“Options” for Early Stage Companies: Designing the Right Stock Option Program

Despite the variety of other forms of equity-based incentive awards available, most early stage companies choose to grant stock options. Regardless of whether the decision to grant stock options is based upon market practice, employee expectations or the lack of knowledge regarding the alternatives, early stage companies must be vigilant when making option grants. In practice, many early stage companies lack the experience and resources to implement a stock option award program that takes into account both the tax impact and practical considerations arising from granting stock options. The failure to take these matters into account can not only have a punitive tax impact, but can cause issues with employee retention, equity dilution and impact the company’s capital raising efforts. By contrast, a carefully designed option program may be structured to serve a variety of aims specific to early stage companies, while simultaneously mitigating tax risk.

In the early stages, a company’s equity value is typically very low. Depending upon the type of startup, once the company finds its footing, the equity value may steadily increase over time, such as a retail venture, or may rapidly increase in the proverbial hockey stick fashion, such as a software as a service venture. In either case, cash is usually a rare commodity for startups and they are generally restricted in their willingness or ability to use cash as a motivational tool. Instead, such companies utilize the one valuable commodity they do possess—stock—by granting to all onboarding employees some form of equity award, usually in the form of stock options. Indeed, most employees joining a startup company are attracted by the potential upside that only equity can provide and expect to be compensated with equity compensation in the form of stock options.

Taxation of Stock Options

Taking a step back, a stock option is an equity-based incentive award that provides the grantee with the right to purchase a specified number of shares of the company’s stock at a stated exercise price, subject to any applicable vesting criteria. From a tax perspective, typically, there will be no tax due upon either the grant or vesting of the option. ¹Treas. Reg. §1.83-7(a). The tax impact upon exercise and disposition of the underlying shares, however, will differ depending upon if the option is structured as a nonqualified stock option or an incentive stock option (ISO). ²I.R.C. §422 (generally, in order for an option to be treated as an ISO (i) the option must be granted to an employee who must exercise the option while employed or within three months after termination of employment (certain exceptions apply upon a termination due to death or disability), (ii) the option must be granted under a written plan document that specifies the number of shares that may be issued and the eligible participants, (iii) the plan under which the option is granted must be approved by the corporation’s stockholders within 12 months before or after adoption, (iv) the option must be granted within 10 years of the earlier of adoption or shareholder approval and the option must be exercisable only within 10 years of grant, (v) the option exercise price must equal or exceed the fair market value of the underlying stock at the time of grant; provided that if the employee owns stock representing more than 10 percent of the voting power of all stock outstanding, the option exercise price must be at least 110 percent of the fair market value and the option must expire no later than five years from the date of the grant, (vi) the option cannot be transferred by the employee other than by will or by the laws of descent and that the option cannot be exercised by anyone other than the employee during the employee’s lifetime, and (vii) the aggregate fair market value (determined as of the grant date) of stock acquired upon exercise of an ISO that are exercisable for the first time cannot exceed $100,000 in a calendar year (to the extent such limit is exceeded such excess options will be treated as nonqualified stock options).

If the option is structured as a nonqualified stock option, the grantee will have to pay tax at ordinary income rates upon exercise on the option’s “spread” value (the difference between the fair market value of the stock on the date of exercise over the stated exercise price). ³Id. In addition, the ordinary income recognized by an employee upon exercise will be treated as wages and will be subject to both payroll tax withholding and employment taxes. ⁴I.R.C. §3402; Treas. Reg. §31.3402(g)-1(a)(i). The company generally will be entitled to a deduction in connection with the exercise in an amount equal to the income recognized by the grantee. ⁵Treas. Reg. §1.83-6(a); I.R.C. §162.

