise and any resulting stock is not eligible for favorable capital gains treatment.

Loss of ISO treatment may be frustrating to both companies and their employees, and therefore, it is important to understand the implications of an option amendment before implementation.

Summary of ISO Requirements

In order for an option to qualify as an ISO under Internal Revenue Code § 422, it must satisfy all statutory requirements, including the following, on the date of its original grant:

• Option must be granted to an employee of the company (or its parent or subsidiary)
• Option must be granted under the company’s written equity plan
• Exercise price must be at least equal to the fair market value of the underlying shares (and for employees who are >10% stockholders of the company, the exercise price must be at least 110% of fair market value)
• The term of the option is no longer than 10 years (or no longer than five years for >10% stockholders)
• No more than US$100,000 of shares (based on the fair market value as of the date of grant) may first become exercisable in any calendar year

To the extent an option fails to meet the statutory requirements, or is in excess of the US$100,000 annual limitation, it is treated as an NSO for tax purposes.

Modifications of ISOs

Under applicable tax rules, a “modification” of an outstanding option is generally treated like a newly granted option as of the modification date. “Modification” is broadly defined to include any change that provides additional benefit to the optionholder, regardless of whether the optionholder actually benefits from such changes.

When an option is “modified,” it must re-satisfy all ISO requirements based on and as of the modification date to continue to be treated as an ISO. To the extent that ISO requirements are not met as of the modification date, the option is thereafter an NSO for tax purposes. In most cases, ISO status that is lost due to a modification cannot be restored.

Common Modifications and Their Impact

Companies may contemplate any number of changes to their outstanding options. Most often, companies propose amendments to (i) grant early exercise rights, (ii) accelerate vesting, (iii) extend exercise periods, or (iv) change exercise price.

Grants of Early Exercise Rights

To make option awards more competitive or attractive for its employees, a company may consider granting early exercise rights, which allow employees to exercise outstanding but unvested options, subject to a right of repurchase. Early exercise allows employees to own shares earlier and accordingly start their capital gains holding periods earlier.

While early exercise rights that are added to an option after its original grant date would seem to be a modification because they appear to provide an additional benefit to the optionholder, the ISO regulations specifically provide that this is not a modification of an ISO and can be added without jeopardizing the ISO status.

Acceleration of Vesting

In connection with acquisitions, layoffs, changes in control, or other special scenarios, companies may consider adding single-trigger or double-trigger acceleration terms to outstanding options to allow employees to vest in unvested options upon the occurrence of such events.

As a general matter, accelerating vesting does not itself constitute a modification for ISO purposes. However, acceleration might cause more shares to “first become exercisable” in a single calendar year, potentially causing all or a portion of the option to exceed the US$100,000 ISO limit for that year. Any excess over the limit is treated as an NSO.

Extensions of Exercise Periods

Most employee options are originally granted with a three-month post-termination exercise period (with certain extended periods provided for death or disability and shorter periods for a termination for cause). When an employee departs, a company may consider extending the exercise periods of the employee’s options to allow them additional time to decide whether to exercise them for shares.

Two separate ISO issues arise with respect to extensions: (i) extending the post‑termination exercise window is generally treated as a modification, causing re‑testing of ISO status as of the extension date, and (ii) regardless of any extension, an exercise that occurs more than three months after employment ends (excluding disability or death) cannot receive ISO tax treatment. In other words, if the ISO is in-the-money when the exercise period is extended, it will become an NSO, and even if the option remains an ISO, if it remains outstanding and exercisable after the three-month post‑employment period, it becomes an NSO at the end of such three-month post-employment period.

Adding Exercise Method (such as Promissory Note)

Adding an additional method of exercising an option, such as allowing exercise with a full-recourse promissory note, is typically expected to be treated as a modification, even though this may have been permissible to include when the ISO was granted. If the ISO is in-the-money or otherwise cannot requalify as an ISO at the date of this modification, it would be expected to become an NSO.

Changes to Exercise Price

If the price of a company’s stock decreases over time, a company may consider repricing any underwater options to restore their retentive purpose. Options are “underwater” if the exercise price per share is greater than the current fair market value of the share, meaning that an employee would inherently lose value by exercising their option. To fix this, a company may want to amend underwater options to reduce their exercise price to the current fair market value.

A reduction in exercise price is among the clearest examples of a modification and results in a deemed new grant of the option. Because ISOs must have an exercise price at least equal to the fair market value on the grant date, a repricing to lower that value will generally cause the option to fail the ISO test; however, repriced ISOs generally should be able to re-satisfy all ISO requirements based on and as of the modification date and typically will continue to be treated as an ISO (although if there are changes that make requalification not possible, such as no longer being an employee, the ISO will lose its ISO status in the repricing). Note that repricing can effectively double count prior ISOs, as the repriced grant is treated as a new ISO, such that the award could exceed the US$100,000 limitation when including the prior ISOs as new awards.

