Underwater Option

An underwater option is a depressing piece of paper. The company promised you the right to buy stock at $50 per share; today it trades at $25. Exercising would mean losing money immediately. Unless the stock rebounds, your equity compensation is gone.

The underwater scenario

You were granted 5,000 options at a $20 exercise price when the company was valued at $100M in a Series B. Today, five years later, the company has faltered. The stock is now worth $8 per share. Your options are underwater: you’d lose $12 per share ($20 strike − $8 current price × 5,000 = $60,000 loss) if you exercised today and sold immediately.

The options aren’t worthless—they retain time value. If the company survives and the stock rebounds to $25 by your option expiration date (another five years out), those options suddenly have intrinsic value again. But as long as the stock is below the strike, exercising is economically irrational.

Why it happens

Underwater options are commonplace in:

• Startups that misfire: Raised too much at too high a valuation, burned through cash, and the market reset.
• Public companies in downturns: Tech stocks crash; options granted at the peak are suddenly underwater.
• Acqui-hires: Company is acquired at a lower price than prior funding rounds. Employees granted stock at $30 (Series C valuation) see it acquired at $5.

In a startup context, underwater options are a recruiting disaster. Prospective hires see that existing employee options are worthless and either negotiate cash instead of equity or don’t join at all. The company has no upside story to tell.

The tax relief

If your options are underwater, you get a minor tax concession. For non-qualified options, exercising when the stock price is below the strike means you owe no ordinary income tax on the spread (because there is no positive spread). You exercise and own shares worth less than you paid, which is a capital loss later.

For ISOs, underwater options are a bigger tax trap: exercising triggers alternative minimum tax on the spread (even though the spread is negative), and you own shares worth less than you paid. Most ISO holders in this position don’t exercise.

The repricing problem

When a company’s options become underwater across the board, executives sometimes propose “repricing” or “restrike”—canceling the old underwater options and issuing new ones at the current lower price. This sounds fair (let employees start fresh), but it triggers regulatory and tax problems:

• Tax consequences: Repricing is often treated as a modification of the original grant, potentially disqualifying ISOs or triggering immediate taxation.
• Shareholder backlash: Repricing is perceived as rewarding employees for failure. Shareholders hate it.
• SEC rules: For public companies, repricing often requires shareholder approval. For private companies, it’s less regulated but still controversial.

Because of these frictions, repricing is rare. Employees are usually stuck with their underwater options and the hope (or knowledge) that the company won’t recover.

When employees walk away

If you have a post-termination exercise window and your options are deeply underwater, you’ll almost certainly not exercise. Your 90-day window expires, and the options vanish.

The opportunity cost is psychologically brutal. A colleague hired at the same time, at a different company that thrived, might have $500k in vested, valuable options. You have $0 in a dead grant. This is the dark side of equity compensation: timing and luck dominate.

Shallow vs. deep underwater

Slightly underwater options (stock at $18, strike at $20) retain real value—the stock might recover quickly, or you might hold the options in hopes of eventual recovery.

Deeply underwater options (stock at $2, strike at $20) are, practically speaking, lottery tickets. The company would need to appreciate 10x just to get back to even. Most employees abandon these.

Private company complications

For private companies, underwater options are especially tricky because there’s no public market to check the stock price. A startup that went underwater in its Series C might not be raising further rounds. The 409A valuation hasn’t been updated in years. You don’t even know if the stock is $50 or $5 per share.

When the company eventually exits (acquisition, IPO, or wind-down), you find out the real valuation. If it’s lower than your exercise price, your options are worthless. If it’s higher, you might have significant upside (though often the acquirer cancels all employee options in the deal).

Psychological weight

Employees sometimes hold onto underwater options far longer than rational actors would, because:

• Sunk cost fallacy: You’ve already waited years; why not wait until expiration?
• Hope bias: “The company will come back. It just needs one more big deal.”
• Anchoring: You remember the high valuation from funding, and you’re psychologically anchored to it.

But holding underwater options past the point of recovery is usually a mistake. Your capital (opportunity cost—time spent waiting for recovery) is tied up in a low-probability outcome.

Negotiating around underwater options

If you’re joining a company where the previous round’s options are underwater, negotiate carefully:

• Ask about the company’s path to recovery. Is it raising another round? Does it have revenue?
• Negotiate for fresh grants at the current (lower) valuation, rather than relying on old underwater options.
• Consider whether the company is actually viable or if you’re betting on a long-shot turnaround.

VCs sometimes give companies “secondary” rounds (not traditional venture rounds) specifically to issue new equity at a lower price, resetting employee options. If your company is considering a down round, it might be an opportunity to reset.