Startup Toolbox

Jay Parkhill 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.

• stock options
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Jay Parkhill July 17th, 2008

This post may get a bit wonky.  I’ll do my best to keep it straightforward.

I have talked to a lot of people in my career who get confused by the value of shares of stock in a startup company.  A venture-oriented company has two or more different kinds of shares with different values attached.  Here’s how to keep them separate.

Pre-Money, Post-Money and Per-Share Value
When a company does a financing, it sets a value for the entire company- the “pre money” valuation before the new money comes in.  Let’s say the value is $10M.  If the company has 5M shares outstanding, this means that each share is worth $10M/5M = $2.00.  This is the price investors will pay to buy stock in the company.

If the investors are putting in $5M, they are buying $5M/$2 = 2,500,000 shares.  The company now has 7.5M shares outstanding, and the total “post-money” valuation is $15M.  We can see by the numbers that on a per-share basis (2.5M/7.5M) and a dollar-value basis ($5M/$15M) that the investors now own 1/3 of the company.

Common Stock vs. Preferred Stock Pricing
The part that gets tricky is that investors buy preferred stock, but the company also has common stock that it will issue to employees.  Preferred stock has superior rights, especially including a right to get paid first when the company is sold.  By convention and IRS rules, we are allowed to say that the preferred stock is worth more today than the common stock.  Thus, when we sell preferred stock to investors at $2.00/share, we can give options to employees to buy common stock at a much lower price- $0.30 or so.

This works well for the most part.  Investors want certain rights that employees don’t care about and pay extra for them.  Employees would rather get low-priced options than the preferred rights.  Everybody is happy.

But I Thought Each Share Was Worth $2.00?
The place people get tied up is comparing the enterprise valuation with the common/preferred stock differential. We valued the entire company at $10M, which meant that each share was worth $2.  At the same time, we say that common stock is not worth $2 and is only worth $0.30.  Which is true?  Both.  Here is how and when to use each number.

Enterprise Valuation is for the Big Picture and Financings Only
When we value the company for a financing, we put a value on the whole company as though it is about to be sold.  We take into account all of the economic preferences and assume that all stock is converted to common.  Every share is the same at that point.  In other words, if the pre-money valuation is $10M and the company has only common stock outstanding, each share is worth $2.  The valuation is really forward-looking to an eventual exit.

Common Stock Price is For Employees Today
Until that happens, though, we maintain different types of stock with different rights- common and preferred.  The preferred is sold based on the as-converted valuation, but the common has fewer rights and we can issue options at a lower price.  The company’s total valuation continues to be $10M and each share would be worth $2 on a sale of the company, but before that happens each share of common stock is actually worth $0.30.

The Simple Rule
The easiest way to think about this is that preferred stock is for investors and common stock is for employees.  Be aware that pricing is set differently for each.

• Financings , Securities , Startups , capitalization , preferred stock , stock options
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Jay Parkhill March 7th, 2008

I get this question a lot from clients. It used to be a very simple situation- companies hired employees and granted them stock options as incentive for expected work. If the employees quit, it stood to reason that they were no longer providing valuable services.

Therefore, essential stock option terms included (i) vesting of the option based on time spent as an employee, and (ii) outright cancellation of the option 90   This post is about part (ii) of that formulation.

IRS rules codify both of these rules. Incentive stock options (the tax-advantaged kind) are only available to W-2 employees and can not be exercised more than 90 days after termination. The other kind, non-statutory options, are not subject to that restriction, but many or most stock option plans say that *all* options expire 90 days after termination of service regardless.

Most companies I work with hire a core group of personnel, but outsource substantial amounts of work (and value creation) to non-employee contractors. The model above has substantial flaws in that case, because it is hard to tell when a contractor “terminates” service.

So are the stock option plan terms wrong? ISOs are locked up by IRS statute, but should NSOs be more flexible to allow termination for more than 90 days after termination?

My answer is generally no, but occasionally yes. Stock options take a lot of attention to administer. They can easily end up “leaking” equity out to people who no longer provide value to a company. For this reason, I encourage my clients to adopt a policy of expiring options after termination. The 90 day period makes it easier to manage ISOs and NSOs without excessive brainpower.

At the same time, there are occasions when a company may wish to allow contributors to exercise options after termination. A private company with a number of long-term contributors (employee or contractor) and a relatively high stock price might choose to let these people retain their options after termination as a way of saying “Thanks for your efforts. We’d prefer that you exercise and get the stock itself, but the exercise price makes that prohibitive, so we’ll let you hold the options until we have a liquidity event”. These situations are few and far between.

The remaining question is how to handle contractors who may make valuable contributions, but work irregularly for the business. An investment banker in this situation might get warrants, which are identical to stock options except that they expire at a prescribed date rather than based on service.

My advice in this situation is to keep warrants for the bankers (the finance types are happier seeing that) and use stock options for contributors to the business itself. This is where an NSO that is exercisable regardless of the holder’s term of service to the business can make sense.  Cases like this in which people provide *really* valuable services that merit long-term options are few and far between, but they do come up.

• employment , stock options
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