Peter Beach Startup companies that lack the cash needed to attract top people can use stock options to attract, motivate and retain personnel. Executives and other key personnel of startups also often demand stock options as part of their compensation package. There is a lot to understand about stock options before putting them in place, but near the top of any list is the tax issues.  Even before the Enron debacle of the early 2000s gave rise to the now infamous Section 409A rules, the IRS was making noise about the income tax consequences of issuing “deep in the money” stock options. That issue is now at the core of any issuance of stock options and is clearly on the IRS’s radar.

A stock option generally gives the optionholder the right to purchase shares at a certain price (the “exercise price”). The expectation is that the stock will grow in value and the optionholder will be able to purchase the shares for less than they are then then worth and thus realize value when the optionholder exercises and either holds or, more commonly, sells the underlying shares. Some of the advantages of stock option plans include giving employees the ability to share in the company’s success without requiring the company to use cash and motivating employees based on stories of optionholders cashing in on stratospheric growth.  Some of the disadvantages of stock options are potential dilution of other stockholders’ equity when options are exercised and the lack of liquidity of private-company stock options and stock.

The primary tax issues related to stock options are choosing between incentive stock options (“ISOs”) and nonqualified stock options (“NSOs”) and in both cases determining the fair market value of the company’s stock in order to set the exercise price of the option. This article will address the choice between ISOs and NSOs only briefly, focusing instead on the critical role that a fair-market-value exercise price plays in qualifying for the tax benefits of both ISOs and NSOs.

For ISOs, neither the grant nor exercise of the option is a taxable event.  On a sale of the stock after exercise, if certain holding periods have been met, all of the gain in the stock is taxed at long-term capital gain rates. Note that ISOs can only be issued to employees.

For NSOs, the grant of the option is not a taxable event.  But, unlike ISOs, when an NSO is exercised, the difference between the exercise price and the fair market value of the stock underlying the option at the time of exercise will be taxed at ordinary income tax rates.  On a sale of the stock, the gain in the value of the stock following the exercise of the stock option is taxed at capital gain rates.  NSOs can be issued to anyone, not just employees.  (The rest of this article will refer to employees as the recipients of stock options with the understanding that employee means employee for ISOs and can mean anyone for an NSO.)

To ensure their favorable tax treatment, both ISOs and NSOs rely on a determination of the fair market value of the stock underlying the option in setting the option’s exercise price.

Determining the exercise price for ISOs

An option qualifies for the tax benefits associated with an ISO only if it meets many requirements (a discussion of which is beyond the scope of this article), including the requirement that the exercise price must not be less than the fair market value of the underlying stock at the time of grant. The ISO regulations provide that the exercise price may be determined in any reasonable manner, including the valuation methods permitted under the estate tax regulations. The ISO regulations also provide that for non-publicly traded stock, if it is shown that the stock’s fair market value at the date of grant was based on an average of the fair market values as of that date set forth in the opinions of completely independent and well-qualified experts, then this generally establishes that there was a good faith attempt to meet the option price requirement and the exercise price will be respected as satisfying the fair market value requirement. Satisfying the good faith standard provides a high level of comfort, but other reasonable methods of valuation could ultimately be used in support of a fair market value exercise price—for example, an appraisal by one independent, well-qualified expert.

Determining the exercise price for NSOs

Under Section 409A, compensation earned in one year that is not paid until a future year is taxable when paid rather than when promised only if it meets the requirements of Section 409A. If an NSO is issued for an exercise price that is less than the fair market value of the underlying stock on the date of grant of the option, i.e., at a discount, the employee has effectively been paid the spread between the exercise price and the fair market value of the stock on the date of the grant and is taxed in the year of the grant.

The Section 409A regulations generally require that the valuation method used to price stock options must be reasonable but they go on to provide much more specific guidance than the ISO regulations.  Notably, the Section 409A regulations provide a valuation safe harbor for startups (generally, companies that have been in business for less than 10 years, have no publicly traded class of securities, and do not reasonably anticipate a change in control within 90 days or a public offering within the next 180 days). If startup stock is valued using this safe harbor method, the method is presumed to be reasonable. However, the IRS may rebut the presumption by showing that either the valuation method or the application of the valuation method was grossly unreasonable.

The startup safe harbor requires a written report of a valuation made reasonably and in good faith (good faith as defined for ISOs is not required here).  Factors that the person determining the value should consider include (i) the value of tangible and intangible assets, (ii) the present value of anticipated future cash flows, (iii) the market value of stock in similar corporations, (iv) recent arm’s length transactions, and (v) other relevant factors such as control premiums or discounts for lack of marketability.

What really sets the startup safe harbor valuation method apart is that the valuation need not be performed by a professional appraiser.  Rather, it must be performed by one or more persons reasonably determined to be qualified to perform the valuation based on significant knowledge, experience, education or training. This generally means that a reasonable individual would reasonably rely on the valuation after being told of the knowledge, experience, education or training of the person performing the valuation. For this purpose, significant experience generally means at least five years of relevant experience in valuation or appraisal, financial accounting, investment banking, private equity, secured lending, or other comparable experience in the line of business or industry of the corporation.  Note that while the startup valuation method does not expressly require that the person performing the valuation be independent, relying, for example, on a company employee or director, even though he or she has the requisite “significant experience,” could under certain circumstances, in particular those where a conflict of interest might exist, make it more difficult to satisfy the requirement that “a reasonable individual would reasonably rely on the valuation.” That said, where conflicts of interest don’t exist or are tempered by the participation of the entire board or a committee of the board, there could be a better chance of the valuation satisfying this requirement—for example, where a board of directors, acting in accordance with its fiduciary duties, sets the price based on industry multiples, comparable recent deals in the industry and their knowledge about the company’s competitive position.

The Tax Consequences

The stakes are high for startups pricing stock options. If an ISO or NSO is granted at a discount, the tax consequences for the employee receiving the option can be severe. An option that fails to qualify as an ISO because it fails to meet the fair market value requirements for ISOs will not only fail to provide the optionholder with the tax benefits characteristic of an ISO, it will also be recharacterized as an NSO and may fail to satisfy the fair market value rules for NSOs under Section 409A.

Any violation of Section 409A results in the employee being taxed in the year the option is vested (instead of when the option is exercised) and the employee is subject to a 20% penalty tax on top of income tax. But proper determination of the exercise price of a stock option is not just an issue for the IRS.  It also can, and frequently does, come up during due diligence in connection with mergers and acquisitions. If a buyer determines that the target company’s board of directors did not adequately address the fair market value issue when granting stock options, the buyer could argue for a purchase price adjustment or a special indemnity and the seller could incur substantial legal fees and be distracted from other more significant deal issues.

In conclusion, startups should determine fair market value every time a stock option is granted. A conservative approach is to use an independent valuation expert for both ISOs and NSOs. However, this can be an expensive process, and while at some point, an emerging company will want to get an independent valuation for purposes of granting stock options, startups may rely on Section 409A’s startup safe harbor valuation method. For startups organized as LLCs taxable as partnerships and their members, compensatory options and profits interests can be used to achieve results similar to those provided to corporations and their shareholders by stock options.  We expect to cover those issues in a future article.