5. A controversial practice with employee share options is repricing.

What happens is that a company experiences a share price decrease, which leaves employee share options far out of the money or

‘underwater’. In such cases, many companies have ‘repriced’ or

‘restruck’ the options, meaning that the company leaves the original terms of the option intact, but lowers the strike price. Proponents of repricing argue that because the option is very unlikely to end in the money due to the share price decline, the motivational force is lost.

Opponents argue that repricing is in essence a reward for failure. How do you evaluate this argument? How does the possibility of repricing affect the value of an employee share option at the time it is granted? As a new graduate, you have taken a management position with Exotic Cuisines Limited, a restaurant chain that just went public last year. The company’s restaurants specialise in exotic main dishes, using ingredients such as kangaroo, crocodile and emu. A concern you had going in was that the restaurant business is very risky. However, after some due diligence, you discovered a common misperception about the restaurant industry. It is widely thought that 90 per cent of new restaurants close within three years;

however, recent evidence suggests the failure rate is closer to 60 per cent over three years. So, it is a risky business, although not as risky as you originally thought.

During your interview process, one of the benefits mentioned was employee share options.

Upon signing your employment contract, you received options with a strike price of $55 for 10 000 company shares. As is fairly common, your share options have a three-year vesting period and a 10-year expiration, meaning that you cannot exercise the options for a period of three years, and you lose them if you leave before they vest. After the three-year vesting period, you can exercise the options at any time. Thus, the employee share options are European (and subject to forfeit) for the first three years and American afterward. Of course, you cannot sell the options, nor can you enter into any sort of hedging agreement. If you leave the company after the options vest, you must exercise within 90 days or forfeit any options that are not exercised.