One Step Forward, Two Steps Back…Dreams of Perfect Equity Outcomes Can Affect Your Judgement

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Holland & Hart - The Benefits Dial

Notes on stock options, restricted stock, private company valuations, Code Section 409A.

There are a number of well-known stories of equity compensation, often focusing on the tax outcomes for awards where fortunate optionees did everything right.  Some of these stories are actual outcomes, such as when ISOs that were issued early in a company’s history at a very low strike price, were then exercised and held for the required holding periods (two years from grant and one year from exercise), and finally were sold at a greatly appreciated price with the entire gain getting long term capital gains treatment.  While such great outcomes do happen, in most cases optionees don’t meet the holding periods because they don’t foresee the liquidity exit or don’t have the funds to exercise and the resulting disqualifying dispositions are subject to ordinary income rate taxation.  We note that even ordinary income rate taxes are a good thing because they apply to income, which is a good problem to have.  But the desire to optimize the tax treatment can lead some optionees to take risky business decisions like exercising options early with promissory notes or exercising options for shares in a company with an uncertain future. If an executive buys restricted stock with a full recourse promissory note and the value of the shares declines, considering that these promissory notes usually accelerate on termination of employment, the potential for debt forgiveness income if the executive leaves or the potential for company claims to recover the balance of the note can serve as unwanted retention incentives.  

Similarly, the desire to maximize the value of an equity award should be managed to prevent companies from taking risky tax positions.  Remember the backdating crisis of 2006.  For private companies, we routinely advise that once a term sheet has been executed (depending on the facts, it can be before the term sheet is executed), this is a material change to the business such that a prior independent valuation under Code Section 409A can no longer be used with a presumption of reasonableness.  The previous fair market value must be updated, and when you consider that most financings for early companies result in only relatively small changes in the common stock fair market value, it is not worth the tax risk to be aggressive about option pricing decisions.  When the likely exercise price on a liquidity event is considered, usually the relatively small change in an exercise price due to a new valuation is not worth the risk of violations under Code Section 409A with the resulting changes in the timing of income inclusion and 20% excise tax.

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