How do you set the exercise price of stock options to avoid Section 409A issues?

January 1, 2009

The following mini-FAQ is somewhat based on a WSGR client alert (note: PDF is slow loading).

Do the 409A regulations provide guidance on the valuation of stock subject to “stock rights”?

Yes. The regulations provide guidance regarding acceptable methods for determining the fair market value of: (a) readily tradable (public company) stock, and (b) stock not readily tradable (private company stock).

These regulations represent a significant change in the process for determining the fair market value of private company stock. In order to comply with Section 409A and thus avoid early optionee income recognition and, potentially, a 20 percent additional tax, prior to option exercise, most private companies will need to significantly revamp their fair market value determination process.

What are the acceptable methods for determining fair market value of public company stock?

The fair market value of public company stock may be based upon:

  • the last sale before or the first sale after the grant;
  • the closing price on the trading day before or the trading day of the grant;
  • any other reasonable basis using actual transactions in such stock as reported by such market and consistently applied; or
  • the average selling price during a specified period that is within 30 days before or 30 days after the grant if the valuation is consistently applied for similar stock grants.

What are the acceptable methods for determining fair market value of private company stock?

The fair market value of private company stock must be determined, based on the private company’s own facts and circumstances, by the application of a reasonable valuation method. A method will not be considered reasonable if it does not take into consideration all available information material to the valuation of the private company.

The factors to be considered under a reasonable valuation method include, as applicable:

  • the value of tangible and intangible assets;
  • the present value of future cash-flows;
  • the readily determinable market value of similar entities engaged in a substantially similar business; and
  • other relevant factors such as control premiums or discounts for lack of marketability.

How often do private companies need to perform fair market valuations?

The continued use of a previously calculated fair market value is not reasonable if:

  • the initial valuation fails to reflect information available after the initial date of the valuation that materially affects the value of a private company (for example, resolving material litigation or receiving a material patent); or
  • the value was calculated as of a date that is more than 12 months earlier than the date for which the valuation is being used.

As a practical matter, most venture backed private companies obtain a new valuation report every time they complete a preferred stock financing.

Is there a presumption of reasonableness?

Yes. The regulations provide a presumption that the fair market value determination will be considered reasonable in certain circumstances, including: (a) if the valuation is determined by an independent appraisal as of a date no more than 12 months before the transaction date, or (b) if the valuation is of “illiquid stock of a start-up corporation” and is made reasonably, in good faith, evidenced by a written report, and takes into account the relevant valuation factors described above.

This presumption of reasonableness is rebuttable only upon a showing by the IRS that either the valuation method, or the application of such method, was “grossly unreasonable.”

What is an “illiquid start-up corporation”?

Stock will be considered to be issued by an “illiquid start-up corporation” if:

  • the company has not conducted (directly or indirectly through a predecessor) a trade or business for a period of 10 years or more;
  • the company has no class of securities that are traded on an established securities market;
  • the stock is not subject to put or call rights or other obligations to purchase such stock (other than a right of first refusal or other “lapse restriction” such as the right to purchase unvested stock at its original cost);
  • the company is not reasonably expected to undergo a change in control or public offering within 12 months of the date the valuation is used; and
  • the valuation is performed by a person or persons “with significant knowledge and experience or training in performing similar valuations.”

This may result in additional expense and burden for smaller companies (for example, having to hire an appraisal firm). Also, this could be problematic for companies issuing stock options or SARs within a year prior to a change in control or an initial public offering.

Are the typical, historical fair market value determinations made by private company boards of directors permissible under Section 409A?

Generally, no. The regulations have significantly changed the method by which a private company determines the fair market value of its stock. For example, valuation of private company stock solely by reference to a ratio related to the value of preferred stock (the old 10 to 1 ratio) generally will not be reasonable.  Specifically, to comply with the proposed regulations, the valuation of “illiquid start-up corporation stock” must be:

  • evidenced by a written report which takes into account the relevant valuation factors discussed above; and
  • performed by a person or persons with significant knowledge and experience or training in performing such valuations.

Consequently, unless a private company board includes a director, or directors, who would satisfy the “significant knowledge and experience” requirement or a company employee satisfies this requirement, the determination of fair market value most likely will need to be made by an independent appraisal. However, if one of the private company directors is a representative of a venture capital investor, or if the company employs individuals with financial expertise who would satisfy the “significant knowledge and experience” requirements, it may be permissible for the written valuation report to be prepared by such individuals.

Are most companies getting independent appraisals done?

Any company that has completed a preferred stock financing with an institutional venture capital firm typically will get a 409A valuation report from an independent appraisal firm.  Most pre-VC financed companies that are not issuing large option grants will not incur the expense of a valuation report.

How much does a valuation report cost?

I have had early stage companies get valuation reports done for as cheaply at $5K.  However, these valuation reports may be rejected by the company’s auditors, resulting in the need to have them redone by another firm.  Valuation reports done by more reputable firms may cost $10K to $25K, and even higher for later stage companies.

What is the typical fair market value of the common stock in relation to the preferred stock price for an early stage company?

The CEO of a boutique valuation company told me recently that the fair market value of the common stock of a typical early stage technology company is at least around 25% to 30% of the last round preferred stock price.  The old rule of thumb that the option exercise price could be 10% of the preferred stock price is not valid.

Comments

  • Geo

    If a startup company is pre-revenue and pre-VC financing, but has a convertible note seed financing of $800K, can it offer options at an exercise price equal to the common stock par value of $0.01 to staff joining before the VC financing. I get it that after the VC round it will have to equal 25%-30% of the Series A VC preferred price, based on what's above, but what about during the angel-seed-convertible note stage?

  • http://www.startupcompanylawyer.com Yokum

    @Geo – Tough call. Options need to be granted at FMV. If a company is able to raise $800K of financing, it probably means that FMV of the common is greater than nominal. BTW, $0.01 is a meaningless number without more context.

  • http://www.startupcompanylawyer.com Yokum

    @Geo – Tough call. Options need to be granted at FMV. If a company is able to raise $800K of financing, it probably means that FMV of the common is greater than nominal. BTW, $0.01 is a meaningless number without more context.

  • Ianakamel

    What if the start-up company has not gone through a round of financing, is pre-revenue, does not currently own any assets, but is having engineers research and develop a proof-of-concept for an idea that the company's owner has for a new product. If the start-up wants to offer the engineers options such that, if the engineers are successful in developing the proof-of-concept (thereby allowing the company to actually patent the idea), the engineers can enjoy the upside potential of their efforts, can the company set the exercise price at or near zero (since the company currently doesn't own anything, has no cash flow, and has had no financing), or does it have to assume future cash flows based on a possible product, and then add an extra layer of discount to reflect the probability (as opposed to the the certainty) of developing the product successfully and receiving cash flows from it at a later date? Thanks!

  • Mike

    Yokum, what is the latest thinking on how to price common stock options for an early stage company?  I saw that in 2009, a valuation firm said 25-30% of the preferred stock price.  Is that the current thinking?

    Mike O.