This is part 5 of our series on startup legal lessons presented in Walter Isaacson’s biography of Apple co-founder Steve Jobs. This post address issues with stock options. On pp. 365-366, Isaacson describes the haggling between Jobs and Apple over his stock options when he dropped the “interim” from his CEO title in 2000. The issue of valuing the strike price of options emerged again in 2001 when Jobs received another grant of stock options. These issues led to an SEC investigation in 2006-2007 related to potential irregularities in the stock option grants to Jobs. Issues with valuing stock options are a common problem for startups.
This post will provide a general overview of stock options and then discuss the importance of accurately setting the exercise price due to 409A.
Stock Option Basics
As described in “Consider Your Options” by Kaye Thomas, a stock option “is an agreement providing terms under which [one] can buy a specified number of shares of stock at a specified price.” That specified price is the “exercise price” or the “strike price.” For example, a company may grant an employee 10,000 stock options at an exercise price of $1/share. The employee pays nothing and recognizes no taxable income on the grant of these options. The employee can later choose to exercise the option by paying the exercise price. For example, if after the stock options are fully vested, the company’s common stock has a fair market value of $5/share, the employee can “exercise” the options by purchasing 10,000 shares of common stock for $1,000 (10,000 shares at $1/share).
Benefits of Options
Stock options can serve as a tax efficient mechanism for giving employees equity exposure to a company. Where as a restricted stock grant is taxed at the time of grant (assuming an 83(b) election has been made), stock options are typically not taxed at the time of grant. This is helpful when the value of the company has increased such that the value of restricted common stock is no longer nominal and a recipient would have to pay a significant amount for restricted common stock (if purchasing outright) or in ordinary income tax (if not purchasing outright).
While stock options can provide tax benefits, they can also present complexity and cost in determining the exercise price. As you can tell from the above discussion, the exercise price is the price an individual will pay to exercise options and therefore has a significant economic impact on the option recipient. Accordingly, a company may be incentivized to grant options at a lower exercise price in order to pass along more value to a recipient (or similarly to “backdate” the grant of options in order to grant them on a date when the company’s common stock had a lower value). Under the current law, neither of these are advisable options. The exercise price of a stock option must equal the fair market value of the underlying common stock on the date of the option grant.
This raises the question of how a company should value its common stock, especially at its early stages. Company’s used to typically value common stock at 10% of the value of the preferred stock at the last financing. That practice changed with the passage of 409A imposing significant regulatory hurdles and penalties for options granted at less than fair market value on the date of grant. 409A provides certain IRS-approved methods for startups to calculate the fair market value of option grants, thus shifting the burden to the IRS to show the fair market value was grossly unreasonable.
These approved methods include an independent appraisal (commonly called a 409A valuation), which is good for 12 months unless something impacts the company’s value (such as a financing). These valuations cost anywhere from $2,500 to much more depending on the provider and the complexity of the company. Another approved method is the illiquid startup appraisal, where the company has no imminent plans for an exit and a person with experience in valuations sets the value of the company. See WSGR attorney Yokum Taku’s blog on setting the exercise price of stock options for more info.
Accordingly, startups should not take lightly the process of setting the exercise price of stock options. At the early stages, when restricted stock can be issued at nominal value, restricted stock awards will typically be a simpler and more efficient way to pass along equity exposure to individuals. As the company increases in value, options may become the preferred equity compensation vehicle, but startups should allocate resources to properly set the exercise price of the stock options and avoid any unnecessary problems under 409A.
As Apple found out, even prior to 409A, playing around with the exercise price of stock options can cause significant problems down the road.