Underwater options

By Tolley in association with Andrew Rainford
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The following Employment Tax guidance note by Tolley in association with Andrew Rainford provides comprehensive and up to date tax information covering:

  • Underwater options
  • What are they?
  • When do underwater options appear?
  • Why is this a problem?
  • Solving the underwater option problem
  • Choices available
  • Technical considerations

What are they?

An option becomes an underwater option if the current price of the shares under option has fallen below the price payable on the exercise of the option. Underwater options cause concerns when there is no reasonable prospect of share price recovery in the short or medium term, eg two to five years.

When do underwater options appear?

Underwater options commonly arise if after an option is granted:

  • there is a bear market where share prices fall generally
  • specific events affect a particular sector, eg bank shares in the early stages of the 2008 financial crisis, or in the aftermath of the EU referendum on 23 June 2016, when the FTSE 250 index dropped sharply, although it later recovered
  • there is war or a natural or other disaster, eg oil companies shares after a major oil spill
  • there is lack of confidence in a particular company or its management, eg following highly publicised criticism of Board members
Why is this a problem?

For the option holder, the option has no value and there is no financial incentive or reward.

For the employer, if underwater options do not incentivise employees, or have a demotivating effect, staff performance and retention may be affected. Employees can move job without losing valuable options and may seek better rewards elsewhere. Plan limits can prevent the employer granting further options.

For the shareholders, they will also have suffered as a result of the share price decline. They may not want employees and directors to have a special advantage by replacing underwater options. However, if the price fall is due to external challenges, the shareholders will want to keep key workers and find ways of

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