How to Price Stock Option Grants: Practical Considerations

September 17, 2021

A precondition to the issuance of stock options by private employers is the formal determination of an exercise price. This requirement arises from Section 409A of the Internal Revenue Code which mandates that the exercise price of a stock option be not less than the fair market price (“FMV”) of the underlying stock at the time of the grant. An underpriced stock option is -in accounting parlance – “discounted” and the IRS (and certain states like California) penalizes holders of such discounted stock options by taxing the stock options at each vesting milestone (IOW not deferring the taxability of the stock option which is a main function of the equity form in the first place) and also imposing a tax penalty for noncompliance (twenty percent in case of the IRS). Section 409A has effectively removed discounted options as an available incentive arrangement for US companies.

As a result, startups have two basic choices when issuing equity to employees:

i) first, a startup may opt to issue straight grant stock (a grant which is governed by Section 83 of the Code and not 409A); or ii) second, it may engage a third party valuation company to produce a 409A appraisal report (establishing the FMV of the common stock) prior to issuing stock options. The cost for this valuation exercise varies, but for planning purposes $3k - $10K is in the right ballpark.

Formally, 409A permits companies to establish FMV by any “reasonable application of a reasonable valuation method” and further IRS interpretative regulations have identified three “safe harbor” methods: (i) the aforementioned third party appraisal, (ii) a “formulaic” determination of value using a formula that meets certain IRS guidelines, and (iii) an “illiquid start-up appraisal” whereby a valuation and written report is conducted and prepared by a person with “significant experience” in performing such valuations.

Start-ups, however, typically lack the administrative capacity, personnel qualifications and/or risk appetite to competently carry out a “formulaic” determination or an “illiquid start-up appraisal” and thus outsourcing the appraisal to an independent third party is often the most viable option. 409A valuations expire at the earlier of 12 months or upon the occurrence of a “material event” (such as a financing round of equity or debt financing) that may change the FMV of the underlying stock, whichever occurs first. Accordingly, startups must reperform (often referred to as a “refresh”) the third party appraisal on a regular cadence.

This alert was prepared by Jake Molland, a Principal at Bound Legal Strategy P.C. The content of this alert is informational only and does not constitute legal or professional advice. Please note that the law changes frequently and further that the generalized information reflected in this alert may not address the specifics of a given factual situation. Please contact Jake at jake.molland@boundlegal.com if you have specific questions or concerns relating to any of the topics covered in here.