Characteristics of Firms Responding to Underwater Employee Stock Options: Evidence from Traditional Repricings, 6&1 Exchanges, and Makeup Grants

Posted: 9 Apr 2008

See all articles by Valentina L. Zamora

Valentina L. Zamora

Seattle University - Albers School of Business and Economics

Abstract

I examine the characteristics of firms choosing to respond to underwater employee stock options using one of three stock option-based responses. A traditional repricing offers a new and lower exercise price to restore the incentive alignment and retention power lost in underwater options but is subject to potential expense recognition. A 6&1 exchange likewise restores what was lost in underwater options but avoids potential expense recognition by delaying the issuance of replacement options until six months and one day later. A makeup grant potentially increases the total option value lost and avoids potential expense recognition, but is more dilutive since old underwater options are not cancelled. Results indicate that makeup grant firms have relatively deeper underwater options with shorter expected remaining lives. Makeup grant firms also issue these options to more non-executives compared to traditional repricing firms. I also find that while both makeup grant and 6&1 exchange firms have less insider ownership and historically report positive income than traditional repricings, 6&1 exchange firms have greater overhang than makeup grant firms. Taken together, a possible explanation for these results is that firms that have more incentive alignment and/or retention power lost in underwater options prefer makeup grants that potentially increase total option value for its non-executive optionholders. However, when dilution from options is also a concern, it appears these firms may opt for a 6&1 exchange. In addition, it is possible that the choice of response is associated more with the desire to avoid recognizing option expense, rather than with potential rent extraction opportunities, as critics claim.

Keywords: underwater, stock options, repricing, executives, non-executives

JEL Classification: J33, G34, M41

Suggested Citation

Zamora, Valentina L., Characteristics of Firms Responding to Underwater Employee Stock Options: Evidence from Traditional Repricings, 6&1 Exchanges, and Makeup Grants. Journal of Management Accounting Research, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1117673

Valentina L. Zamora (Contact Author)

Seattle University - Albers School of Business and Economics ( email )

901 12th Avenue
P.O. Box 222000
Seattle, WA 98122-1090
United States
206-296-5703 (Phone)

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