The Advisors' Blog

I blogged a few months ago about the unique challenges that life sciences / biotech companies face with equity awards. This Pearl Meyer memo delves into the very common problem of underwater stock options – and suggests “auto forfeiture” of significantly underwater options as a way to improve the durability of the equity pool. Here’s an excerpt:

There are a variety of ways that an auto-forfeiture provision can be structured. In its simplest form, the agreement could stipulate that on, for example, the fifth anniversary of the grant date, and each anniversary thereafter until the term is reached, if the price of the company’s stock is more than 50% higher than the exercise price, the option is automatically forfeited and returned back to the equity pool. Companies can tailor aspects of this to their specific needs, including how deeply underwater the option needs to be, the measurement period, the method for measuring the stock price, and so on. Another example of customization, as well as simplification, is to have one measurement period for all options granted in a given year which reduces administrative burden.

This solution requires careful planning. The memo gives these high-level steps:

1. Seek legal counsel on the feasibility of this approach, including, but not limited to, checking your stock plan(s) to ensure that forfeited stock options return back to the available pool for reissuance.

2. Seek advice from the finance group (or outside equity valuation experts) on the valuation of stock options with these provisions to ensure they are able to implement this structure on the accounting side. It is likely accounting will require a more sophisticated option valuation methodology than the standard Black-Scholes option pricing model that many companies use.

3. Assess the impact based on the go-forward compensation program, including but not limited to, how significant the option grants are as a percentage of the overall equity grants made, the likelihood of grants being materially underwater in the future, etc.

4. Socialize this concept and the analysis with the appropriate senior leaders in the company, and if aligned, the compensation committee of the board.

5. Establish the language to use in future award agreements, as well as processes and protocols to ensure that the grants do not run afoul of any accounting or legal rules.

6. Develop language for plan participants that explains the new provision, including its benefits to the company and benefits to the plan participant.

See this Pay Governance memo from 2023 for more suggested alternatives to address underwater options without having to reprice or exchange the awards.

– Liz Dunshee