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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