We’ve covered the bare basics of stock options on this blog before. Here we will look into something that is all important when issuing stock options – that is the option’s exercise price. The exercise price is the amount an option holder needs to pay in order to exercise the option to receive the share of underlying stock. Most option holders will not exercise their options until the price of the underlying stock has risen higher than the exercise price, so that they can receive the shares and then sell on the open market for a profit. The IRS got keen on the fact that a company could issue stock options with an artificially low exercise price, which would allow the option holder to immediately exercise the option to receive the shares with the greater value and sell those shares, which is in effect as if the company paid cash to the option recipient. Hence Section 409A voted into effect in the American Jobs Creation Act of 2004. The reason stock options can receive beneficial tax treatment is because they are treated as deferred compensation. To get that treatment, stock options should only be granted with exercise prices at or above the fair market value (“FMV”) of the underlying shares of stock on the date of the option grant.
To ensure that the stock options you grant retain their beneficial tax treatment the exercise (also called “strike”) price, must be set at a FMV at the time of the grant, using a reasonable valuation method. Granted, performing a valuation of a startup company, especially a pre-revenue startup company, is difficult to say the least. The burden falls on the company to defend its valuation if the IRS should look into it. To ensure that the FMV is obtained, various valuation methods can be used. There are however, a number of IRS approved valuation methods which most companies should utilize. There are three methods approved by the IRS and called the Presumptive Valuation Methods, they are:
- Independent Appraisal – this method is for more established companies with historical operations and revenues. A third-party professional appraiser need to be commissioned to perform an analysis and prepare a report. There are certain methods the appraisers can follow which are in the Internal Revenue Code. One of these appraisals will presumptively lead to the FMV of the company. These appraisals are in high demand at the moment and can be costly.
- Illiquid Startup Appraisal – this method is for only relatively new companies, which have been in existence for less than 10 years, which do not expect an IPO in the next 180 days or an acquisition in the next 90 days. This type of appraisal can be performed by a person with adequate knowledge, experience (5 years) and/or training in performing such valuations. The person can be also be an in-house company employee/officer.
- Binding Formula Method – this method allows a valuation to be set using a formula used in the company’s shareholder buy-sell agreement, or other similar binding agreement. The formula must be used for all noncompensatory purposes requiring valuation of the company’s stock.
A startup company should be wary of issuing any stock options without a proper appraisal. Further, whenever a company needs to reprice stock options, it also should have a proper appraisal. A repricing is considered a termination of the underwater option and the grant of a new option with the updated strike price. As long as the repriced option’s strike price is set at or above the FMV of the underlying shares of stock, it will comply with section 409A. A appraisal can be relied upon for up to twelve months, provided no significant corporate activities occur which would change a premise relied upon in the appraisal.