Option Exchange Programs Reduce Overhang and Dilution--Not So Fast!
I
often hear reducing overhang and stock plan dilution cited as a reason
for option exchange programs; I've even seen companies state this in
their Schedule TO filing. But, in my opinion, this isn't the case;
exchange programs don't reduce overhang or dilution.

Overhang Remains the Same

While there's no legally defined formula for computing overhang, the typical computation is:

( options/awards outstanding + shares available for grant ) / common stock outstanding = overhang

This is essentially the computation we used in the 2007 Domestic Stock Plan Design and Administration Survey and it's the computation I see most often in other industry surveys and resources.

In a one-for-one exchange program (e.g., Google),
the transaction has no impact whatsoever on overhang. All of the
cancelled options are immediately regranted, so that the total options
outstanding and the total shares available for grant remain the same.
And the transaction clearly has no impact on the denominator, so stock
plan overhang doesn't change.

Even in the more typical less than one-for-one exchange, there often
is no impact on overhang. With a few rare exceptions (e.g., Intel and eBay),
in most of the option exchange programs I see, the shares underlying
the cancelled options return to the plan and are again available for
grant. Even though the company has reduced its options outstanding, the
shares available for grant have increased by the same amount, keeping
the numerator the same. So once again, stock plan overhang remains
unchanged.

Only when the cancelled shares are not added back to the plan (which
we recommend) does the option exchange program truly reduce overhang.

Dilution Increased, Not Decreased

In the case of dilution, not only is it not reduced, it could
actually increase as a result of the option exchange. Dilution is the
impact a company's stock plans have on earnings-per-share. This is
computed using the Treasury Stock Method, which is a little more
complicated than we have time to discuss today (see Chapter 10 of "Accounting for Equity Compensation Under FAS 123(R)" in the NASPP's Stock Plan Expensing Portal for an explanation of the Treasury Stock Method).

Under the Treasury Stock Method, options that are underwater are
excluded from the calculation altogether. But, once the options are
regranted with a lower price, they are likely to be in-the-money quite
a bit sooner and once again diluting EPS. If the options are replaced
with full value awards, they are likely to be immediately dilutive to
EPS. And, in both cases, there will be fewer exercise proceeds
available to repurchase shares to offset that dilutive impact. Thus,
even in an exchange at a less than one-for-one ratio, the
options/awards are likely to be more dilutive afterwards than they were
before the exchange

http://www.naspp.com/blog/2009/06/dilution-overhang-and-repricings.html