Underwater option meaning

The aim of this note is to set out the principal areas in which parallel options are commonly useful, how they interact with other share incentive arrangements, HMRC’s acceptance of such plans and the practical considerations around implementation. The main application of parallel options is either to add tax efficiency to an unapproved share incentive arrangement or to address issues within existing arrangements such as underwater options. Practitioners should exercise particular care when putting in place parallel options that involve a tax-advantaged scheme such as an enterprise management incentives (EMI) scheme or a company share option plan (CSOP). The key points are highlighted below (together with HMRC’s published views). What are parallel options? Parallel options are employee share option arrangements that are linked to another employee share incentive scheme. They will typically be introduced either to enhance another share plan, eg deliver tax efficiency, or to help ‘fix’ problems with the main incentive scheme, eg where options are underwater. They can relate to either phantom options or options...

What is share dilution? Share dilution arises when a company issues more of its own shares. As a result, the proportion owned by existing shareholders falls when the new shares are created. Example of share dilution A small business has 100 shares in issue. Ten shareholders each hold ten shares, so each owns 10% of the company. The following year, the company issues another ten shares to a different party (for example, directly to a single investor or to satisfy an option that a share plan participant has exercised over ten shares). There are now 110 shares in issue, and there are 11 shareholders each holding ten shares. Those ten shares now account for 9% of the company. In this way, by issuing an extra ten shares, the original shareholders are each diluted from 10% to 9%. How do shares cause dilution? Dilution of existing shareholders can occur in various situations. A typical cause linked to employees’ share schemes includes: options being...

What is an underwater share option? An ‘underwater option’ refers to a share option (issued under any share option scheme) where the exercise price per share exceeds the prevailing actual market value of the share. Consequently, if such an underwater option were exercised and the shares sold at once, the option holder would incur a loss. Unsurprisingly, holders are disinclined to exercise underwater options, so in many situations alternative approaches to reward and incentivise those holders must be considered. Note that underwater options outside exit or leaver circumstances (ie where they do not lapse on an imminent exit or the imminent cessation of the option holder’s employment) may still carry a degree of ‘hope value’, reflecting the prospect of an improvement in the company’s position and a rise in the share price, which could lift the market value of a share above the option’s exercise price. Underwater options are most prevalent in economic downturns and, as a result, they tend to be a cyclical issue for companies. A share...