Comments on: When to Issue Stock Options http://blog.jparkhill.com/2008/09/26/when-to-issue-stock-options/ Business and Legal Notes, mostly Wed, 31 Mar 2010 15:12:39 -0700 http://wordpress.org/?v=2.9.2 hourly 1 By: mdco http://blog.jparkhill.com/2008/09/26/when-to-issue-stock-options/comment-page-1/#comment-5548 mdco Mon, 10 Nov 2008 00:56:45 +0000 http://blog.jparkhill.com/?p=287#comment-5548 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.<br><br>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. <br><br>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.<br><br>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. 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.

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