How much should you pay an executive in a startup company?

May 1, 2009

CompStudy publishes an annual report of equity and cash compensation that provides compensation data on top management positions and Boards of Directors at private companies in technology and life sciences.  CompStudy covers more than 25,000 executives at 5,000 companies and is the largest study of its kind.

Data is analyzed by: founder/non-founder status, company revenue and headcount, geography, business segment, and number of financing rounds raised. Additional detail is provided on compensation for the Board of Directors, general organizational changes over time and other compensation trends.

The survey consists of a Web-based questionnaire, which can be filled out by a single member of a company’s executive team and takes approximately 45-60 minutes to complete.

CEOs or CFOs of startups in the US, China, India, Israel, or the UK in the technology or life science industry should consider taking the survey.   Participants who complete the survey will receive the full results at no cost. 

The 2008 results are available on Altgate and are also embedded below.

For example, below are the 2008 results for average equity granted at time of hire in IT companies:

  • CEO 5.40%
  • President/COO 2.58%
  • CFO 1.01%
  • Head of Technology/CTO 1.19%
  • Head of Engineering 1.32%
  • Head of Sales 1.20%
  • Head of Marketing 0.91%
  • Head of Business Development 1.23%
  • Head of Human Resources 0.24%
  • Head of Professional Services 0.60%

2008 CompStudy Report in Technology

Publish at Scribd or explore others: Law & Government Business & Law startup equity

2008 CompStudy Report in Life Sciences

Publish at Scribd or explore others: Law & Government Business & Law startup equity

Should a company allow option exercises with promissory notes?

January 18, 2009

I typically discourage companies from allowing option exercises by means of a promissory note. Promissory notes can provide employees a means of exercising options and starting their capital gains holding periods without coming up with cash. However, the promissory notes must be substantially full recourse to start the capital gains holding period, which creates a real obligation for the employee even if the stock eventually becomes worthless. A bankruptcy trustee might attempt to collect on a full recourse note in the event the company goes bankrupt. Full recourse means that the note is a general obligation of the employee, as opposed to recourse being limited to the stock purchased in the event of default.

If the promissory note isn’t substantially full recourse, then the option isn’t deemed to be exercised for tax purposes. If the note is repaid (or forgiven) in the future and there is a difference between the purchase price and fair market value at that time, then the employee may have a taxable event. In addition, if the note is forgiven, it will create debt forgiveness income to the employee.

Promissory notes can create accounting problems for the company as well, and they create administrative complexities. Finally, loans to executive officers have received intense public scrutiny over the past several years, and public companies are now barred from making loans to (or materially modifying existing loans to) executive officers.

Should a company allow early exercise of stock options?

January 11, 2009

Some companies allow employees to exercise their unvested stock options, or “early exercise.”  Once purchased, the unvested stock is subject to a right of repurchase by the company upon termination of services.  The repurchase price is the exercise price of the option.  Please note that a stock option is typically not early exercisable unless the board of directors of the company approves an option grant as early exercisable and the company issues the stock option pursuant to an option agreement that permits early exercise.

Allowing early exercise of unvested shares can provide employees with a potential tax advantage by allowing the employee to start their long-term capital gains holding period with respect to all of their shares and minimize the potential for alternative minimum tax (AMT) liability.  If an employee knows that he/she will early exercise a stock option immediately upon the grant of an option (when there is no difference between the exercise price and the fair market value of the common stock), the employee typically should want an NSO as opposed to an ISO, because long-term capital gain treatment for stock issued upon exercise of an NSO occurs after one year.  In contrast, shares issued upon exercise of an ISO must be held for more than one year after the date of exercise and more than two years after the date of grant, in order to qualify for favorable tax treatment.

