What to Do With Underwater ISOs and NSOs
In the world of equity compensation, Incentive Stock Options (ISOs) and Nonqualified Stock Options (NSOs) offer employees incredible financial upside. The downside, however, is that if your company stock price drops from the time you received your options, your ISOs and/or NSOs don’t have immediate value and are referred to as being “underwater.”
With so many companies seeing drops in their share price, we’re writing this article so you have a better idea of what to do if your ISOs and NSOs are underwater.
We’ll first share some general thoughts about underwater options, then we’ll dive into actions you can take, and what choices you have to make the most of your underwater options. If you want to learn the beginner basics of ISOs and NSOs, please read the linked articles.
Companies Don’t Want Underwater Options
Companies want to attract employees, incentivize employees, retain employees, and reward employees for a job well done. A common method to accomplish all of this is to grant employees equity in the form of options like ISOs and NSOs.
Options tie you and the company together by offering you a financial benefit if the company does well and the share price goes up. However, if the share price of the company goes down, your options will be worthless. (Having worthless options isn’t ideal, but viewed from a glass-half-full perspective, at least they aren’t worth a negative amount!)
Worthless options are created when the stock price of the company falls below what your cost to exercise those options is. Here’s a look at an “in the money” option and an underwater option.
As you can see from the two examples, the underlying equity of ISOs and NSOs only have immediate value if their current market value (aka fair market value) is greater than the exercise price.
This should make sense since you wouldn’t pay more than the current price of the company to own shares, you’d just choose not to exercise since you’d be able to buy shares of the company on the open market vs. exercising your options.
5 Potential Choices with Underwater ISOs and NSOs
Now that we have baseline understanding, here are some options/choices/actions/things you can do with your underwater ISOs and NSOs. Some are simple, but others will require some action on your part and may even require a little detective work.
For each bullet, we’ll explain the choice itself, the likelihood of it happening, and why the company may or may not go for it.
Underwater ISOs and NSOs Option #1 - Exercise Patience
The first option at your disposal is to wait for the share price to get back above your exercise/strike price.
Sometimes the best course of action is to do nothing, but doing nothing can feel very unsatisfying. And, of course, the greater the difference between the exercise price and the current price, the harder it is to believe the stock price will ever get back to where it was.
If your exercise price is $40 and the current market value is $39, you’re probably not too concerned about your underwater options. However, if your exercise price is $40 and the current market value is $15, you’ve probably lost all hope that this equity will ever be worth anything.
If you find yourself in this super-downtrodden option position, it’s safe to say that your equity isn’t doing what it was supposed to when it was granted to you. Your equity is no longer incentivizing you and is more likely disincentivizing you! Assuming this is the case, you still have options to actually make your equity do what it’s intended to do.
Underwater ISOs and NSOs Option #2 - Ask for an Extension
The first option at your disposal when dealing with underwater options is to ask for an extension of the expiration date.
The rationale for asking for this is that if the price has tumbled significantly, it might take years to recover. And if it takes years to recover, you could find yourself bumping against the expiration of your options.
By asking for an extension, you’re essentially saying, “Hey I’m down to wait this out, but I want a little more assurance that my options won’t expire before they have value again.”
If you’re getting close to the expiration of your options, the employer might be more inclined to push out the expiration a few years. If it’s only been one year and you have 9 more years until expiration, you may not have as strong of an argument. This is true even if the price has dropped significantly. You may, instead, want to choose one of the options below.
An important note if you have underwater ISOs: By pushing out the expiration date of your ISOs, you’re likely going to cause them to convert to NSOs. This may not be a big deal in all situations, but there are quite a few differences between ISOs and NSOs that you should familiarize yourself with.
Underwater ISOs and NSOs Option #3 - Ask for a Regrant
The next option at your disposal if you have underwater options is to ask for a regrant.
A regrant would mean that your employer would cancel your current grant of options and then reissue you another grant of options so that the exercise price would match the current market price (in most cases).
This seems like the best possible scenario, but it’s a difficult ask to make of the company. Therefore, even though it requires extra work, we think it’s important to understand what the company is likely to be thinking so that when/if you decide to ask, you can be as persuasive as possible.
When a company is asked for a regrant, you should anticipate that they’ll take some of the following into consideration:
How many employees from your have similar grant(s) and are being affected by the large drop in share price?
What level and role are the employees who received these grants? (If they are leaders of the company, you can expect that the company will be more open to the request.)
Are there other types of equity grants made to employees around this same time period that could also be thrown into this group?
What’s the total number of ISOs or NSOs that are being affected?
Is the company public or private? (If public, a regrant typically needs shareholder approval; if private it’s usually easier to get approval.)
Will the company reissue the same number of options that were originally granted? Or will there be a reduction in order to keep the value close to the same?
Is the company willing to go through the administrative and accounting headache of the cancellation and regrant?
This list isn’t exhaustive, but these considerations may help you think of creative ways to ask for a regrant. At the very least, it can arm you with some ways to help you prepare to negotiate.
When asking for a regrant, you might want to first start by pursuing 1-to-1 value and then work your way down to trading in for less (assuming you’re willing to do that). It’s a big ask of the company regardless, but you may as well shoot your shot!
Underwater ISOs and NSOs Option #4 - Ask for a Regrant of Another Equity Type
The next option is similar to the last one. The difference is that instead of asking for a like-to-like one-to-one cancellation and regrant, you can ask for a cancellation and regrant of another type of equity.
When this type of regrant happens, we’d say that the most common switch we’ve seen is a switch from options to RSUs. However, there are a lot of accounting rules that the company will have to consider for this switch to happen and they will need to adjust the number of RSUs you receive since public company RSUs will always have a value once they vest (so long as the company doesn’t go under).
This option may not be ideal if you’re at a private company since they’d likely replace your options with double-trigger RSUs. This would basically mean that you’d be unable to receive anything until after working at the company for “X” number of years and staying through an IPO or other liquidity event.
Underwater ISOs and NSOs Option #5 - Leave
The last, and saddest, option is to cut your losses and leave.
Employees of companies whose stock price is increasing are generally happier. So yes, it really stinks that the equity you received isn’t currently worth anything. But no, you’re not alone. And it’s important to remember that you probably possess an awesome skill set that might be better used at another company.
Even if you have underwater options at a company, you can still use the grants you’ve received and the frequency at which you’ve historically received those grants to help you negotiate equity at the new company.
Ask Us For Help
We’re really sorry if you have ISOs or NSOs that are underwater. When you think back to how you felt at the time you first received the grant, it’s usually quite a stark contrast to how you feel now. But try to take heart and remember that in spite of everything, equity remains a powerful tool for financial growth. Please don’t let this experience sour you completely from embracing its wealth-building power.
We appreciate you reading this article and if you’d like to hear our two cents worth or just want someone to vent to, we’re happy to lend an ear.