By contrast, if the option is structured as an ISO, the employee will not be taxed upon exercise (except for possible alternative minimum tax). ⁶I.R.C. §421; I.R.C. §422 (ISOs may only be granted to employees); I.R.C. §56(b)(3). Moreover, if: (i) the employee does not dispose of the shares acquired within two years from the date of grant or within one year from the date of exercise, and (ii) the employee was employed by the company at all times during the period beginning on the date of the grant and ending on the day three months before the date of exercise (this can be extended to up to one year if the termination resulted from disability or, later, from death), any gain or loss realized on a subsequent disposition of the shares will be treated as long-term capital gain or loss. ⁷I.R.C. §421(a); I.R.C. §422(a); I.R.C. §422(c)(6). Under such circumstances, the company will not be entitled to any deduction for federal income tax purposes. ⁸I.R.C. §421(a)(2).

If, however, the employee disposes of the shares before the later of such dates or was not employed during the entire applicable period (resulting in a “disqualifying disposition”), the ISO will lose its qualified status and be treated as a nonqualified stock option for income tax purposes. ⁹I.R.C. §421(b); Treas. Reg. §1.421-2(b). In such an event, the employee will have ordinary income equal to the lesser of (i) the difference between the exercise price and the fair market value of the shares on the date of exercise and (ii) the difference between the exercise price and the amount realized on the disposition. ¹⁰Id. Any gain or loss realized in excess of the amount of ordinary income recognized or the loss, if any, will be treated as a capital gain or loss. ¹¹Id
.; I.R.C. §422(c)(2). The company will typically be entitled to a corresponding tax deduction in connection with a disqualifying disposition. ¹²Id.

Valuing Options

In order to grant either nonqualified stock options or ISOs, the company must first determine the applicable exercise price for the options being granted. With respect to nonqualified options, while the company can technically choose any exercise price it desires, under Section 409A of the tax code, a stock option having an exercise price less than the fair market value of the stock on the grant date constitutes a deferred compensation arrangement. Stated another way, a properly structured option granted with an exercise price which is not less than the fair market value of the underlying stock on the date of grant is exempt from Section 409A. ¹³Treas. Reg. §1.409A-1(b)(5).

As a result, unless the company grants “409A options” (discussed below), if the exercise price is less than the fair market value on the date of grant, the option will violate Section 409A and the spread will be taxed at the time the option vests rather than the date of exercise, the grantee will be subject to a 20 percent excise tax on such amount in addition to regular income and employment taxes, and the grantee will potentially be subject to an interest charge. ¹⁴Note that Internal Revenue Service Notice 2008-113 provides a limited correction procedure to avoid the Section 409A penalty with respect to an option that would otherwise be exempt from Section 409A, but the exercise price was inadvertently set at less than fair market value on the date of grant. Moreover, the company is required to withhold the applicable income and employment taxes at the time of vesting (but not the Section 409A excise tax). ¹⁵I.R.C. §409A(a)(1)(B); Notice 2008-115. Furthermore, in order for an ISO to obtain its qualified status, the exercise price of the ISO must generally be at least equal to the fair market value of the underlying shares on the date of grant. ¹⁶I.R.C. §422(b)(4). Thus, any time a company issues a stock option, regardless of which kind, it is critical for the company to accurately determine the fair market value of its stock.

Fortunately, Section 409A recognizes the difficulty of startup company valuations and provides for a startup company valuation safe harbor methodology. Specifically, for purposes of Section 409A, a valuation of the stock of a private company will be presumed to be reasonable if it:

• is performed by a person with significant knowledge or experience in performing similar valuations,
• is evidenced by a written report; and
• takes into account the value determined by the reasonable application of a reasonable valuation method based on all the facts and circumstances, taking into account the other factors applicable to mature private companies.

Moreover, to use the safe harbor, the startup must be a genuine early stage company that has not conducted a material trade or business for at least 10 years or have stock that is directly or indirectly traded on an established securities market, and the applicable stock of the company must not be subject to any put, call, or other right or obligation of the company or other person to purchase the stock (other than a right of first refusal). The safe harbor valuation method, however, is not available if it is reasonably anticipated, as of the time the valuation is applied, that the startup company will undergo a change in control within the 90-day period following the valuation or will make a public offering of securities within the 180-day period following the valuation. ¹⁷Treas. Reg. §1.409A-1(b)(5)(iv)(B)(2)(iii).

