409A Option Pricing Redux
January 9, 2012
Last week I had a conversation with an entrepreneur who was confused about option pricing, and no matter how many times I tried to explain it, he never seemed to get his head around it. Now, there may be a psychological explanation for his inability to understand, because he clearly wanted to hear a particular answer, and it was not what I was telling him. Nonetheless, option pricing is a topic that comes up all the time in the representation of early stage companies and, while I have written about it before, it is worth one more post.
What is 409A and why do you care?
409A is a section of the Internal Revenue Code that governs the tax treatment of certain options. 409A provides that an option either (1) be an option for common stock of the employer and have a per share exercise price on the date of the grant equal to or greater than the fair market value of a share of common or (2) if the option has an exercise price of less than the fair market value of a share of common stock the recipient and the issuing company suffer some pretty draconian tax consequences. (There are other ways to comply, but relate to less usual situations, such as options that are only exercisable on a liquidity event, and I am not going into that level of detail here and now.)
What are the draconian tax consequences?
There are three particularly nasty tax consequences: (1) The recipient of the option will have income equal to the difference between the fair market value of a share of common stock and the exercise price of the option multiplied by the number of options, at the time the option vests, even if the recipient does not exercise the option. (2) The recipient will get to pay a surtax of 20% over and above his or her normal income tax on the option related income. (3) For each year for which the option remains outstanding, the recipient will suffer the same nasty tax consequences with respect to any increase in the value of the common stock.
Why on earth would the IRS create such a rule?
Consider what could happen if the issuing company were publicly traded and was issuing options with below marked exercise prices to its execs. Need I say more? Unfortunately, 409A applies to all companies – not solely public ones.
What can I do to avoid the bad tax consequence?
Issue your options with an exercise price equal to or greater than the fair market value of the underlying shares.
How do I know what the fair market value of a share of my privately held technology start-up is?
Here are some ways to price your options:
- You can take a guess at the fair market value. If you guess wrong you are toast. And, by the way, your guess will be judged with 20/20 hindsight by the IRS. So, that does not seem like a good solution.
- If there is a recent actual arms-length transaction in which common stock was sold, then you have price. Note that I said “actual,” “recent,” and “arms-length.” The fact that your lawyer took a few shares a year ago in consideration of an old invoice won’t cut it.
- If you have a financially sophisticated person on your board (or as your CFO), and your company has been in business fewer than 10 years, 409A provides that such person can perform a valuation.
- You can pay an outside appraiser to perform a valuation. Most (all?), of my clients who have professional money invested in them end up doing this. It is a toll and it is unfortunate that you have this cost, but that is you tax dollars at work.
Like my entrepreneur friend, you can want to price options at $.03 but if you sold common stock last week in an arms-length transaction for $.30 per share, don’t do it.