Six Mistakes to Avoid When Issuing Common Stock Options

Whether you are part of an up-and-coming start-up or a more established company, you’ve probably faced challenges recruiting in the technology job market.  Companies need to issue competitively priced stock options in order to attract the best and brightest.  But from time to time, companies have made costly mistakes which resulted in invalid option grants and damage employee morale.  Teknos has highlighted six mistakes to avoid when issuing common stock options so that your company can avoid future problems.

1.  Not Renewing a Valuation Report After 12 Months

This is probably the most common mistake that companies make in connection with stock option issuance.  We regularly see companies issue options using a valuation report that is more than 12 months old.  A key provision of IRC §409A is that obtaining an “independent appraisal” places a company in a regulatory “safe harbor”.  But that protection is only valid for 12 months (or less if the company experiences a “material change”, such as a financing).  If a company issues options after the 12 month anniversary date (from the valuation date, not the report date) without obtaining a new valuation report, those options will expose the option recipients to the 20% penalty tax (California imposes an additional penalty tax.  See California Lowers Penalty Tax for IRC §409A Violations.).

2.  Using a “Rule of Thumb” to Price Options

Before IRC §409A went into effect in 2009, most boards of directors did not devote much time to stock option pricing.  A common practice was to apply a “rule of thumb” (e.g., 10% of the price of the last round of preferred stock) to price common stock.  This practice was never accepted by the regulators and was one reason for the creation of IRC §409A.  Stock option strikes prices must be set in reliance on a valuation report.

3.  Overvaluing Stock Options

While it is more common to see stock option stirke prices set too low, Teknos has seen companies overvalue their common stock options.  Some foreign companies are not familiar with US tax and accounting regulations and set the price of common stock options at the same level as the price of preferred stock.  In other cases, companies with private equity backing also priced common stock options at the same level as the preferred stock.  Teknos has been retained to retrospectively re-value stock options that had been priced too high.

4.  Not Considering the Effect of a Multi-stage Financing

Many financings are arranged so that the funds arrive in stages or tranches.  This is especially true with life science companies in drug development, but it happens in other industries too.  A company needs to consider whether receiving a second or third tranche is a “material change” that triggers the need for a new IRC §409A valuation.

We have seen companies assume that if the later tranches purchase preferred stock at the same price as the first tranche, then there is no change in the value of the common stock and no IRC §409A risk.  But, even if the additional funds are invested at the same price as the earlier funds, the new funds could change the value of the common stock.  If the value of common rises – as it usually does –  then stock options issued after the second or third tranche will not be in the IRC §409A “safe harbor” and the employees who receive them could be subject to federal and state tax penalties.

5.  Forgetting to Issue Options to an Employee

Sometimes, companies just forget to issue options to employees after obtaining a valuation report.  This can be a simple administrative oversight, for example, when a board of directors postpones a discussion of option grants to a later board meeting.  But it can be a costly mistake if the company’s 12 month anniversary date to renew a valuation report has passed (see Mistake #1).

Boards of directors should adopt best practices when granting options to ensure that appropriate board action, such as a meeting or written consent, occurs when needed.

6.  Not Hiring a Qualified Appraiser

Sometimes Teknos is retained to re-price options that have not been supported by an independent appraisal or had been valued by a nonqualified firm.  Some of our clients have spent hundreds of thousands of dollars to fix improper option grants.  In addition to having to pay for a new valuation report and the accompanying legal and audit work, companies have had to cancel and reissue options at a higher strike price, with negative consequences for employee morale.

When choosing a qualified appraiser, ensure that the valuation provider has significant valuation experience, has accredited staff, and has had its work successfully reviewed by auditors.

Teknos Associates provides valuation and advisory services for emerging growth companies and their venture capital backers. Clients rely on our financial expertise, knowledge of technology markets, and high standards to deliver relevant and timely valuation reports and fairness opinions.

Special Note:  From time to time, Teknos Associates has been retained by the Internal Revenue Service to perform valuation services.  However, nothing in this communication may be taken to represent the official position or policy of the IRS.  The opinions expressed herein are those only of Teknos Associates.

IRS Circular 230 Disclaimer:  Pursuant to regulations governing the practice of attorneys, certified public accountants, enrolled agents, enrolled actuaries, and appraisers before the Internal Revenue Service, unless otherwise expressly stated, any U.S. federal or state tax advice in this communication (including attachments) is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of (i) avoiding penalties that may be imposed under federal or state law or (ii) promoting, marketing, or recommending to another party any transaction or tax-related matter(s) addressed herein.

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