Adjustment in option shares: Overview, definition, and example
What is an adjustment in option shares?
An adjustment in option shares refers to a modification made to the terms of a stock option in response to certain corporate actions or events, such as stock splits, mergers, acquisitions, or dividends. These adjustments are made to ensure that the holder of the option is not unfairly impacted by changes in the number of shares or the price per share after the event. For example, if a company undergoes a stock split, the number of shares in circulation will increase, and the strike price of existing options may be adjusted accordingly to maintain the option's value and fairness for the holder.
The purpose of these adjustments is to maintain the original economic value of the options for both the holder and the issuer, ensuring that the option remains fair despite changes in the company's stock structure. The specifics of how and when adjustments are made are usually outlined in the option agreement or the company's terms of the stock option plan.
Why are adjustments in option shares important?
Adjustments in option shares are important because they ensure that the value of stock options remains consistent and fair in light of corporate changes that could otherwise distort the value or attractiveness of the options. Without these adjustments, a corporate action like a stock split or dividend issuance could unfairly penalize option holders, either by diluting their potential gains or changing the terms of their options in a way that makes them less valuable.
For companies, making the necessary adjustments helps maintain employee trust in the company’s stock-based compensation programs, avoiding potential conflicts or dissatisfaction. For investors or employees holding options, adjustments preserve the intended value of the options and prevent any dilution of their potential profit.
Understanding adjustment in option shares through an example
Imagine an employee holds an option to buy 100 shares of a company at $10 per share. The company then decides to perform a 2-for-1 stock split, which means each existing share will be divided into two, and the number of shares outstanding will double. As a result, the employee's 100 options would now be adjusted to 200 options, but the strike price would be adjusted to $5 per share (half of the original $10). This adjustment ensures that the employee’s total cost of exercising the options remains the same and reflects the changes in the company's share structure.
In another scenario, if the company declared a stock dividend, such as a 10% stock dividend, the number of options would be increased by 10%. So, if the employee originally held 100 options, they would now hold 110 options, but the strike price would be adjusted accordingly to reflect the dividend. This ensures that the option holder’s potential economic benefit is maintained despite the corporate action.
Example of adjustment in option shares clause
Here’s an example of how an adjustment in option shares clause might appear in an option agreement:
"In the event of a stock split, stock dividend, recapitalization, merger, acquisition, or other corporate actions affecting the shares, the number of shares subject to the option and the exercise price shall be adjusted by the Company to preserve the original value of the option as determined by the Board of Directors. For example, in the case of a 2-for-1 stock split, the number of shares subject to the option will be doubled, and the exercise price will be halved. Such adjustments will be made in accordance with the provisions of the option plan and any applicable laws."
Conclusion
Adjustments in option shares are crucial for maintaining the fairness and value of stock options after significant corporate events. These adjustments ensure that the option holder is not unfairly disadvantaged by changes such as stock splits, dividends, or corporate reorganizations. By defining the method of adjustment in the option agreement, both companies and option holders can be assured that the terms of their stock options will remain equitable despite any changes in the company’s share structure. Understanding how these adjustments work is essential for employees, investors, and businesses alike to ensure that stock options continue to serve their intended purpose as a form of compensation or investment.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.