There are a number of significant issues relating to the effect of Section A on option terms and on nonqualified deferred compensation more generally that are beyond the scope of this article. This is an update of an article we wrote in , a year after the final Section A regulations were issued by the IRS.
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. 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.
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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.
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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.
For the Last Time: Stock Options Are an Expense
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. 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:.
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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.
Fallacy 1: Stock Options Do Not Represent a Real Cost
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.
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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. 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.
That means that a portion or all of your unvested options will vest once an acquisition is completed.
Acceleration is typically a right held for executives that have such clause in their compensation plan, but it can also be applied to others in the organization if the acquisition agreement indicates so. All information provided herein is for informational purposes only and should not be relied upon to make an investment decision and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision.
Readers are recommended to consult with a financial adviser, attorney, accountant, and any other professional that can help you understand and assess the risks associated with any investment opportunity. Private investments are highly illiquid and are not suitable for all investors. Your email address will not be published. Save my name, email, and website in this browser for the next time I comment. EquityBee helps employees get the money they need to exercise their stock options by connecting them to investors who want to invest in their companies. Entering into this agreement with an investor will allow him or her a percentage claim to a liquidation event, with no guarantee of such an event, and is subject to the terms of your company options agreement.
But what happens to your shares and options when that happens? Stock vs. Vested Options That Have Not Been Exercised In most cases, employees will preserve the value of their options when their company gets acquired. Unvested Options This one is a little trickier.
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