Oh, Making Bad Decisions…or Not Really Considering the Long Game for Stock Options

by John Ludlum

We often encounter questions relating to the fair market value of a private company for granting stock options where the company has experienced an event, such as receiving a signed term sheet, which almost certainly will result in a higher fair market value when the company had intended to grant options at an earlier price but had not gotten the grants completed.  Usually, the questions focus on when the company has to consider the business event and whether it would be possible to quickly make the awards at the price that was promised.  Almost always, this is short term thinking that could turn out to be long term expensive in a risky tax position.

At this point, we are all familiar with the Code Section 409A requirement that NSOs must be granted at no less than fair market value on the date of grant in order to be exempt from Code Section 409A as “stock rights.”  While most companies obtain an independent valuation to gain a presumption that the valuation is at least fair market value on the date of grant, a valuation by the board could still be considered reasonable if it reflects a “reasonable application of a reasonable valuation method” and considers the identified business factors from the Code Section 409A regulations:  value of the company’s tangible and intangible assets, anticipated future cash flows, similar corporation value data points, recent arms’ length transactions, control premiums, and discounts for lack of marketability.  However, a valuation method is not considered reasonable if it does not take into account all available information material to the value of the corporation at the time of the valuation, and a signed term sheet is generally considered to be material to the value of a corporation.

This is where we need to check our inclination to try and use the lower valuation at the cost of a risky tax position.  Option pricing is a hot button issue for diligence for financings and acquisitions, so the exercise price will be scrutinized, and the possible penalties under Code Section 409A for an option that is found to be a discount option include income inclusion on the vesting dates, a 20% penalty on top of all ordinary income taxes, and potential penalties for reporting and interest on amounts that should have been reported and withheld.  For an early stage company, even a substantial move in the strike price is likely to be small relative to what the shares are worth on an exit, and a longer perspective would probably take the higher exercise price and sleep well at night.