A few weeks back we talked about stock options in some detail. I explained that the strike price of an option is the price per share you will pay when you exercise the option and buy the underlying common stock. And I explained that the company is required to strike employee options at the fair market value of the company at the time the option is granted.
The Board has the obligation to determine fair market value for the purposes of issuing options. For many years, Boards would do this without any third party input. They would just discuss it on a regular basis and set a new price from time to time. This led to some cases of abuse where Boards set the strike price artificially low in order to make their company’s options more attractive to potential employees. I sat on many Boards during this time and I can tell you that there was always a tension between keeping the strike price low and living up to our obligation to reflect the fair market value of the company. It was not a perfect system but it was a decent system.
About five years ago, the IRS got involved and issued a rule called 409a. The IRS looks at options as deferred compensation and will deem options as taxable compensation if they don’t follow very specific rules. Due to rampant abuse of the deferred compensation practices in the late 90s and early part of the last decade, the IRS decided to change some rules and and thus we got 409a. The 409a ruling is very broad and deals with many forms of deferred compensation. And it directly addresses the setting of strike prices.
409a puts some real teeth into the Board’s obligations to strike options at fair market value. If the strike prices are too low, the IRS will deem the options to be current income and will seek to collect income taxes upon issuance. Not only will the employee have tax obligations at the time of grant, but the company will have withholding obligations. In order to avoid all of this, the Board must document and prove that the strike price is fair market value. Most importantly, 409a allows the Board to use a third party valuation firm to advise and recommend a fair market value.
As you might expect, 409a has given rise to a new industry. There are now many valuation firms that derive all or most of their income doing valuations on private companies so that Boards can feel comfortable granting options without tax risk to the employees and the company. This valuation report from a third party firm is called a 409a valuation.
The vast majority of privately held companies now do 409a valuations at least once a year. And many do them on a more frequent basis. When your company grants options, or if you are an employee and are getting an option grant, the strike price will most likely be set by a third party valuation firm.
You’d think this system would be better. Certainly the IRS thinks it is better. But in my experience, nothing has really changed except that companies are paying $5000 to $25,000 per year to consultants to value their companies. There is still pressure on the companies to keep the prices low so that their options are attractive to new employees. And that pressure gets transferred to the 409a valuation firms. And any time someone is being paid to do something, you have to question how objective the result is. I look at the fees our companies pay to 409a valuation firms as the cost of continuing to issue options at attractive prices. It is the law and we comply. Not much has really changed.
There is one thing that has changed and it relates to timing of grants. It used to be that the Board could exercise a fair bit of “judgement” around the timing of grants and financing events. If you had a big hire and a financing planned, the Board could set fair market value, get the hire made, and then do the financing. Now that is so much harder to do. It takes time and money to get a 409a valuation done. Most companies will do a new one after they conclude a financing. And most lawyers will advise a company to put a moratorium on option grants for some time leading up and through a financing and do all the grants post financing and post the new 409a. This has led to a bunch of situations in my personal portfolio when a new employee got “screwed” by a big up round. It behooves the Board and management to be really strategic around big hires and financing events to avoid these situations. And even with the best planning, you will run into problems with this.
If the company you are joining is early in its development, the strike price will likely be low and you don’t have to pay too much attention to it. But as the company develops, the strike price will rise and it willl become more important. If the Company is a “high flyer” and is headed to a big exit or IPO, pay a lot of attention to the strike price. A low strike price can be worth a lot of money in a company where the value is rising quickly. In such a situation, if there has been a recent 409a valuation, you are likely in a good situation. If the company is a high flyer and is overdue for a 409a valuation, you need to be particularly careful.
This whole area of option strike prices is complicated and full of problems for boards and employees. It has led to a growing trend away from options and toward restriced stock units (RSUs). We’ll talk about them next week.
This article was originally written by Fred Wilson on November 1, 2010 here.