By: Sean Valle
Option grants can be a powerful way to incentivize and reward your business’s key employees, contractors, and consultants. In a previous blog post, we discussed why you might issue stock options. Once you’ve decided to issue stock options, there are a few critical details to determine. Here, we discuss the exercise price for an option grant.
An option grant enables a team member to purchase company stock at a future time for a predetermined exercise price per share (sometimes referred to as the “strike price”). Generally, the exercise price is set as low as possible when the options are granted. That way, assuming your company’s value increases over time, when an optionee exercises their options and purchases shares for the low, preset price, they’ll enjoy the upside they helped create.
As a default rule under IRS regulations, the exercise price of an option grant must be equal to at least the fair market value (“FMV”) of the underlying shares as of the option grant date. Your company must therefore determine the FMV of its shares to assign an option exercise price. It is difficult for private companies (and especially difficult for early stage startups) to determine the FMV of their stock because there is no traded stock value from an open market to rely on. Because of this, the company’s Board of Directors must decide which value to use for the strike price.
In order to determine FMV, Section 409A of the Internal Revenue Code requires a company’s Board to utilize a “reasonable application of a reasonable valuation method.” According to the IRS, a valuation method is a “reasonable valuation method” if it considers factors including, as applicable:
- The value of tangible and intangible assets.
- The present value of anticipated future cash-flows.
- The market value of equity in similar companies.
- Recent arm’s-length transactions.
- Control premiums or discounts for lack of marketability.
- Whether the valuation method is used for other purposes.
- Other financial and non-financial items.
The Board’s determination of a company’s valuation is considered presumptively reasonable if it meets at least one of the Safe Harbor criteria below:
- A qualified independent appraiser performs the valuation.
- For startup companies, someone other than an independent appraiser who has the requisite knowledge and experience performs the valuation, and the valuation satisfies other criteria under Section 409A.
- A formula is used to determine the valuation, as prescribed under Internal Revenue Code Section 83.
A Safe Harbor valuation can apply for up to 12 months unless intervening events have a material impact on the company’s FMV. Intervening events include general economic factors like changes in interest rates, inflation or deflation, general economic outlook, as well as company-specific changes, such as a merger/acquisition, new material customer, new capital raise, or other significant company events that materially affect its value.
The company must carefully consider the valuation to avoid adverse tax consequences for both employers and employees. If the company fails to comply with exercise price requirements, the employee must recognize ordinary income for the FMV that is in excess of the strike price. Further, any appreciation in the fair market value of the option in subsequent years will be recognized with accruing penalty and interest from the date of vesting. Although these negative tax consequences apply to the recipient (employees), employers may still be responsible for failing to withhold and pay tax due on the income. Additionally, the company may face potential state taxes, liability exposure for Board members, negative impact on employee morale and potential employee turnover, and decreased marketability of a business to investors and/or acquirers.
For early-stage companies, the Board is generally responsible for determining a reasonable valuation and associated exercise price for option grants. Early-stage companies usually have minimal economic value and very little information to use as a basis for a valuation by an independent appraiser. Additionally, third-party valuations generally cost between $1,000-5,000 dollars, money that new companies often prefer to allocate to more pressing needs. As such, for early option grants, a company’s Board is often tasked with reviewing, discussing, and assessing the IRS reasonable valuation factors outlined above. However, there is always a risk that an IRS audit deems a Board’s determination of an option exercise price to be unreasonable. The IRS might conclude that the Board did not appropriately document in writing adequate consideration of the relevant valuation factors or that the Board members did not possess significant knowledge and experience or training in performing such valuations.
Due to this risk, as startups grow, the determination of FMV is best made by an independent business valuation expert. Any company that has completed a preferred stock financing with a venture capital firm typically will get a 409A valuation report from an independent appraisal firm soon after closing. The management, Board, and investors of many companies think of an independent valuation as insurance against the risks of inappropriate option grant exercise prices, since such independent valuations are presumed to be reasonable by the IRS.
If you are affiliated with a growing startup granting options to its employees, contractors, and consultants, consider whether it is reasonable and affordable to engage a third-party appraiser to help determine your company’s FMV and the appropriate exercise price for your option grants.
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