By: James Graves and Joe Wallin
There may be times during the life of your company in which you will want to reprice underwater stock options. Depending on your cap table, however, this may not be as easy as you think.
As you know, Rule 701 sets forth mathematical limitations you must follow when issuing shares under the rule. If you want to reprice your options, you have to be aware of the fact that C&DI 271.10 requires a company that is repricing their options to count them as new grants/sales under Rule 701 as of the date of the repricing. C&DI 271.10 states:
Question: Within 12 months of an original option grant, the issuer reprices the option grant at a lower exercise price, which, in turn, lowers the aggregate sales price or amount of securities sold during the 12-month period. May the issuer exclude the original grant in determining the amount of securities that may be sold and whether it has an obligation under Rule 701 to deliver the additional disclosure called for when its issuance level exceeds $5 million?
Answer: Yes, but the issuer must count the repriced options as a new sale, and include them in determining its aggregate sales price or amount of securities sold within any consecutive 12-month period that includes the repricing date. [Jan. 26, 2009]
https://www.sec.gov/divisions/corpfin/guidance/securitiesactrules-interps.htm
This means that you can hit any of the three mathematical limitations in Rule 701 without issuing a single new option.
An example
Here’s an example. Typically, a growing company that is outside of its initial stages, but without a huge amount of assets, will rely on the 15% of shares test, test number three. Say this company wants to reprice all of their options outstanding, which are 10,000,000. The Company sold 15,000,000 shares of common stock, sold 15,000,000 shares of preferred stock in their Series A round, 10,000,000 shares of preferred stock in their Series B round, and have 5,000,000 warrants for common stock outstanding.
Under the guidance set forth in Rule 701(d)(3)(iii), all of these shares of outstanding stock are to be included in the sum. What can be confusing at times is the inclusion of the preferred stock. This is included because it is most often convertible into common stock. The rule states:
In calculating outstanding securities for purposes of paragraph (d)(2)(iii) of this section, treat the securities underlying all currently exercisable or convertible options, warrants, rights or other securities, other than those issued under this exemption, as outstanding.
Per the rule, the sum of these outstanding stock x .15 must be greater than or equal to the amount of options they wish to reprice, which in this example is 10,000,000 options.
So, (15,000,000 + 15,000,000 + 10,000,000 + 5,000,000) x.15 = 6,750,000.
Therefore, in this example, the Company is out of compliance with Rule 701 even though it has not issued a single new option. If you are going to reprice options, make sure to consider the Rule 701 mathematical limitations.
(On a different note, the SEC’s Advisory Committee on Small and Emerging Companies has recommended that the Rule 701 “hard cap” be eliminated. We couldn’t agree more.)