The following Share Incentives practice note provides comprehensive and up to date legal information covering:
'Underwater option' is the term used to describe a share option (granted under any share option scheme) which has an exercise price per share greater than the current actual market value of a share. This means that should such an underwater option be exercised and the shares immediately sold, the option holder would make a loss. For obvious reasons, an option holder is unlikely to exercise an underwater option and therefore in many cases alternative ways to reward and incentivise underwater option holders have to be found.
It should be noted that underwater options outside of exit or leaver scenarios (ie where they do not lapse in the event of an imminent exit or the imminent cessation of employment of the option holder) may still hold a 'hope value' based on the possibility of an economic recovery and a subsequent increase in the share price which may result in the market value of a share rising above the exercise price of the share option.
Underwater options are most common in economic downturns and therefore underwater options are a cyclical issue for companies. A share option most commonly results in becoming underwater when it is originally granted with an exercise price equal to or in excess of the market value of a share at the date of grant (market value share option).
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