As a Senior Financial Analyst at Economics Partners, I have heard time and time again, “I promised stock options to my employees and have yet to deliver”. Issuing stock options should be simple, but due to IRC Section 409a, created through the American Jobs Creation Act of 2004, employers cannot simply issue options with an exercise price that “feels right”. As such, standard practice is that a third-party valuation firm is engaged and assesses the value of a company’s common stock which becomes the exercise price at which that employer may issue options.
Within the United States, equity compensation plans require that businesses ensure the targeted exercise price is supported by the fair market value of a business’s common stock as of the option grant date. If a company desires to issue options or any other form of deferred compensation to its employees, the company must seek an expert adviser who will give a fair/conservative assessment.
According to the IRS, a firm should have significant experience, which the IRS defines as at least five years of relevant experience in business valuations. The AICPA Practice Aid suggests that companies select a valuation specialist with professional certifications (for example: ASA, ABV, CPA, CVA). In addition, a company should consider the provider’s reputation. A Google search might be helpful; however, a company should consider reaching out to references, law firms and/or accounting firms, or checking for firm rankings and reviews.
BEYOND THE SUGGESTIONS FROM THE AICPA, COMPANIES SHOULD CONSIDER DOING THE FOLLOWING:
Overall, the IRS takes the 409a requirement seriously. Undervaluing the company, or not having a 409a valuation performed can lead to severe penalties imposed by the IRS. In contrast, overvaluing the company will cause employees to recognize less income than they otherwise would have. Errors in either direction can lead to audit headaches as well as issues at the time of a liquidity event. Determining the fair market value and the value per Common Stock share, is a tightrope walk for providers, but an experienced provider understands how to maneuver across and deliver reports that satisfy tax and reporting requirements while making sense to all stakeholders.
Inexpensive can become long-term expensive as the price of a 409a valuation may be reflective of rigor and quality. As such, there could be hidden costs, such as having to re-price stock options and having to restate stock-based compensation for purposes of financial reporting – which can be costly in auditor billing hours. In addition, if options are re-priced, an employer may need to ensure that the recipient of the re-priced options feels whole on what they believe they are giving up in lost spread if they don’t want unhappy employees. As such, consider the quality and potential value add a quality firm can bring rather than deciding purely on price. Warren Buffett once said, “Price is what you pay. Value is what you get.”
Options used as incentives can be a powerful motivational tool. Growth-stage companies are walking a well proven path in using stock options as part of an overall compensation package. They should deliver on granting those options in a timely way and a quality valuation firm can be a trusted resource to help make that happen.