March 30, 2011 by bhawkins
In the good ol’ days, circa 2000, boards routinely granted options for common stock at deep discounts to the preferred price, as much as 90% of that preferred price. The business rationale for the discount is to give key service providers common stock at the lowest possible price so that they have the greatest incentive to create value. And if the price is kept low, both the service provider and the company receive more ‘bang for the buck.’ The incentive effect of 10,000 options at $.10/share may be the same as 20,000 options at $1.00/share. And the justification for the discount is that the preferred stock has extra bells and whistles as compared to common stock—most notably, liquidation preference, dividends, and antidilution protection—and so should be priced higher.
The good ol’ days are gone. In 2004, the Internal Revenue Service promulgated Section 409A of the Internal Revenue Code, which, among other things, applies for valuing common stock for options. Here’s what you’ll need to consider:
- The fair market value must be determined using “reasonable application of a reasonable valuation method.”
- A valuation needs to be performed by someone who is qualified (based on their knowledge, training, experience, etc.). In most cases, companies choose to hire outside appraisal firms to meet this requirement.
- The valuation needs to be updated at least every 12 months, or more frequently if significant changes occur in the business between grant dates (such as new rounds of financing).
- If your company fails to comply with 409A, your employees will be personally liable for immediate taxation – plus a 20 percent penalty tax, and potential interest payments.
- And perhaps most importantly, potential investors and acquirers want to know that your company has complied with Section 409A. The failure to comply with Section 409A can be a significant red flag to them.
Many of our venture-financed clients elect to have third parties provide valuations for this purpose. Of course, valuations take time and money. A good valuation firm can do a valuation in a month’s time, and we see the costs of most good outside valuations for companies in our market ranging between $4,000 to $10,000. For a fun (and even animated!) discussion around these issues, see http://www.xtranormal.com/watch/7471325/. For a spirited and colorful discussion about why 409A is stupid, see http://www.feld.com/wp/archives/2005/12/409a-government-maximus-interruptus.html and the posts that follow it. But remember: we as lawyers don’t make the rules, we’re just charged with advising you of them.