Emerging Enterprise Center Blog - Commentary and Analysis For Entrepreneurs and Startups

Last week I had a conversation with an entrepreneur who was confused about option pricing, and no matter how many times I tried to explain it, he never seemed to get his head around it.  Now, there may be a psychological explanation for his inability to understand, because he clearly wanted to hear a particular answer, and it was not what I was telling him.  Nonetheless, option pricing is a topic that comes up all the time in the representation of early stage companies and, while I have written about it before, it is worth one more post.

What is 409A and why do you care?

409A is a section of the Internal Revenue Code that governs the tax treatment of certain options.  409A provides that an option either (1) be an option for common stock of the employer and have a per share exercise price on the date of the grant equal to or greater than the fair market value of a share of common or (2) if the option has an exercise price of less than the fair market value of a share of common stock the recipient and the issuing company suffer some pretty draconian tax consequences.  (There are other ways to comply, but relate to less usual situations, such as options that are only exercisable on a liquidity event, and I am not going into that level of detail here and now.)

What are the draconian tax consequences?

There are three particularly nasty tax consequences:  (1) The recipient of the option will have income equal to the difference between the fair market value of a share of common stock and the exercise price of the option multiplied by the number of options, at the time the option vests, even if the recipient does not exercise the option.  (2) The recipient will get to pay a surtax of 20% over and above his or her normal income tax on the option related income.  (3) For each year for which the option remains outstanding, the recipient will suffer the same nasty tax consequences with respect to any increase in the value of the common stock. 

Why on earth would the IRS create such a rule?

Consider what could happen if the issuing company were publicly traded and was issuing options with below marked exercise prices to its execs.  Need I say more?  Unfortunately, 409A applies to all companies – not solely public ones.

What can I do to avoid the bad tax consequence?

Issue your options with an exercise price equal to or greater than the fair market value of the underlying shares.

How do I know what the fair market value of a share of my privately held technology start-up is?

Here are some ways to price your options:

(1) You can take a guess at the fair market value.  If you guess wrong you are toast.  And, by the way, your guess will be judged with 20/20 hindsight by the IRS.  So, that does not seem like a good solution.

(2) If there is a recent actual arms-length transaction in which common stock was sold, then you have price.  Note that I said “actual,” “recent,” and “arms-length.”  The fact that your lawyer took a few shares a year ago in consideration of an old invoice won’t cut it. 

(3) If you have a financially sophisticated person on your board (or as your CFO), and your company has been in business fewer than 10 years, 409A provides that such person can perform a valuation. 

(4) You can pay an outside appraiser to perform a valuation.   Most (all?), of my clients who have professional money invested in them end up doing this.  It is a toll and it is unfortunate that you have this cost, but that is you tax dollars at work. 

Like my entrepreneur friend, you can want to price options at $.03 but if you sold common stock last week  in an arms-length transaction for $.30 per share, don’t do it.

 Jeff Bussgang has a recent post on why vesting schedules should anticipate the time to exit (the gist of it is that vesting should align VC and employee expectations). In his post he notes that time to exit these days is 6 to 8 years.   His fund is likely performing better than the industry because it is more like 8 than like 6.

In response to a comment from me the effect that vesting should be more keyed around expected milestones than arbitrary time frames, he notes that this is what employees get a salary for. Here is the quote:

Employees get paid salaries to deliver results and cash or stock bonuses help focus on milestones. Stock options are really about earning into equity ownership over time. That equity value is only really realized at exit.

I gave this some thought and I agree and disagree. Options, like money and everything else, have a time value and are only motivating if the option holder really thinks she has a decent chance of actually realizing on their value in this lifetime.

Here is a comment to Jeff Busgang’s post from Healy Jones,

Jeff, this is crazy talk! Keep your hands off my vesting schedule; it seems really long to me as is. ;)

Many of the early employees are not likely to be there in 6, let alone 8, years. (No doubt some will.) Many people who are highly suited for the early stage environment and can (and do) make significant contributions are not well suited for the middle or later stage environments.   A classic example is the first CEO. Let’s be honest, a lot of these folks make a real contribution then get moved on. 

