Leapfrog's Option Exchange Makes Sense

| About: LeapFrog Enterprises (LF)
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Leapfrog (NYSE:LF) has filed for an Employee Option Exchange.

From the SEC Filing:
On March 26, 2008, our Board of Directors approved a voluntary one-time only stock option exchange program, subject to stockholder approval. The opportunity to participate in the stock option exchange program will be offered to domestic and certain foreign employees, including our executive officers, and directors holding eligible options granted under either our 2002 Equity Incentive Plan or 2002 Non-Employee Director Stock Award Plan or under two special inducement grants awarded to our Chief Executive Officer upon his joining us. The new options granted in exchange for surrendered options will have an exercise price per share equal to the higher of (a) $7.50 or (b) $0.25 above the closing price of our Class A common stock as reported on the NYSE for the business day prior to the date the new options are granted (the “Exchange Price”). Under the program, outstanding stock options with an exercise price greater than the Exchange Price will be eligible to participate.

While I am normally against this stuff, at least LeapFrog has the courtesy to let shareholders approve it. Again from the Proxy,
This proposal must receive a “For” vote from the holders of a majority of votes cast either in person or by proxy on the proposal, provided that the total vote cast on the proposal represents over 50% of the votes of holders entitled to vote at the annual meeting. If you “Abstain” from voting, it will have the same effect as an “Against” vote. Broker non-votes will have no effect.

That is a good bar because essentially a no-vote is a "no vote".

Here is the reasoning:
Many of our employees now hold stock options with exercise prices significantly higher than the current market price of our Class A common stock. For example, on March 14, 2008, the closing price of our Class A common stock on the NYSE was $6.53 per share and the weighted average exercise price of outstanding options held by Eligible Participants was $12.74.

Consequently, as of March 14, 2008, approximately 7.1 million shares of outstanding stock options held by Eligible Participants were “underwater,” meaning that the exercise price of the outstanding stock option was less than the market price for our stock. Although we continue to believe that stock options are an important component of our employees’ total compensation, many of our employees view their existing options as having little or no value due to the difference between the exercise prices and the current market price of our common stock. As a result, for many employees, these options are ineffective at providing the incentives and retention value that our board believes are necessary to motivate our management and our employees to complete and deliver the important strategic and operational initiatives that we began implementing in late 2006 to increase long-term stockholder value.

In addition to providing key incentives to our employees, the Option Exchange Program is also designed to benefit our stockholders by reducing the potential dilution from stock option exercises in the future and by providing us better retention tools for our key contributors due to the extended vesting terms for certain of the New Options. We estimate a reduction in our overhang of outstanding stock options of approximately 2.8 million shares, assuming full participation in the Option Exchange Program, market price of $7.00 per share, an exercise price of the New Options of $7.50 per share and exchange ratios that result in the fair value of the New Options being equal to the fair value of the Eligible Options surrendered based on valuation assumptions made as of the close of the Option Exchange Program.

The actual reduction in our overhang that could result from the Option Exchange Program could vary significantly and is dependent upon a number of factors, including the actual level of participation in the Option Exchange Program.

In this case, unlike Circuit City (NYSE:CC) the change does make sense. When Katz announced the restructuring plan, it was clear sales and profits would suffer in the short term. That would then, assuming the turnaround went as planned, be followed by appreciation to higher levels. The turnaround, based on all evidence I have seen it on track to date.

All this being said, since the "plan" seems to be working, shareholders have the ultimate say and potential dilution from new hires is diminished, I do not have a problem with the way LeapFrog has structured the exchange.

Disclosure: Long LF.