Let’s say it’s March 2024 and you have some stock options you would like to grant members of your team. You’ve heard that you can rely on a tax code Section 409A valuation for up to 12 months. You received a valuation of $0.30 per share effective as of December 31, 2023, so you should be good, right?
Maybe. But what if you recently received a term sheet for a financing?
To fall within the safe harbor a Section 409A valuation must reflect all information that “may materially affect the value of the corporation (for example, the resolution of material litigation or the issuance of a patent)”.[1] The general view of tax practitioners is that receipt of a signed term sheet for a financing (unless for an immaterial amount) invalidates an otherwise current Section 409A, rendering it stale.
This can be particularly painful if the to-be optionees were told their options would be granted with an exercise price of $0.30 per share.
So what can you do?
I would get an updated valuation which takes this term sheet into account prior to issuing new stock options. If price goes up and you want to get the employees the benefit of the prior price you could:
- Sell the employees stock at $0.30 per share while recognizing the delta as compensation that would have tax withholding that would need to be satisfied; OR
- If the option is fully an incentive stock option (ISO) grant a tandem bonus payable when the option is exercised intended to reduce the effective exercise price to $0.30 per share; OR
- If the option is fully or in part an nonstatutory stock option (NSO) grant a bonus that doesn’t reference the option at all and is not tied to exercise but pays out an amount on an exit subject to continuous service that only roughly (use rounding) approximates the lost value due to the increased exercise price; OR
- Grant a 409A-compliant discount nonstatutory stock option with a $0.30 exercise price (no new 409A valuation needed for this alternative) that is only exercisable within 90 days post-termination or at an exit if earlier. This might require an amendment to the company’s equity incentive plan or to be granted outside of the equity incentive plan. For more details regarding discount stock options see here.
Mike Baker frequently advises with respect to stock options. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.
[1] See Treasury Regulation Section 1.409A-1(b)(5)(iv)(B)(1).