As a general rule, all stock option grants need to have an exercise price at or above the fair market value of the company’s common stock on the date such grant is made. This requirement, and its many related complexities, generally comes from Section 409A of the Internal Revenue Code and the related Internal Revenue Service (“IRS”) regulations (collectively, “Section 409A”). Section 409A was enacted several years ago in response to perceived abuse of deferred compensation arrangements brought to light during various high-profile corporate scandals.
The two main penalties imposed by Section 409A for granting a stock option with an exercise price below fair market value are (i) immediate tax upon vesting of the option (as opposed to at exercise or sale) and (ii) an additional 20% federal tax penalty (on top of the regularly applicable federal and state taxes). In addition, some states, such as California, may impose their own Section-409A-equivalent penalty tax. In order to avoid these penalties, the IRS requires that a stock option must be granted with an exercise price no less than the underlying shares’ fair market value determined as of the grant date and that such fair market value must be “determined by the reasonable application of a reasonable valuation method.”
The good news is that Section 409A provides three “safe-harbor” methods for determining fair market value, two of which are most commonly relied upon by startups and venture-backed companies (discussed below). If one of these safe harbor methods is used, then the resulting fair market value is presumed to be “reasonable” unless the IRS can establish that the company’s determination was “grossly unreasonable.”
Most Common Safe Harbor Valuation Methods for Startups
In addition to prescribing general valuation guidelines (discussed below), Section 409A creates a presumption that certain safe harbor valuation methods will result in a reasonable valuation. However, a method will not be considered reasonable if it does not take into consideration all available information material to the valuation of the company’s common stock. Further, a company may not rely on any valuation for more than 12 months. In other words, a company’s valuation must be updated after the earlier of (i) the occurrence of a development that impacts the company’s value (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) or (ii) 12 months after the date of the prior valuation. The following two safe harbors are most commonly used by startups and venture-backed companies:
1. Independent Valuation. A valuation will be presumed to meet the requirements of Section 409A if it was performed by a qualified independent appraiser. These qualified independent appraisers range from valuation groups within very large accounting firms to small boutique shops and individuals that focus only on valuation work. In my experience, the cost of an initial independent valuation report ranges from $5,000 to $35,000, depending on the name brand of the firm conducting the valuation and the complexity of the company being valued (i.e., its financials, operations and capitalization). Subsequent “bring-down” updates to the initial valuation are often less expensive than the initial report. That said, given the cost associated with obtaining an independent appraisal (and its subsequent bring-downs), later-stage venture-backed companies often grant stock options less frequently (and instead batch them for board approval in bulk), in order to minimize the need for potentially costly and time consuming bring-down updates.
2. 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 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:
- the company must have been conducting business for less than 10 years;
- the company may not have a class of securities that are traded on an established securities market;
- 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
- 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).
A word of caution, though, given the potential liability involved with performing a valuation in-house: a startup will want to make sure that they have appropriate D&O insurance coverage and indemnification agreements in place if relying on such safe harbor in order to protect directors and officers from potential future claims related to such valuation.
General Valuation Guidelines
As noted above, in addition to the foregoing safe harbors, Section 409A also contains general guidelines that apply to all valuation methodologies (safe harbor or otherwise) – and a valuation method will not be considered reasonable if it does not take into consideration all available information. Under the general guidelines, all valuation methods must consider the following factors, as applicable:
- the value of tangible and intangible assets of the company;
- the present value of anticipated future cash-flows of the company;
- the market value of stock or equity interests in similar companies and other entities engaged in trades or businesses substantially similar to those engaged in by the company, the value of which can be readily determined through nondiscretionary, objective means (such as through trading prices on an established securities market or an amount paid in an arm’s length private transaction);
- recent arm’s length transactions involving the sale or transfer of such stock or equity interests; and
- other relevant factors such as control premiums or discounts for lack of marketability and whether the valuation method is used for other purposes that have a material economic effect on the service recipient, its stockholders or its creditors.
Which Safe Harbor is Right for My Company?
While understanding these formal legal requirements and the available valuation options is important for any startup granting stock options, in my experience, the safe harbor method a company selects is usually determined largely by its stage of development and available resources (both cash and appropriate personnel).
At Formation. At formation, before a startup has begun operations or has tangible assets, any valuation method will be difficult to apply. As such, companies often elect to sell or grant restricted stock (rather than stock options) at formation, since restricted stock is generally outside the scope of Section 409A and an error in valuation would not raise the same concerns as with stock options.
Post-Seed Funding. After a startup has obtained its initial round of seed funding (typically from angels, friends and family), the company will often rely on the illiquid startup insider valuation safe harbor. At such point in a startup’s life, the company will often have an officer who is running the startup’s financial operations and who would qualify to perform such a valuation – where such an officer does not exist, the company may elect to rely on an advisor or board member who possesses the appropriate set of skills.
Post-Venture Capital Funding or Pre-Liquidation Event. After a startup either has (i) accepted an investment from a venture capital fund (and a VC designated director has joined the board) or (ii) “may reasonably anticipate” that the company will be acquired or go public in the foreseeable future, the company will typically rely on the independent valuation safe harbor. That said, if a venture-backed company is not yet earning revenue and/or a liquidity event in not on the near-term horizon (and the company is very focused on cash conservation), it is not usual for such a company to continue relying on the illiquid startup insider valuation safe harbor (assuming they can get their VC director(s) comfortable with that approach).
As indicated above, an alternative to dealing with Section 409A’s fair market value exercise price requirement is to grant restricted stock, which is not subject to Section 409A. However, it is important to also note that restricted stock grants pose a different challenge – the receipt of restricted stock for services is considered taxable income as the stock vests. See our prior post here regarding restricted stock and making a Section 83(b) election in connection with receipt of such grant.
While not within the scope of this post, it is important to note that the requirements of Section 409A are independent of accounting considerations associated with granting options below fair market value, such as the SEC’s concern with the proper accounting for “cheap stock.” Such “cheap stock” accounting assessments are performed by the SEC (typically in connection with a company’s IPO registration process) and may result in one-time, non-cash earnings charges on the company’s financial statements.
Here are the Section 409A final regulations in case you are interested in reviewing the full text from the IRS.