When to Issue Stock Options

September 26th, 2008

Lately I have run into the same issue several times with different clients.  Small businesses looking to grow bring in non-founder staff and want to offer them an equity stake.

It used to be relatively simple and inexpensive to create an option plan for the company and issue options to the employees.  The plan document itself is pretty close to “boilerplate” and depending on how organized the client is I could usually prepare the plan, related Board and shareholder consents, California securities filing and issue option grants to the employees for somewhere between $1,000 – $2,000.

No more.  IRS Code Section 409A now gets involved and raises the cost by about 10x.  409A was enacted to put a stop to backdating and intentional option mispricing shenanigans.  It imposes severe penalties on option holders who receive stock options granted below fair market value.

This is ok for public companies that can point to a clear stock price on a daily basis.  For private companies, 409A says that stock price may be determined by a valuation done internally by someone with significant relevant experience or externally by a valuation expert.  Most startups don’t have an internal person with the required experience, so this means an external valuation and that can cost $5,000 – $10,000.

I understand that fast-growing companies like Facebook do external 409A valuations quarterly to avoid problems.  For them, it is an unfortunate expense.

What if a company raises only a tiny amount of money, or perhaps no money, and still wants to offer options?  The cost of the valuation makes this prohibitively expensive and leaves three practical alternatives:

1)  Grant the options when the company is brand new.  If we grant options at the same time the founder stock is created, we can be confident that the value is quite low.  Obviously, though, this only works in the early days of the company.

2)  Get the valuation.

3)  The third option is to grant options that aren’t exercisable at will.  If an employee gets an option that is exercisable only on a change of control event or other external trigger, then the option is not covered under 409A.

There are downsides to this approach, including the fact that if the option can only be exercised on a merger or sale of the company the option holder loses any chance at capital gains treatment of the resulting gain.  The difference in tax rates could be as bad as the 409A penalties (noting that California now tacks on its own 20% penalty to 409A violations, which would make the effect of violation much worse than mere ordinary-income treatment).  Not an appealing option.

All of this makes me say that 409A needs a blanket exemption for non-public companies.  409A only went into effect this year.  Let’s hope the IRS sees the light soon and fixes this problem so that companies can offer equity incentives to employees without breaking the bank.

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  • mdco

    The problem with granting options that are not exerciseable at will (your 3rd option) is not just a capital gains issue. If they can only be exercised at a change of control or other external trigger, the employee needs to be with the company at the time of exercise (or within usual 90 day window after the employee leaves). If the employee is in early enough, this could be years away. As people have a tendancy to move on often times before the liquidity event, the end result is that these will do little incent employees, except those that just don't understand. The problem of course is that everyone will understand eventually (as coworkers leave and people complain that they have worked for 2 years and can't exercise options), and people will just attribute little value to the options until that external event is near. In short, if you are not going to value the options, don't bother granting them, or at the least expect to pay market or above on the salary side of things.

    409A does NOT prohibit the discounting of the strike price for common shares, it merely makes the company (and the employee eventually) establish the value based on the facts of the situation (stage, whether there is preferred, and how much, liquidation preferences, debt, etc.). In the good old days, you would just say common was 10% of the value of preferred…no more unfortuately.

    So doesn't it make sense to make the investment to get the valuation done. If you have 20 employees, and can legitimately discount the value of common and thus the strike price of options, they are much more valuable to the employee and put the company in a position to preserve cash by retaining leverage in salary negotiations. At $5K per quarter, and with 20 employees, that's $250 per head. If you've got 40 employees – $125 a head per quarter. You get the picture…you give significantly more value to your employees at a nominal fee, and gives you much more leverage in salary negotiations that should drive the effective cost per head much lower.

    I agree completely that 409A is a nightmare with unintended consequences, and that is should not apply to private companies. But it's here for now, and complanies need to figure out how to work within the paramaters to preserve the value of stock options to employees.