Consider the AMT

As a final thought, if the ISO holder would otherwise be subject to the AMT, the loss of ISO status may be less detrimental than for someone not subject to AMT. Losing ISO status would subject the holder to ordinary income tax rates, which may not be dramatically different than the AMT rates (26% or 28%, based on 2026 rates). Additionally, the vast majority of ISOs are not exercised and held for the required ISO holding periods and become NSOs in any event. Accordingly, the loss of ISO status is less impactful than it would otherwise be, although the tax benefits of an ISO when utilized to get long-term capital gain are measurably better where possible.

Many private companies are having to grapple with the realities of lower valuations. When a new Section 409A valuation values the company’s common stock at a lower price than any past Section 409A valuations relied on to grant prior stock options, the company may want to consider repricing the stock options held by its service providers. Where an existing stock option has an exercise price higher than the company’s current valuation, the result is an “underwater option.”

While repricing can restore some of the incentive and retention value of employee equity, it raises a host of valuation, perception, legal, tax, and accounting considerations that a company must manage.

Is a repricing necessary?

If the decreased valuation is a temporary situation that is expected to shift and change in a short period of time, or the long-term value is expected to be significantly greater than the current price, a repricing may not be necessary. This is particularly true if the value that is added to the option as a result of the repricing is not significant from a long-term perspective (i.e., the adjustment in price is relatively small). For example, if an employee held 1,000 company stock options that were currently priced at $2 per share, but that could be repriced to $1 per share, it may feel like making this change would be a significant repricing. However, if, a few years later, the company were to have a liquidity event where the shares were sold at $100 a share, this repricing only added an additional $1,000 to the total sale amount of $99,000, which is an increase of only 1 percent. Contrast that to a situation where the shares are ultimately sold at $3 a share. Repricing the options to $1 a share would still only add $1,000 to the total sale amount, but that would effectively double the holder’s total sale proceeds from $1,000 to $2,000.

While companies may not be able to predict the ultimate sale price, it is useful for a company to look at what a healthy potential exit will look like and how significant this repricing would be in that context, to ensure there is material value being added as a result of the repricing.

Negative Aspects of a Repricing

At first blush, most people would expect employees would be happy to have their options repriced as it gives them additional potential equity value; however, repricing options can introduce worry about the long-term value and prospects of the equity and, as a result, impact employee morale. Repricing can, and often does, have a positive impact on employees, but employees may also interpret it to mean the equity they hold is decreasing in value and that they are less likely to get the hoped-for. This can be particularly true where there are multiple repricings over a period. Repricing can also impact employees’ trust in management, especially if the message coming from management is about how well the company has been doing during that same period. If the future value of the shares is perceived to be weak, it creates jitters among the service providers and can negatively impact retention and hiring. The impact is exacerbated if the company is in an industry where most companies are doing well, as opposed to general market downturns impacting all similar companies. Finally, a company repricing can be a signal to investors that the company does not perceive as much long-term value in the shares and can actually lead to low-ball investment proposals, creating a self-fulfilling prophecy. Companies need to carefully weigh both the long-term and short-term impact of a repricing and its perceptions by service providers and investors.

Repricing Terms & Participation

If the company has decided that a repricing is necessary to properly incentivize its employees, the next consideration is what terms the company should offer in connection with the repricing. While a private company may be tempted to use the repricing as a chance to add vesting or other terms favorable for the company, anything other than a simple repricing (e.g., changing only the price) adds considerable cost and complexity for the repricing and could trigger the tender offer rules as discussed in more detail below.

Generally, only current service providers can participate in a repricing. This is because the repricing is effectively treated as a cancellation of the prior grant and a grant of a new award at the new price. All new awards need to be granted pursuant to a valid securities law exemption; thus, the repricing is generally limited to service providers that satisfy compliance under Rule 701 (discussed more below). If a significant number of former service providers are impacted by underwater stock options, the company should consult with counsel to determine the best path forward.

Tax Considerations

Any time a company wants to do a repricing, it needs to consider Section 409A compliance and Incentive Stock Option (“ISO”) tax issues.

