By James Lawrence, partner at Hewitsons LLP

James is head of the corporate finance team in Cambridge and specialises in the design and implementation of employee share schemes

Successive governments have, over the last 20 years, encouraged businesses of all sizes to offer their employees to have a stake in their success. The concept of granting options is now widely accepted with the prospect of a future reward helping to ensure that staff or key employees have a clear motivation to remain with and grow the business.

In any economic downturn, the impact on the financial performance and prospects of the business can significantly reduce its value and the value of the share options held by employees.

Where the depressed value is such that the options are ‘underwater’, namely where exercise price for the share option is less than the value of the share itself, or where the options are subject to performance conditions which are now hopelessly optimistic, the perceived benefit of the options at best heavily diluted.

Many companies should then consider modifying the share options to reflect the new circumstances to restore the perceived value.

For some companies, the effect on their valuation may be temporary. For others, the effect will be more permanent, whether by reason of a higher level of debt on its balance sheet or as a consequence of structural changes in their business sector which will need a new strategic approach.

In the latter case, re-energising employees to fully engage in the new strategy could be particularly important.

Where share options do not have any tax-advantaged status, then a re-pricing of existing options, coupled perhaps with new options with performance conditions, is fairly straightforward to achieve.

For option schemes which do carry tax advantages, notably Enterprise Management Incentives (EMI), re-pricing existing options to reflect the reduced valuation of the company will result in the loss of the tax advantages. Accordingly, it will usually be achieved by the surrender of the existing options and the re-grant of new options at a lower exercise price.

For EMI options, this will generally be permitted, provided that the employee does not hold unexercised EMI options over shares with an unrestricted market value (when granted) of more than £250,000 and has not been granted EMI options over shares with a value of £250,000 in the previous three years (the 3 year rule). It is not often that this is the case.

If an employee holds options over shares with an unrestricted value of £249,999, then it is possible to surrender all of those options and re-grant new options up to that £250,000 limit. This does not offend the three-year rule.

This can be particularly beneficial for a key manager who has been granted EMI options up to £249,999 and additionally holds non-EMI qualifying options. Where the value of the shares has diminished since the date the EMI options were granted, it should be possible to convert the non-qualifying options into EMI options.

The tax advantages would be significant: Under current rules (and let’s keep our fingers crossed) any gain on EMI options would be taxed at 10%, whereas non-qualifying options are subject to income tax and NICs with a potential overall tax rate of close on 53%.

A surrender and re-grant of options would also be appropriate where a company with venture capital or other external investors is raising new equity at a reduced valuation to the previous funding round. Re-granting by reference to that reduced valuation would maintain the positive impact for employees.

Where re-granting tax-advantaged options is not feasible, then another possibility to consider is the issue of shares to key employees at a time when the market value of those shares will hopefully be at its lowest.

Whilst in the current climate many employees are content to be in work, it would be complacent to assume that something more attractive will not present itself, and leaving re-pricing to a later date when valuations are then on the rise would miss the window of opportunity.