In reality, most startup companies should be able to meet the safe harbor valuation criteria. Where many startups fail, however, is in appropriately following the administrative steps necessary to meet the safe harbor. As previously mentioned, the Section 409A regulations require that the valuation be performed by an experienced individual and that there is documentation of the methodology utilized. Since many startups are unable or unwilling to spend the time or incur the costs involved in complying with the administrative requirements, many companies are not able to rely on the startup company valuation safe harbor methodology.

Notably, the ISO rules are more forgiving than Section 409A, in that an ISO will not lose its qualified status if the failure occurs solely because the exercise price was less than the fair market value of the underlying stock as of the date of grant, provided the company attempted in good faith to set the exercise price at fair market value. ¹⁸I.R.C. §422(c)(1). Interestingly, since Section 409A specifically states that options granted in compliance with Section 422 (the ISO requirements) are exempt from Section 409A, presumably, an ISO, even if ultimately determined to have been granted with an exercise price less than fair market value at the time of grant, should not be subject to Section 409A. ¹⁹Treas. Reg. §1.409A-1(b)(5)(ii).

However, it is unclear to what extent an ISO that otherwise loses its qualified status (e.g., failure to meet the holding period requirements), could subsequently become subject to Section 409A, and when the Section 409A interest and penalties would apply. In other words, if an option is granted with an exercise price less than fair market value but qualifies as an ISO due to the good faith valuation exception, upon a disqualifying disposition, should Section 409A apply retroactively to the date of grant or at the time the ISO loses its qualified status (or not at all). ²⁰The most logical reading of the regulations should provide that a stock option that meets the requirements of I.R.C. §422 will continue to be subject to the ISO taxation regime, and exempt from I.R.C. §409A. Nevertheless, if the fair market value is determined in accordance with the more stringent requirements of Section 409A, it should also satisfy the fair market value criteria under the ISO rules; thus, alleviating the need to rely on the good faith valuation exception to the ISO requirements. In this regard, it is usually recommended that a company follow the Section 409A valuation methodology.

When granting options, a startup company has a distinctive issue with respect to determining the applicable exercise price and fair market value of the underlying stock. Most mature companies have had experience with valuation issues and either have established valuation protocols or engaged an independent outside valuation firm. Early stage companies, however, often have little experience with valuation, have not implemented an established methodology for determining fair market value, and do not want to incur the costs necessary to engage an independent valuation. As a result, any fair market value determination under such circumstances may reasonably be questioned, and the company may have to overcome the challenge of proving that its fair market value determination was reasonable.

Granting “409A Options”

Early stage companies must also consider the proximity of their option grants, and related fair market value determinations, to capital raising events. In the event the company grants options shortly before a capital raise, the company must consider two distinct, but related, issues. Specifically, if the company grants options shortly before a capital raise, and the fair market value determination is lower than an investor’s perceived value, the company will be disadvantaged in its negotiations with the potential investor. This may result in the existing shareholders being overly diluted, in that a stated dollar value investment will purchase a larger percentage of the company. By contrast, if the fair market value determination is too high, the capital raise may not be successful and/or the incentive value of the options may suffer because the options will have effectively been granted underwater. Thus, the importance of the fair market value determination extends well beyond the potential tax exposure.

One solution to avoid the potential adverse Section 409A tax issues associated with granting options in the startup context, irrespective of the company’s confidence in its valuation or compliance with the startup company valuation safe harbor methodology, is to grant options that are structured to be exercisable only upon the occurrence of a Section 409A permissible payment event (“409A options”). ²¹Treas. Reg. §1.409A-3(a). For example, a 409A option may be structured such that it vests in equal installments over a four-year period, but can only be exercised upon or within the 30-day period following a Section 409A qualified change in control. Under this construct, even if the option were granted with an exercise price below fair market value at the time of grant, and thus, subject to Section 409A, the option would be deemed a nonqualified deferred compensation arrangement structured in compliance with Section 409A. Thus, the 409A option would avoid the Section 409A penalties.