There are several disadvantages to allowing early exercise, however, including:

  • Risk to employee.  By exercising a stock purchase right or immediately exercisable option the employee is taking the risk that the value of the stock may decrease. In other words, the exercising employee places his or her own capital (the money used to purchase the stock) at risk. Even if a promissory note is used to purchase the stock (future post to come), the note must be full recourse for the IRS to respect the purchase. In addition, if the employee purchases the shares with a promissory note, the note will continue to accrue interest until it is repaid, and a market rate of interest must be paid in order to satisfy accounting requirements. Depending on the number of shares purchased, the expected tax benefit from early exercise may not justify these increased risks to the stockholder.
  • Tax upon spread. If there is a “spread” at the time of exercise, the employee will trigger ordinary income (in the case of an NSO exercise equal to the difference between the exercise price and fair market value of the common stock on the date of exercise) and may trigger AMT liability (in the case of an ISO exercise, with the difference between the exercise price and fair market value of the common stock on the date of exercise being an AMT preference item). Any taxes paid will not be refunded if unvested shares are later repurchased at cost. (Please see the post “What’s the difference between an ISO and an NSO?” for a summary of the tax implications of exercising an ISO or an NSO.)
  • “Back door” public company.  Allowing employees to early exercise may increase the number of stockholders.  If the company ever reaches 500 stockholders, Section12(g) of the Securities Exchange Act of 1934 will require the company to register as a publicly reporting company.
  • Securities law issues upon a sale.  If the company has more than 35 unaccredited stockholders at a time when it has agreed to be acquired in a stock for stock transaction, the acquisition will likely be more complex and take longer to complete.
  • Administrative hassles.  A significant increase in the number of stockholders can place a tremendous administrative burden on the company. This is especially true when employees purchase shares subject to repurchase and when they purchase shares with promissory notes. The forms that the employee must complete and sign are much longer and more complicated. 83(b) elections must be filed with the IRS within 30 days of the purchase. Stock certificates for unvested shares must be kept by the company so that they can be easily repurchased if the employee leaves the company, which increases the risk that the stock certificates are lost or misplaced. Interest on promissory notes must be tracked.
  • Stockholder rights. Optionees have no rights as stockholders until they exercise their stock options.  If optionees exercise stock options, whether vested or unvested, they have the same voting rights as any other stockholder. Certain actions, such as amendment of the certificate of incorporation, which typically occurs in connection with every venture financing, require stockholder approval.  This requires certain information to be provided to the stockholder in order to make an informed decision.  Stockholders also have more statutory rights than optionees, including inspection rights. Stockholder information requirements may also be triggered under Rule 701.

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.

What’s the difference between an ISO and an NSO?

March 5, 2008

[The following is not intended to be comprehensive answer. Please consult your own tax advisors and don't expect me to answer specific questions in the comments.]

Incentive stock options (“ISOs”) can only be granted to employees.  Non-qualified stock options (“NSOs”) can be granted to anyone, including employees, consultants and directors. 

No regular federal income tax is recognized upon exercise of an ISO, while ordinary income is recognized upon exercise of an NSO based on the excess, if any, of the fair market value of the shares on the date of exercise over the exercise price. NSO exercises by employees are subject to tax withholding. However, alternative minimum tax may apply to the exercise of an ISO.

If shares acquired upon exercise of an ISO are held for more than one year after the date of exercise of the ISO and more than two years after the date of grant of the ISO, any gain or loss on sale or other disposition will be long-term capital gain or loss. An earlier sale or other disposition (a “disqualifying disposition”) will disqualify the ISO and cause it to be treated as an NSO, which will result in ordinary income tax on the excess, if any, of the lesser of (1) the fair market value of the shares on the date of exercise, or (2) the proceeds from the sale or other disposition, over the purchase price.

A company may generally take a deduction for the compensation deemed paid upon exercise of an NSO.  Similarly, to the extent that the employee realizes ordinary income in connection with a disqualifying disposition of shares received upon exercise of an ISO, the company may take a corresponding deduction for compensation deemed paid. If an optionee holds an ISO for the full statutory holding period, the company will not then be entitled to any tax deduction.

