When Your Stock Options are Underwater

What to Do When Your Startup Stock Options Are Underwater

Understanding Underwater Stock Options

When you join a startup, equity compensation often forms a significant part of your total compensation package. This typically comes in the form of stock options—the right to purchase company shares at a predetermined price (the “strike price” or “exercise price”) after a vesting period.

Stock options are considered “underwater” when the current fair market value (FMV) of the company’s shares falls below your strike price. In simple terms: if you were to exercise your options today, you’d be paying more for the shares than they’re actually worth on the market.

Example:

• Your stock options have a strike price of $10 per share
• The company’s current FMV is $6 per share
• Your options are underwater by $4 per share

How to Determine if Your Options Are Underwater

Identifying underwater options requires two key pieces of information:

1. Your Strike Price: This is documented in your option grant agreement, which you should have received when you joined the company.
2. Current Fair Market Value (FMV): This can be more challenging to determine for private companies. Sources include:
   • Recent 409A valuations (companies typically perform these annually)
   • Recent funding rounds
   • Secondary market transactions
   • Information provided during company-wide financial updates

For publicly traded companies, determining FMV is straightforward—it’s the current market price of the shares.

Why Options Go Underwater

Several factors can cause stock options to become underwater:

• Market Downturns: Overall economic conditions affecting company valuations
• Industry-Specific Challenges: Regulatory changes, new competition, or technological shifts
• Company Performance Issues: Missed targets, failed product launches, or leadership problems
• Down Rounds: New funding at a lower valuation than previous rounds
• Overvaluation in Previous Rounds: If your strike price was set during a period of inflated valuations

Strategic Considerations When Holding Underwater Options

1. Evaluate the Company’s Trajectory

Before making any decisions, assess:

• Business Fundamentals: Is the company’s core business model sound?
• Leadership Quality: Do you have confidence in the executive team?
• Growth Path: Is there a clear, viable path to increased valuation?
• Funding Status: Does the company have sufficient runway, or is it at risk of running out of cash?
• Market Conditions: Are the company’s struggles unique or part of a broader market correction?

2. Consider Your Vesting Schedule

• Early in Vesting: If you’re early in your vesting schedule, you have more time for a potential recovery
• Near Completion: If you’re close to being fully vested, the “golden handcuffs” effect is weaker
• Cliff Period: If you haven’t reached your cliff (typically one year), leaving means forfeiting all options

3. Assess the Gap Size

• Slightly Underwater: Options just marginally underwater might recover more easily
• Significantly Underwater: Large gaps may require dramatic company performance improvements or restructuring to recover

4. Calculate the Opportunity Cost

• Alternative Compensation: Could you earn significantly more cash compensation elsewhere?
• Other Equity Opportunities: Are there companies offering equity with better growth potential?
• Career Development: Are you gaining valuable skills and experience that justify staying despite underwater options?

Possible Courses of Action

1. Stay the Course

When to consider this approach:

• You believe strongly in the company’s long-term vision
• Recent setbacks appear temporary rather than structural
• You value other aspects of the job (culture, work, learning opportunities)
• You’re relatively early in your vesting schedule

Potential benefits:

• Avoiding the “buying high, selling low” mistake
• Maintaining stability in your career
• Potential for significant upside if the company rebounds

2. Request Option Repricing or Additional Grants

Companies facing widespread underwater options may consider:

• Repricing: Adjusting the strike price of existing options to reflect current FMV
• Option Exchange Programs: Trading underwater options for fewer options at a lower strike price
• Supplemental Grants: Issuing additional options at the new, lower FMV

How to approach this conversation:

• Research whether other employees face similar situations
• Frame the discussion around retention and motivation
• Understand that repricing has tax and accounting implications for the company
• Time your request with annual compensation reviews when possible

3. Negotiate Compensation Adjustments

If repricing isn’t feasible, consider:

• Salary Increases: To offset the lost expected value from options
• Performance Bonuses: Tied to company or individual milestones
• Restricted Stock Units (RSUs): These have value regardless of price fluctuations
• Additional Options: New grants at the current lower FMV

4. Plan Your Exit

If the outlook appears bleak, it may be time to look elsewhere:

Considerations before leaving:

• Exercise Analysis: Determine if any vested options are worth exercising despite being underwater (rare, but possible for tax planning)
• Notice Period: Plan your departure to maximize any upcoming vesting milestones
• Employment Agreement Review: Check for any contractual obligations or restrictions

During your job search:

• Be prepared to explain your equity situation to potential employers
• Research equity structures at prospective companies to avoid similar pitfalls
• Consider negotiating for more cash compensation if you’re skeptical about equity

Legal and Financial Considerations

Exercise Windows

Most startups have a limited post-employment exercise window (often 90 days). If you leave:

• Underwater options rarely make sense to exercise
• However, review your specific grant terms, as some companies offer extended exercise windows

Tax Implications

• NSOs (Non-qualified Stock Options): Little tax consequence for underwater options
• ISOs (Incentive Stock Options): May have Alternative Minimum Tax (AMT) considerations even with underwater options
• Tax Loss Harvesting: In rare cases where you’ve previously exercised options that are now worth less

Always consult a tax professional about your specific situation

Documentation Review

Before making any decisions, carefully review:

• Your original option grant agreement
• The company’s equity incentive plan
• Any communications about valuations or repricing programs

Making Your Decision: A Framework

1. Gather Information:
   • Current company valuation and trends
   • Vesting schedule and exercise terms
   • Market compensation for your role
   • Company’s financial health and prospects
2. Calculate Scenarios:
   • Best case: Company rebounds significantly
   • Expected case: Moderate improvement or stability
   • Worst case: Further devaluation
3. Assess Personal Factors:
   • Financial needs and risk tolerance
   • Career development goals
   • Job satisfaction beyond compensation
   • Alternative opportunities
4. Create an Action Timeline:
   • Set checkpoints for reassessment
   • Identify triggers that would prompt action
   • Plan conversations with management

Red Flags vs. Temporary Setbacks

Concerning Signs:

• Multiple down rounds
• Executive departures
• Significant layoffs without strategic explanation
• Lack of transparency about company finances
• Repeated missed targets
• Dwindling market share

Potential Recovery Indicators:

• Clear communication about challenges and solutions
• New strategic direction with measurable milestones
• Cost-cutting that preserves core capabilities
• New leadership with relevant turnaround experience
• Interest from new investors despite challenges

Final Thoughts

Underwater options represent a challenging situation, but not necessarily a hopeless one. The tech landscape is filled with companies that experienced significant valuation dips before achieving tremendous success.

The right decision varies based on your unique circumstances, risk tolerance, and career goals. By systematically evaluating your options (both literally and figuratively), you can make a choice that aligns with your long-term professional and financial objectives.

Remember that equity is just one component of compensation and career satisfaction. Consider the total picture—including work environment, growth opportunities, and alignment with your values—when deciding whether to stay or seek new opportunities.