Exchanging Underwater Stock Options for At-the-Money Options at a Bank Holding Company
Background
Bank Holding Co. is a regional community bank with a residential, commercial, and agricultural loan portfolio. Although the bank’s loan portfolio was performing well, especially in a turbulent and depressed financial market of 2009-10, the stock price of the bank lost significant value over the prior years.
The Bank Holding Co. has a history of granting stock options to top executives to provide an incentive to increase the overall value of the bank. The bank found itself in a position where it had a competitive amount of equity held by the executives, yet that equity was unlikely to provide a performance incentive to the key employees. With depressed stock price, the large majority of the outstanding options were underwater.
The Bank had already taken an accounting expense for stock options that no longer had any value and wouldn’t likely regain its value before the options expired. In addition to paying for an incentive vehicle that was no longer effective, the Bank also faced a limit on granting and paying for additional equity as a result of the underwater options that were already outstanding.
Approach
The Delves Group began by analyzing all of the current outstanding equity awards held by Bank executives. To get a baseline, we determined how far underwater the outstanding options were and their current fair market value.
Once we understood the value of the outstanding options, we modeled an exchange where the old, underwater options could be exchanged for new, at the money options. During our analysis, we took into account many different considerations, including the fact that to some extent, we were giving the executives a second chance to create real stockholder value. The Delves Group and the Bank Holding Co. held several discussions to fully understand all relevant variables and potential outcomes.
Recommendations
The Delves Group suggested the Bank Holding Co. offer the underwater option exchange to its key executives. This exchange took advantage of an accounting expense that no longer performed its intended purpose of creating an incentive for executives through an equity vehicle and revitalized it. The executives would be given a one-time opportunity to exchange their underwater options for new at-the-money options of the same value (i.e., an executive could exchange 6 old underwater options for 1 new at-the-money option).
When the executives engaged in this exchange, the old options were cancelled and went back into the pool of authorized options available for grant. In addition to providing an incentive to the executives, the Bank gained the ability to make future equity grants.
Results
The Bank Holding Co. had a clear understanding of the current value of its outstanding equity, the degree to which the outstanding equity provided an incentive to key executives, and its possible strategies for revitalizing its incentive program. We clearly demonstrated that the outstanding equity grants were so far underwater that they were effectively no longer acting as an incentive vehicle for the executives. We empowered the Bank with the ability to take advantage of incentive plan, for which it has already paid for in the form of an accounting expense, and revitalize it in an effort to drive increased performance from the executives.