Section 409A Tax Compliance

Section 409A governs deferred compensation, including stock options, and imposes severe tax penalties on options granted with an exercise price below fair market value. Section 409A penalties include an immediate income inclusion plus a 20% extra tax for the option holder. Any option repricing must therefore be done in compliance with Section 409A. In practice, this means the new exercise price cannot be less than the then-current fair market value of the underlying stock as of the repricing date. To ensure this, companies generally obtain an updated Section 409A valuation before repricing options. The board will use this valuation to set the repriced exercise price at or above fair market value, preserving the options’ exemption from 409A. Furthermore, a single repricing is usually not a risk under Section 409A, but successive repricings may be. While market volatility may tempt companies to repeatedly adjust option prices, serial repricings can be seen as the company not having a fixed price for options (e.g., the repeated repricings are seen as chasing a price to the bottom), which could be a Section 409A violation. Each modification should be carefully considered and tied to a material change in value (not minor fluctuations), and any subsequent repricings should be analyzed for their impact under Section 409A.

ISOs

Repricing an ISO is deemed a grant of a new ISO. This means that the regular limit on ISOs ($100,000 per year in which the option first becomes exercisable) must be recalculated, and some holders of repriced options may end up with fewer ISOs and more non-qualified stock options (“NSOs”) as a result of these recalculations. Also, since the repricing of ISOs is deemed a grant of new ISOs, the ISO holding periods (specifically, the prong requiring the ISO be held for two years from date of grant) will restart from the repricing date. Whether these changes are sufficiently material to require the consent of the option holder or a company tender offer should be analyzed by the company in consultation with its counsel under the terms of the plan (such as plan limitations on ISO grants and changes to existing grants) and applicable securities law.

Securities Law Considerations

A repricing raises securities law issues under Rule 701 and could trigger tender offer issues.

Rule 701

Rule 701 of the Securities Act of 1933 is the primary federal exemption that allows private companies to offer stock options and other equity compensation to employees without registering shares with the Securities and Exchange Commission. Repriced options count toward Rule 701 limits and disclosure thresholds. Importantly, as noted above, a repriced stock option is generally treated as issuance of a new security which must qualify for an exemption at the time of repricing. Therefore, the company must ensure that the repriced options, taken together with other equity compensation issued in the same 12-month period, do not exceed Rule 701’s size limits (the greater of $1 million, 15% of assets, or 15% of outstanding securities). Moreover, if the value of the repriced options, taken together with other equity compensation issued in the same 12-month period at the time of repricing, exceeds $10 million, the company must provide the required disclosures under Rule 701 (financial statements, risk factors) to all participants. Companies should keep in mind that, because Rule 701, by its terms, covers offers to current employees, directors, consultants, and advisors, it is generally not available as an exemption for repricing options to former service providers.

Tender Offer

An issuer tender offer under Rule 13e-4 and Regulation 14E of the Securities Exchange Act of 1934 (the “Exchange Act”) encompasses an offer by the company to security holders to exchange securities, which offer is open for a limited time and involves decisions by the holders. Importantly, a “simple” unilateral repricing that changes only the exercise price to the new Section 409A valuation while leaving the other terms the same is generally not thought to rise to the level of a tender offer. However, an option repricing where the option holder’s consent or action is needed may require compliance with tender offer rules, which are triggered because the option holder is making an investment decision over whether to accept the proposed terms of the repriced options. To comply with tender offer rules, the company then must observe a host of requirements under the Exchange Act. Also note, if the option is an ISO, keeping an exchange offer open more than 30 days might affect ISO status, so companies with ISOs will sometimes limit the offer window to 29 days to be safe.

Corporate Governance Considerations

A repricing will also raise a number of corporate governance issues, including approval requirements and fiduciary duties.

Board Approval

In almost all cases, repricing will require approval by the company’s board of directors (or a committee with delegated authority). The board should formally approve the repricing terms (who is eligible, new exercise price, timing, etc.) via a resolution. This is both a governance requirement and a key part of the board fulfilling its fiduciary duty (documenting that it considered the repricing and found it in the company’s interest to retain talent). The board should also be mindful of any conflicts of interest that may arise, particularly if grants to the directors are implicated.

Stockholder Approval

For private companies, stockholder approval of a repricing is typically not required unless the company is contractually obligated pursuant to agreements with investors. It is crucial to review the stock option plan documents, the company’s charter or organizational documents, and any investor agreements (such as an Investor Rights Agreement) before proceeding. Credit agreements or other contracts might also restrict modifications of equity incentives.

Fiduciary Duties and Legal Risk

A company’s decision to reprice options should also be evaluated through the lens of fiduciary duties and fairness to all stockholders. While repricing is aimed at benefiting employees (and, by extension, the company, through improved retention), it does effectively transfer potential economic value from existing stockholders to the option holders. Directors must justify the repricing as a reasonable, informed, and fair decision. To withstand scrutiny, the company’s board should document the business purpose, such as, for instance, maintaining team morale and productivity during a downturn. Additionally, to the extent any holders benefiting from repriced stock options are directors, officers, or controlling stockholders of the company, the company should be mindful of the safe harbor requirements under Section 144 of the Delaware General Corporation Law and obtain the appropriate approvals.