While companies consider ever more creative equity compensation structures to attract and retain talent, it is critical that they not lose sight of the fundamentals. And one of the most fundamental of fundamentals is that a stock option must (except in rare circumstances) be granted with an exercise price per share that is no less than the fair market value (FMV) of the underlying stock on the date of grant.
The results are costly—primarily to the option holder—if this cardinal rule is, intentionally or inadvertently, broken. Under Section 409A of the US tax code, a so-called discounted option (i.e., an option with an exercise price that is less than the FMV of the underlying stock on the date of grant) is taxed to the option holder at the time the option vests (prior to exercise!) and is subject to a 20% tax on the income recognized at that time (i.e., the difference between the FMV of the stock at vesting and the exercise price), in addition to all applicable regular federal and state taxes. (Note that some states, most notably California, impose their own additional penalty tax as well.) Any appreciation in the value of the stock after the vesting of the option is taxed annually at regular federal and state rates, plus the additional federal (and state) Section 409A tax and special Section 409A interest charges, until the option is either exercised or expires. Not insulated from the adverse consequences, companies have enhanced withholding and reporting obligations associated with discounted options.
Determining the FMV of the underlying stock, then, is critical to avoiding a very unhappy workforce. While Section 409A only requires a company to determine FMV by the “reasonable application of a reasonable valuation method,” relying on this rule leaves the company with the burden of having to prove that the valuation was, in fact, reasonable. And this may be difficult after the fact, particularly when those questioning it have the benefit of 20-20 hindsight. Happily, where a company relies on an independent third-party valuation in determining FMV (i.e., a Section 409A valuation), the valuation is presumed to be reasonable if (1) the valuation considers all the quantitative and qualitative factors bearing on the value of the stock and (2) it is no more than 12 months old and no material events have occurred between the “as of” date of the valuation and the date of the option grant that would make reliance on the valuation unreasonable.
While engaging an independent appraiser to do a valuation involves up-front costs and time, the benefits of doing so—avoiding legal costs to fix discounted options, eliminating a source of friction in financings and exit events, ensuring that the company isn’t inadvertently failing to comply with required tax reporting and withholding obligations, maintaining a motivated and engaged team—are well worth the effort.
