Valuing Your Stock Options and the Effects of Reg 409A
Every founder of a startup requiring growth capital will eventually need to create an employee stock option plan (ESOP). This serves to compensate your hard-working employees with skin in the game when your company achieves the ultimate goal of a healthy exit. I limit my explanation to startups that require growth capital because once you take someone else’s money, especially if that someone is a professional investor, you’re going to exit or fail trying. For stock options to be worth anything, an exit is required.
Imagine, for a moment, that a company never needs outside capital. Maybe the founders funded the company themselves or with bank debt, and cash is generated fast enough so no further capital is required. In that case, there is no outside force, such as an investor who is also on the board, that will eventually demand an exit when the time is right. Even if the employee’s options have vested, and they purchase shares at the agreed price, their new-found wealth is still only theoretical until the company is sold or goes public. Without that exit event, they are only holding paper and their holding is probably too small to influence any kind of liquidation. Imagine getting options working for the Trump Organization. Probability of a liquidity event? Less than zero.
Prior to 2004, the fair market value of the strike price was determined by the board. This lead to abuse by some boards who would price their options far below what could reasonably be described as fair market value. In 2004, the American Jobs Creation Act came into existence and with it came IRS section 409A, which is defined as follows:
“Section 409A applies to compensation that workers earn in one year, but that is paid in a future year. This is referred to as nonqualified deferred compensation. This is different from deferred compensation in the form of elective deferrals to qualified plans (such as a 401(k) plan) or to a 403(b) or 457(b) plan.”
Stock options are considered to be deferred compensation, and a 409A is essentially an appraisal that must be conducted to determine the price at which they can be purchased (the strike price). A 409A expires after 12 months or after an event which materially affects the value of your company, like a funding round for example. That said, an expired 409A doesn’t mean you have to rush out and get another one. You can keep going with business as usual until you decide you want to issue more options. Then you must get a new one.
Valuation firms take a wide range of variables into account when constructing this appraisal, such as recent funding events, your five-year forecast, cash generated by the business, your most recent financials, your cap table and so on.
As a founder, you want to maximize each employee’s stock option profit, so you want the strike price to be as low as possible. The limiting factor is the IRS. If the IRS decides that you issued options with a strike price below fair market value, then the employee has effectively received a taxable benefit, i.e. the difference between the fair market price and the strike price times the number of options. Getting this calculation wrong or simply not doing it would be very unprofessional and potentially damaging to your employees. Firstly, you would have put all your employees that are option holders at risk because any holder in violation would have to pay taxes plus a 20% federal penalty, any applicable state penalties, an IRS tax underpayment penalty, and any interest on unpaid taxes. In addition, your company would be guilty of not withholding tax.
Realistically, a loss-making startup is probably not going to attract a 409A audit from the IRS. It’s when you succeed that everything could start to get messy. It’s not a difficult process, nor is it overly expensive. Therefore, it is absolutely worth it to get it done right.