How to Set Exercise Price of Underlying Shares in Granting Stock Options as Compensation

The answer is by a reasonable valuation method to make it fair market value at the time of the grant. Recipients of stock options with exercise prices that cannot be shown to be at or above the “reasonably-determined FMV” on the date of grant face immediate tax on vesting at a combined federal and state tax rate as high as 85% or more.

An issuer of stock options may avoid such issue by using an IRS-approved valuation method, which shifts the burden of proof that the FMV determination method was reasonable or unreasonable from the issuer to the IRS, reducing the likelihood of successful challenges by the IRS.

Section 409A (https://www.irs.gov/irb/2007-19_IRB/ar07.html) of the Internal Revenue Code and Some State Laws

·         From Option Holder’s Perspective

Section 409A requires an option holder with an option having an exercise price below FMV at the time of grant to recognize the taxable income (federal income and employment taxes) equal to the spread between the FMV and the exercise price (FMV – exercise price) as they vest, not at the time the holder exercises the option nor at the time the holder dispose of the shares underlying the options.

Moreover, an additional 20% + federal tax also applies as the option vests. Certain states like California will also have parallel statutes that impose additional 20% + state tax on top of the state regular income and employment taxes.

·         From Issuer’s Perspective

For companies granting stock options to its employees and withholding the income and employment taxes, upon failure to properly withhold these taxes, such companies could be liable for these taxes plus penalties and interest.

Establishing a Defensible FMV

Section 409A approves three valuation methods as reasonable. Such valuations are valid up to 12 months unless there are intervening events that would reasonably and materially impact the valuations (e.g., (e.g., the resolution of material litigation, the issuance of a material patent, a financing, an acquisition, a new material customer or other significant corporate event).

·         Formula-based Valuation: not commonly used

·         Independent Expert Valuation: Section 409A allows the FMV to be established presumptively by qualified independent valuation experts using certain methods recognized under the IRC.

·         Illiquid Startup Inside Valuation.  A valuation will also be presumed to meet the requirements of Section 409A if it was prepared by someone that the company issuer reasonably determines is qualified to perform such a valuation based on “significant knowledge, experience, education or training.”  Section 409A defines “significant experience” to mean at least five years of relevant experience in business valuation or appraisal, financial accounting, investment banking, private equity, secured lending or comparable experience in the company’s industry. This person does not need to be independent from the company. However, in order to rely on the illiquid startup insider valuation safe harbor:

ü  the company must have been conducting business for less than 10 years;

ü  the company may not have a class of securities that are traded on an established securities market;

ü  neither the company, nor the recipient of the option, “may reasonably anticipate” that the company will be acquired within 90 days or go public within 180 days; and

ü  the common stock must not be subject to put or call rights or other obligations to purchase such stock (other than a right of first refusal or a “lapse restriction,” such as the right of the company to repurchase unvested stock held by the employee at its original cost)

Restricted Stock as Alternative, Not Subject to 409A

Shares of restricted stock are not subject to Section 409A of the IRC. A recipient of shares of restricted stock may file an “election under Section 83(b) of the IRC to be taxed” in the year the election is made on the spread between the purchase price and the FMV as of the date of grant (typically nominal or zero) rather than being taxed, when the restriction on the shares lapses, on the spread between the purchase price and the FMV at the time of such lapses (when the shares are hopefully worth more).