Stock options are a popular form of compensation for early-stage companies because they are a cost-effective way to attract talented employees. Additionally, stock options offer significant motivational value, as they foster loyalty and encourage employees to focus on long-term value creation.
For many entrepreneurial job seekers, stock options are an attractive incentive because they offer the potential for a sizeable payoff. The brightest and most talented candidates will closely evaluate the stock option plans offered by potential employers. From the employee’s perspective, stock options with lower exercise prices are generally more attractive because they offer a larger potential payoff. As such, most startups prefer to set the exercise price for their stock options as low as possible, without exposing themselves to tax risk.
In the article below, we review tax compliance and valuation issues related to stock options. More specifically, we discuss the differences between certain methods used by appraisers and how they impact option pricing. By understanding these issues, companies can select an appraiser who can help them set the exercise price of their stock options as low as possible while ensuring tax compliance.
Section 409(A) Compliance
The IRS enacted Section 409(A) of the Internal Revenue Code in 2004 to regulate the tax treatment of nonqualified deferred compensation plans such as stock options. According to 409(A), if a company issues stock options, the exercise price must be set at or above fair market value. If a stock option’s exercise price is set below fair market value, then both the company and its employees could face tax penalties.
To ensure 409(A) compliance when issuing stock options, companies should obtain a business valuation from a qualified appraiser. A qualified appraiser can determine the fair market value of a company’s underlying common stock by applying appropriate professional standards and IRS-approved valuation methods. By obtaining a valuation, a company can set a reasonable exercise price for its stock options and will be protected in the event of an IRS challenge.
409(A) Valuation Process
Performing a valuation for 409(A) compliance purposes consists of multiple steps. First, the appraiser will determine the fair market value of the total equity of the subject company using one or more of the primary valuation approaches, which include the income approach, market approach, and asset approach.
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Next, the appraiser will allocate the equity value of the company across all shareholder classes, resulting in a per-share value of the class of stock for which the stock options are being issued. The appraiser will begin this step by selecting a forward-looking value allocation method, the most common of which are the current value method, the option pricing method (OPM) and the probability-weighted expected return method (PWERM). Below we discuss each method in further detail and explain why start-up companies should be cognizant of the fundamental differences between each allocation method.
Current Value Method
The current value method is applied by first calculating the equity value of the subject company on a control basis and allocating the value to each class of stock based on the rights under each share class. While this method is easier to apply than the OPM and PWERM, it is not forward-looking. In other words, it assumes that a liquidity event occurs on the valuation date and does not take into account any future possible changes to the company’s value. Due to this limitation, the current value method would not be the most appropriate allocation method to apply in valuations performed for the purpose of establishing equity compensation plans.
Option Pricing Method
The OPM is a commonly used, forward-looking method for allocating a company’s equity value between share classes. The OPM treats common and preferred stock as call options on the subject company’s equity value, with exercise prices based on the liquidation preference of the preferred stock. Under this method, if the liquidation preference exceeds the value of the funds available for distribution, then the common stock holds no value.
Most appraisers use the Black-Scholes option pricing model to price call options under the OPM. While other option pricing models exist (e.g., binomial model), the Black-Scholes model has gained widespread acceptance because it is easy to apply and allows the appraiser to quickly calculate a large number of option prices. To apply the Black-Scholes method, the appraiser must first identify potential liquidity events or exit scenarios for the company, then determine the following inputs:
- Equity value of the subject company under each liquidity event
- Expected time left until each event occurs
- Risk-free rate of return
- Volatility (standard deviation of historical stock prices of comparable public companies)1
The PWERM is also forward-looking and involves estimating the value of a subject company’s common stock based on an analysis of future values for the company under various scenarios. This method includes the following steps:
- Identifying possible future outcomes available to the subject company (e.g., IPO, merger or acquisition, dissolution, liquidation, continued operation)
- Estimating the future equity value of the subject company under each scenario
- Determining the probability of each scenario occurring
- Weighting the future equity value under each scenario by its respective probability
- Discounting each probability-weighted future equity value to present value
Under the PWERM, the appraiser must consider the rights of each shareholder class and allocate the future equity values to each share class appropriately under each scenario. The appraiser may also need to determine and assign a different discount rate to each class of shares in order to determine the probability-weighted present value for each share class. Additional adjustments may also need to be considered for each class of shares, such as a discount for lack of control or discount for lack of marketability.
In some cases, the appraiser may elect to use a range of values and dates and multiple probabilities for each possible scenario. While this generally requires additional, rigorous analysis, it often helps produce a more accurate valuation.
Differences Between the OPM and PWERM: Why Should You Care?
A primary difference between the OPM and PWERM is that the OPM requires fewer subjective inputs, making it easier and quicker to apply. Conversely, the PWERM can be a more complex undertaking and requires a higher level of expertise. It requires in-depth discussions with management of the subject company regarding subjective details, performing exhaustive research on outcome probabilities, and the construction of complex probability models. Although the PWERM requires additional effort and expertise to apply than the OPM, it generally results in a more favorable and accurate valuation for early stage companies offering stock options.
An often cited deficiency of the OPM is that it assumes that the future possible outcomes for early stage companies are log-normally distributed, a notion that research suggests is unrealistic. In reality, the probabilities of future outcomes for most start-ups are heavily skewed towards failure. By some estimates, the failure rate for start-up companies is as high as 90%.2
Another deficiency of the OPM is that it does not allow for the consideration of the subject company’s future financing needs. In other words, the OPM doesn’t account for the dilution impact of future financing rounds. Due to these weaknesses, the OPM often overvalues the common stock for early stage companies, resulting in higher stock option exercise prices.
In contrast, the probability distribution of future possible outcomes is generally more realistic under the PWERM. Under this method, failure scenarios are generally assigned higher probabilities. Additionally, the PWERM accounts for future financing rounds that the subject company may require to reach an exit. As a result, the estimated value of a company’s common stock is likely to be lower if the appraiser applies the PWERM as opposed to the OPM. As previously discussed, stock options with low exercise prices are more attractive to potential employees. Therefore, it’s often in a company’s best interest to obtain a 409(A) valuation that applies the PWERM.
Companies should consider the tax compliance issues and allocation methods discussed in this article when searching for a third-party appraiser. Before hiring a valuation firm, companies should communicate their goals and be sure that the appraiser possesses the expertise required to apply the above allocation methods and provide defensible support for their conclusions.
This document is for informational use only and may be outdated and/or no longer applicable. Nothing in this publication is intended to constitute legal, tax, or investment advice. There is no guarantee that any claims made will come to pass. The information contained herein has been obtained from sources believed to be reliable, but Mariner Capital Advisors does not warrant the accuracy of the information. Consult a financial, tax or legal professional for specific information related to your own situation.