A 409A option restricts the optionees’ ability to exercise their option outside of the specified events. While vesting conditions could be designed to serve a similar purpose, employees may be less incentivized if the award will be forfeited prior to the applicable qualified Section 409A event. In other words, if an option will not vest until a change in control, for example, the award will have little value to the employee until a change in control event is on the horizon. By contrast, if the option is fully vested and nonforfeitable, but the employee is restricted from exercising the option prior to the specified event, the employee is still incentivized to increase the company’s value.

Furthermore, with respect to “regular” options, once an optionee exercises the option, the optionee will hold stock of the company and will have all of the rights of a shareholder, including access to the company’s books and records, dissenter rights, and even voting rights if the options were granted on voting stock. Additionally, the exercise of a stock option by an employee will trigger the company’s tax reporting and, with respect to nonqualified stock options, tax withholding obligation on the spread. If an employee exercises an option apart from a liquidity event, the company will be required to determine the fair market value for tax reporting and withholding purposes. As noted, for many startups, the determination of fair market value may be difficult and an errant valuation may result in failure to withhold penalties and interest.

Withholding Taxes

Moreover, 409A options may avoid certain unintended consequences from the employee’s perspective. Generally, when an employee receives cash compensation the employer withholds a specified percentage of the cash compensation, and the employee receives an amount net of taxes. If the employee’s taxable event, however, arises from the exercise of a stock option, the company will not have cash from which to withhold. Rather, since the IRS does not accept stock or property as payment for taxes, either the company or the employee must come up with cash to pay the tax liability.

Practically, because the company is private, the employee will likely be unable to sell the distributed stock and will have to resort to paying cash “out of pocket.” This may be a particularly unappealing possibility because the employee has to pay tax on property that has no market and cannot be sold. Moreover, the cash withholding obligation will be in addition to the payment of the applicable exercise price, which may also have to be paid in cash. It should be noted that some startup companies do permit employees to utilize a “net exercise” mechanic (sometimes referred to as a “cashless exercise”). Upon a net exercise, employees pay the exercise price and/or settle their withholding tax liabilities by requiring the company to withhold shares underlying the option having a fair market value equal to the exercise price and/or applicable tax. Under this mechanic, the employee receives fewer shares upon exercise but the employee does not have to pay cash for the exercise price, and the obligation to make the cash payment to the IRS rests with the company, thus alleviating the employee from coming out of pocket upon exercise. For startup companies, however, the net settlement mechanic, while appealing to employees, is often inconsistent with its business needs. Most startups are cash starved and cannot financially tolerate cash outflows associated with employee compensation.

Thus, 409A options can be structured to avoid the foregoing issues, in addition to the significant tax consequences imposed by Section 409A. Specifically, if the 409A options are structured only to be exercisable upon a liquidity event, the company will not have to concern itself with additional shareholders and the additional issues associated therewith before such event. Moreover, the applicable tax withholding obligation will not be triggered until the liquidity event when the company should have a clear picture of fair market value, its withholding obligation, and even possibly have cash against which to withhold. Thus, not only do 409A options mitigate the potential Section 409A impact, they can also serve several practical purposes.

Conclusion

Ultimately, there is no “one size fits all” approach to equity compensation, and each startup or early stage company should assess its own specific situation and objectives. While 409A options may be appropriate for companies concerned with accurately determining fair market value, the attendant lack of flexibility or other business realities may make them unacceptable for use. Each long-term incentive alternative has its own unique benefits and detriments. Thus, it is important for startups and early stage companies to carefully consider their “options” before settling on any one approach.