While there are many differences between large and small employers when it comes to executive compensation, one common issue confronted by employers of varying sizes is how to set the exercise price of stock options. Having a sound process for setting the price is important because flawed procedures can have far-reaching and costly tax implications for both the employer and the employee.

Why Is It Important to Set the Exercise Price Correctly?

Stock options with an exercise price no lower than the fair market value of the underlying stock on the grant date generally get favorable tax treatment in that taxation can be deferred beyond the vesting date. Non-qualified options are not taxed until exercise, and so-called “incentive” stock options are generally not taxed until the stock purchased on exercise is sold.

All of this potential tax deferral is jeopardized, however, if the exercise price of the option is lower than the fair market value of the subject stock on the grant date. Unless the ability to exercise such a “discounted” stock option is limited to certain predetermined events or specified dates, the option is taxed as soon as it vests, regardless of when it is exercised or whether it was intended to be a non-qualified or incentive stock option. The option holder is also subject to an additional income tax of 20% and interest penalties under the rules relating to deferred compensation under Section 409A of the Internal Revenue Code. Employees, members of the Board of Directors and certain consultants are covered by Section 409A. The issuer of the stock option can be penalized if it does not report the option as having violated Section 409A and withhold taxes accordingly, or if it does not account for the option as having been granted at a discount.

A recent case, Sutardja v. United States[1], demonstrates the willingness of the IRS to enforce discount option rules under Section 409A, the difficulty of trying to correct discount options retroactively and the potential costliness of getting the grant date and exercise price “wrong.” In Sutardja, the compensation committee authorized a grant of stock options to the Chief Executive Officer in December 2003 and “ratified” it in January 2004, after the stock price had increased significantly from December 2003. The company initially used the lower December 2003 stock price as the exercise price of the options, but a special committee of the Board later determined that the January 2004 ratification was in fact the correct grant date and that the higher stock price should have been used to set the exercise price. The Chief Executive Officer repaid the difference of approximately $5 million between the lower and higher exercise prices, but the IRS still asserted that the option grant was nonqualified deferred compensation subject to penalties under Section 409A because the option had originally been granted at a discount. The Chief Executive Officer disputed the IRS view, but the Court of Federal Claims agreed with the IRS. The potential taxes and penalties under Section 409A in this case were in excess of $5 million.

How Should the Exercise Price be Set so That an Option is Exempt From Section 409A?

One requirement for options to be exempt from Section 409A is that the exercise price never be less than the fair market value of the underlying stock on the date the option is granted. Therefore, there are two key questions: on what date is the option granted, and what is the fair market value of the underlying stock on that date?

When is an Option’s Grant Date?

An option is considered “granted” for purposes of Section 409A on the date on which the issuer completes the corporate action necessary to create the legally binding right constituting the option. At a minimum, this means that the maximum number of shares that can be purchased and the minimum exercise price must be fixed or determinable, and the class of stock subject to the option must be designated. Typically, the grant date will be the date the Board of Directors or Compensation Committee approves an option award, unless they designate a future grant date. Note that the grant date can occur before the individual receiving the option is notified, as long as there is not an unreasonable delay between the date of the corporate action and the date on which notice is provided.

If an issuer imposes a condition on the granting of an option, generally the grant date will not occur until the condition is fulfilled. However, if the condition is shareholder approval, under 409A the grant date will be determined as if the option was not subject to shareholder approval.

How Should the Fair Market Value on the Grant Date be Determined?

For publicly traded companies, 409A permits fair market value to be established by any reasonable method using actual sale prices. For example, all of the following are considered reasonable methods: the last sale before or the first sale after the grant, the closing price on the trading day before or the trading day of the grant, and the arithmetic mean of the high and low prices on the trading day before or the trading day of the grant. An average selling price during a specified period within 30 days before or 30 days after the grant date can also be used as the fair market value if the corporation commits “irrevocably” to grant the option with an exercise price set using the average selling price over the specified period before the beginning of the period.

For privately held companies, 409A provides less specific guidance. It requires that fair market value be established using a “reasonable application of a reasonable valuation method.” Although this may sound like a forgiving standard, its imprecision can work against the taxpayer, since it is the taxpayer who must be able to show that the procedures used to establish fair market value were reasonable. The 409A regulations include a non-exclusive list of factors that should be considered in a reasonable valuation method and state that a method is not reasonable if it does not take into consideration in applying its methodology “all available information material to the value of the corporation.”

The regulations provide a possible roadmap for setting an exercise price in the form of three “safe harbor” methods that are presumed reasonable:

  1. Independent Appraisal. An independent appraisal meeting the requirements of an ESOP valuation that is done within 12 months before the grant date.
  2. Formulaic Determination of Value. A determination of the fair market value using a formula that meets certain IRS guidelines, so long as that valuation is used consistently for purposes of all transfers of the stock to the issuer or any 10% or greater shareholder, other than an arm’s length transaction involving the sale of all or substantially all of the stock of the issuer. The IRS guidelines require generally that the price of the stock be determined using a formula, such as a formula price based on book value, a reasonable multiple of earnings or a reasonable combination of those inputs.
  3. Illiquid Start-Up Companies. A valuation method applied to stock of an illiquid start-up company that is evidenced by a written report. The method must take into account certain IRS-specified factors (such as the value of assets; the present value of anticipated future cash flows; the objective, non-discretionary market value of equity in similar entities engaged in trades or businesses substantially similar to the company; recent arm’s length transactions in the stock; control premiums; discounts for lack of liquidity; and other purposes for which the valuation method is used) and must be performed by a person the company reasonably determines is qualified to perform the valuation based on the person’s significant knowledge, experience, education, or training. This presumptive safe harbor is available for companies that (i) have no material trade or business that they or any predecessor have conducted for ten or more years, (ii) do not have any class of equity traded on an established securities market, and (iii) do not anticipate a change in control within 90 days after the grant date or an initial public offering within 180 days after the grant date.

All three of these alternatives have pros and cons, so determining which of them makes sense for any particular stock option issuer depends on the nature of the issuer’s business, the size of the issuer’s equity program and other factors. The independent appraisal provides a high level of comfort and an objective standard, but can be costly. The formulaic safe harbor may be less expensive on an ongoing basis, but it can be challenging initially to find a satisfactory formula for all purposes and that will remain accurate over time. The illiquid start-up safe harbor may also be less costly than the independent appraisal, but it is available only for a relatively narrow class of issuers.

[1] 11 Fed. Cl. No. 724T (Feb. 27, 2013).