Private Company Option Exchanges Guide: Overview & Costs

Understanding Option Exchanges for Private Companies

As markets rise and fall, equity compensation trends tend to follow. Companies riding AI-driven momentum are awarding top talent unprecedented, sometimes nine-figure grants. On the other hand, companies facing headwinds from tariffs, inflation, and uncertainty have different strategic choices to make about equity compensation, especially when existing grants fall short of expectations.

One choice that becomes more common during a market or industry downturn is the use of option exchanges and repricings to realign incentives and preserve talent.

What Is an Option Exchange?

An option exchange, sometimes called a repricing, is an equity compensation program that allows employees to exchange their underwater stock options for a new award of at-the-money options or restricted stock units.

At a high level, option exchange programs are a retention tool, much like equity grants themselves. A company issues options or stock to motivate employees to stick around and generate value for the company.

As options fall out of the money, however, they’re more likely to expire without any value. More importantly, the perceived value craters, with employees often concluding they have little to lose from termination or forfeiture. An option exchange mitigates these issues by restoring the retention and incentive value of outstanding awards.

Key Considerations for Private Company

In a public company setting, governance constraints and proxy advisor pressures can create tight guardrails around when and how companies can offer option exchanges. As a result, exchange programs are rare outside of full-scale macroeconomic downturns like the dot-com crash or the 2008 financial crisis. The programs also tend to look similar from one company to another because they’re structured to gain shareholder approval.

Private companies, however, have nearly complete flexibility around option exchange offerings. Pre-IPO share plans typically have no restrictions on option repricing. And gaining shareholder approval is much easier given the smaller and usually like-minded pool of shareholders.

This increased flexibility means private companies can:

• Offer exchanges when it makes business sense. Public companies are often forced to wait for sustained and sometimes market-level price declines to justify the program to shareholders.
• Offer a one-to-one repricing. This is an approach where the strike prices of exchanged options are lowered to current levels, but share counts remain the same (e.g., 10 underwater options are exchanged for 10 at-the-money options). Among public companies, it’s much more common to reduce share counts during the exchange, such that the pre and post-exchange award values are equal (e.g., 10 underwater options are exchanged for 4 at-the-money options).
• Potentially exchange awards without employee opt-in and the resource-intensive tender offer process. If an option exchange makes employees unilaterally better off (one-to-one repricing, no change to the vesting schedule, etc.), the requirement for option holder consent can be waived, making the program much simpler to implement.

Should We Do an Option Exchange?

It’s essential to monitor employee sentiment and behavior to determine when an option exchange program may be beneficial. The combination of underwater options and weak company performance can lead employees to devalue the options they hold. Any reductions in force can hurt perceived value even more.

Low perceived value can weigh on morale, but more tangibly, it makes it easier for competitors to buy out and poach employees. If multiple years’ worth of grants have dwindled in perceived value, the appeal of a new-hire grant at a competing firm can be hard to pass up. After all, any employee can “exchange” their own options by changing employers.

We recommend tracking both qualitative and quantitative indicators, including:

• Employee sentiment about equity
• The proportion of options that are underwater
• Trends in regrettable turnover

Costs and Constraints to Consider.

Although private companies have more flexibility than public companies, an option exchange program—especially a one-to-one repricing—isn’t an altogether free lunch.

Accounting impact under ASC 718.

First, an option exchange is considered a modification under ASC 718. As such, any incremental value created for employees during the exchange must be estimated and amortized as stock-based compensation expense. Non-cash expense is often less of a focus at private companies, making the tradeoff worthwhile. If it is a focus, say during the period before a purchase or IPO, the company is probably not in a situation where an option exchange is under consideration.

Dilution for existing investors.

Second, an option exchange will have a dilutive effect on other investors. When employees are permitted to buy the same number of shares at a lower price, less cash will flow into the company, and that means the dilutive impact of those options will be higher. This is usually a relatively minor concern for companies facing the potentially existential people issue that an option exchange is intended to solve.

Wrap-Up

In an ideal world, company value would only grow over time and employees would reap the rewards. In the real world, however, most companies will see their share price decline. If those declines accompany reduced retention and employee turnover, it can be much harder to recover.

Option exchanges are an important part of the equity compensation toolbox due to their power to restore incentives and foster retention. Private companies, which lack many of the third-party pressures facing public companies, have a comparatively unique opportunity to apply this tool with sole consideration to the business goals of the firm.

If you would like to explore option exchanges further, we invite you to review Equity Methods’ detailed post on key decision points.

Are there any other considerations to worry about?

So many! To learn about other considerations that apply to award modifications, check out NASPP blog entry “5 Things to Know About Award Modifications” and this handy table summarizing the considerations for various types of modifications.