Valuing incentive stock options

Any significant developments affecting this resource will be described below. What's on Practical Law? Show less Show more. Ask a question. Related Content. A Checklist outlining the requirements that must be satisfied for a stock option to qualify as an incentive stock option ISO under Section of the Internal Revenue Code and receive more favorable employee tax treatment than non-qualified stock options. An individual who exercises a non-qualified stock option must pay ordinary income taxes on the excess of the fair market value of the underlying shares on exercise over the exercise price the "spread".

However, ISOs are not subject to ordinary income taxes if the shares are held for both:. An employee incurs no income tax at grant or on the exercise of an ISO although the spread is a tax adjustment item for purposes of calculating alternative minimum tax and the profit if any made on the sale of the shares is taxed as long-term capital gain. From the employer's perspective, ISOs are less attractive than non-qualified stock options, because the employer is not entitled to a tax deduction on an employee's exercise of an ISO, if the employee meets the above holding requirements.

The terms of the option must not provide that the option will not be treated as an ISO. The option must be granted to an individual in connection with that person's employment by the corporation granting the option or by a related corporation as defined in Treasury Regulation Section 1.

The option must be for the purchase of stock of the employer or a related corporation. The option must be granted under a formal plan which may be in written or electronic form that is approved by shareholders of the granting corporation within 12 months before or after the date the plan is adopted by the corporation. In this article, we address, as we did previously, the application of Section A to the valuation of the common stock of privately held companies for purposes of setting the exercise prices for compensatory grants of ISOs and NQOs to employees 3 and we update the best practices we have observed, now over the last decade, in stock valuation and option pricing.

To appreciate the significance of Section A, it is important to understand the tax treatment of nonqualified stock options both before and after the adoption of Section A. Prior to the enactment of Section A, an optionee who was granted a NQO for services was not taxable at the time of grant. Section A changed the income tax treatment of nonqualified stock options.

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A company that grants a NQO may also have adverse tax consequences if it fails to properly withhold income taxes and pay its share of employment taxes. Fortunately, a NQO granted with an exercise price which is not less than fair market value of the underlying stock on the date of grant is exempt from Section A and its potentially adverse tax consequences. While ISOs are not subject to Section A, if an option that was intended to be an ISO is later determined to not qualify as an ISO for any of a number of reasons which are beyond the scope of this article, but importantly including being granted with an exercise price that is less than fair market value of the underlying common stock , it will be treated as a NQO from the date of grant.

Under the rules applicable to ISOs, if an option would fail to be an ISO solely because the exercise price was less than the fair market value of the underlying stock as of the date of grant, generally the option is treated as an ISO if the company attempted in good faith to set the exercise price at fair market value. Thus, setting ISO exercise prices at fair market value using Section A valuation principles has also become good practice.

Until the issuance of IRS guidance with respect to Section A, the time-honored practice of privately held companies in setting the exercise price of incentive stock options "ISOs" for their common stock 7 was simple, easy and substantially free of worries that the IRS would have much to say about it. After subsequent investments, the exercise price was pegged at the price of any common stock that was sold to investors or at a discount from the price of the latest round of preferred stock sold to investors.

For the sake of illustration, a company with a capable and complete management team, released products, revenue, and a closed C Round might have used a discount of 50 percent. It was all very unscientific.

Rarely did a company buy an independent valuation for option pricing purposes, and, while the company's auditors were consulted — and their opinions carried weight, although not necessarily without some armwrestling — the conversation among them, management and the board was typically quite brief. The IRS guidance pertaining to Section A established a dramatically different environment in which private companies and their boards must operate in determining the valuation of their common stock and setting the exercise price of their options.

The General Rule.

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Section A guidance sets forth the rule which we will call the "General Rule" that the fair market value of stock as of a valuation date is the "value determined by the reasonable application of a reasonable valuation method" based on all the facts and circumstances. A valuation method is "reasonably applied" if it takes into account all available information material to the value of the corporation and is applied consistently. A valuation method is a "reasonable valuation method" if it considers factors including, as applicable:. The General Rule provides that use of a valuation is not reasonable if i it fails to reflect information available after the date of calculation that may materially affect value for example, completing a financing at a higher valuation, accomplishment of a significant milestone such as completion of development of a key product or issuance of a key patent, or closing a significant contract or ii the value was calculated with respect to a date more than 12 months earlier than the date on which it is being used.

If a company uses the General Rule to value its stock, the IRS may successfully challenge the fair market value by simply showing that the valuation method or its application was unreasonable. The burden of proving that the method was reasonable and reasonably applied lies with the company.

The Safe Harbor Valuation Methods. A valuation method will be considered presumptively reasonable if it comes within one of the three Safe Harbor valuation methods specifically described in Section A guidance. In contrast to a value established under the General Rule, the IRS may only successfully challenge the fair market value established by use of a Safe Harbor by proving that the valuation method or its application was grossly unreasonable.

In the Section A valuation environment, companies may decide to take one of three courses of action:. When we wrote the first draft of this article in , we suggested that the valuation patterns among private companies were falling along a continuum without sharp demarcations from start-up stage, to post-start-up to pre-expectation of liquidity event, to post-expectation of liquidity event. Since then it has become clear in our practice that the demarcation is between those who have enough capital to obtain an Independent Appraisal and those that do not. Start-Up Stage Companies.

At the earliest stage from a company's founding to the time when it begins to have significant assets and operations, many of the well-known valuation factors set forth in the IRS guidance may be difficult or impossible to apply. A company typically issues stock to founding shareholders, not options.

Until a company begins to grant options to multiple employees, Section A will be of less concern. Some valuation firms even offer a 'package deal' where subsequent quarterly valuations are priced at a discount when done as an update to an annual valuation. Even though the cost of the Independent Appraisal Method is now very low, many start-up stage companies are reluctant to undertake the Independent Appraisal Method due to the need to preserve capital for operations.

Use of the Formula Method is also unattractive because of the restrictive conditions on its use and, for early stage start-ups, the Formula Method may be unavailable because they have neither book value nor earnings. Intermediate-Stage Private Companies. Once a company is beyond the start-up stage but does not yet reasonably anticipate a liquidity event, its board of directors will have to apply its judgment in consultation with the company's legal counsel and accountants to determine whether it should obtain an independent appraisal.

#3 The Best Time To Exercise ISOs

There is no bright line test for when a company should do so, but in many cases the company will have reached this stage when it takes its first significant investment from outside investors. An 'angel' round could be significant enough to trigger this concern. Boards that gain truly independent outside directors as a result of the investment transaction will be more likely to conclude that an independent appraisal is advisable.