Below is a table summarizing the principal differences between an ISO and an NSO.

  ISO NSO
 Tax Qualification Requirements: * The option price must at least equal the fair market value of the stock at the time of grant.

* The option cannot be transferable, except at death.

* There is a $100,000 limit on the aggregate fair market value (determined at the time the option is granted) of stock which may be acquired by any employee during any calendar year (any amount exceeding the limit is treated as a NSO).

* All options must be granted within 10 years of plan adoption or approval of the plan, whichever is earlier.

* The options must be exercised within 10 years of grant.

* The options must be exercised within three months of termination of employment (extended to one year for disability, with no time limit in the case of death).

None, but an NSO granted with an option price less than the fair market value of the stock at the time of grant will be subject to taxation on vesting and penalty taxes under Section 409A.
Who Can Receive: Employees only Anyone
How Taxed for Employee: * There is no taxable income to the employee at the time of grant or timely exercise.

* However, the difference between the value of the stock at exercise and the exercise price is an item of adjustment for purposes of the alternative minimum tax.

* Gain or loss when the stock is later sold is long-term capital gain or loss. Gain or loss is the difference between the amount realized from the sale and the tax basis (i.e., the amount paid on exercise).

* Disqualifying disposition destroys favorable tax treatment.

* The difference between the value of the stock at exercise and the exercise price is ordinary income.

* The income recognized on exercise is subject to income tax withholding and to employment taxes.

* When the stock is later sold, the gain or loss is capital gain or loss (calculated as the difference between the sales price and tax basis, which is the sum of the exercise price and the income recognized at exercise).

What is Section 409A?

January 19, 2008

Background

On April 10, 2007, the Internal Revenue Service (IRS) issued final regulations under Section 409A of the Internal Revenue Code. Section 409A was added to the Internal Revenue Code in October 2004 by the American Jobs Creation Act.

Under Section 409A, unless certain requirements are satisfied, amounts deferred under a nonqualified deferred compensation plan (as defined in the regulations) currently are includible in gross income unless such amounts are subject to a substantial risk of forfeiture. In addition, such deferred amounts are subject to an additional 20 percent federal income tax, interest, and penalties. Certain states also have adopted similar tax provisions. (For example, California imposes an additional 20 percent state tax, interest, and penalties.)

Implications for discount stock options

Under Section 409A, a stock option having an exercise price less than the fair market value of the common stock determined as of the option grant date constitutes a deferred compensation arrangement. This typically will result in adverse tax consequences for the option recipient and a tax withholding responsibility for the company. The tax consequences include taxation at the time of option vesting rather than the date of exercise or sale of the common stock, a 20% additional federal tax on the optionee in addition to regular income and employment taxes, potential state taxes (such as the California 20% tax) and a potential interest charge. The company is required to withhold applicable income and employment taxes at the time of option vesting, and possibly additional amounts as the underlying stock value increases over time.

Please also see the post on “How do you set the exercise price of stock options to avoid Section 409A issues?

Additional information

Below are links to all of WSGR’s client alerts on 409A.

You can assess the applicability of Section 409A by reviewing WSGR’s client alerts covering various aspects of Section 409A and the final Section 409A regulations in detail, including:

Highlights of the Final Section 409A Regulations (published April 16, 2007)

Stock Rights Under Final Section 409A Regulations (April 19, 2007)

Separation Pay Arrangements under the Final Section 409A Regulations (April 27, 2007)

A Road Map for Traditional Nonqualified Deferred Compensation Plans under the Final Section 409A Regulations (May 17, 2007)

Action Items for Compliance with Section 409A Final Regulations (June 12, 2007)

IRS Provides Transition Relief until December 31, 2008, for Section 409A Compliance (October 24, 2007)

Compliance Required with Section 409A before December 31, 2008 (June 12, 2008)