Another point is that many people take employment with start-ups for the equity and not for the salary. My sense is that start-ups don’t pay what IBM or Google pay for the same resumes. The equity is an important (perhaps critical) part of the compensation for the day to day work (for which they are being underpaid in the sense that they could get more cash from Microsoft).

So, my point is that pure time based vesting (whether it is slow or fast) does not make sense because it does not compensate for the work done and the contribution made. I have noted this before from the point of view of founders with co-founders or employees that do not perform.

Milestone vesting may not make sense because milestones can sometimes be hard to define and they can be all over the place. 

So, perhaps some amount of time that makes sense in terms of the horizon in which the employee is expected to make a material contribution is a sensible compromise. Whether that should be 2 years, 4 years or 8 years, perhaps depends. 

Jeff is probably right to point out that the industry seems to have settled on 4 because it reflected some sense of historical time to exit.  That does not mean that we have to live with the logic and change the time frames. 

I work with a lot of very early stage companies and as among founder and very early contributors the vesting time frames vary dramatically. Very short time frames (such as one year or even less) and milestone vesting is common. The reason for this is the one I originally gave. Very early stage companies need to get work done, they can’t pay dollars so they pay equity. In this situation, vesting has to make sense in terms of expected contribution. When the contribution is made, you get your stock. 

If you want to hire W2 employees (people looking to work for a salary) and you want to keep them around, pay the salaries, provide the benefits, and vest the options at a slow rate because the options will be one more good benefit, like a 401K.

Many start-ups would like to be at the stage where this is the need. Unfortunately, the nature of the animal is that there are a lot of other phases you have to go through to get to this place. Vesting is one tool you can use to attract people to work for you for less cash than it might otherwise take. Vesting has a time value. The longer it takes the lower the value to the employee and therefore the lower value options have as a form of currency.

For those of you who know Sim Simeonov, you won’t be surprised or disappointed. He has developed and posed on his site, fastignite.com , a set of start-up tools together with commentary. The tools are good; the commentary is better. The initial set of tools covers (1) calculating true pre-money valuation, (2) getting a better Series A deal, (3) a vesting calculator for options and restricted stock, and (4) option exercise and sale.

With respect to the true pre and post money valuation, Sim points out that Fred Wilson has an insightful post on this topic. I think I agree with what Sim and Fred say on the subject, but I also think it sounds more ominous than it is. Keep in mind that the investor is assuming you will have to spend equity to attract talent. This is analogous to having to spend money for capital expenditures. It has to be a budgeted cost and has to be "in the mix" when you negotiate your deal. Your investor will not overlook this "cost." It will be built into the investor’s valuation assumptions. You just need to look at it the same way. A company that needs to spend money to acquire and IP license is not going to get the same valuation as one that does not (all other factors being equal).

I am coming back to one of my personal bugbears. Clients seem to have a positive desire to express option grants in terms of a percentage of the company, as in "You will receive options to purchase 5% shares of Common Stock of the Company…" The problem is 5% of what? As of when? Usually clients resort the percentage expression precisely because there is some ambiguity in the cap table. This ambiguity is usually around some new money coming in. For example, is it to be 5% before or after the bridge note is converted? Before or after the next round of financing? Or what? I can testify that I have experience and employee pulling out such an offer letter years later at a multihundred million dollar exit and try to claim a percent rather than the number of options he actually had. Now, it did not take long to straighten him out, but do you really want to?

Sometimes practical reality and legal niceties collide like trains guided by Chas Adams. Here is a typical situation that must happen on a daily basis somewhere: I recently had a start up client call up and say that he wants to issue options to a new employee. The company was founded a couple of months ago, founder shares were issued, IP was contributed, options were offered, new guy was hired, client wants to know how to price the options. Enter Section 409A of the Internal Revenue Code which provides that the options must have an exercise price not less than the fair market value of the stock and fair market value be determined “by the reasonable application of a reasonable valuation method.”

Client: “OK, you’re my lawyer, how do I do that?”

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I spend a lot of time with entrepreneurs explaining how restricted stock and Section 83(b) or the tax code work. It was the subject of a prior blog entry. However, it comes up so often and different people absorb the concept in different ways, so I thought it might be worth attacking again in a different way. Restricted stock can have some very material tax benefits when compared with options, especially in the early stages of any venture. So, here is how restricted stock works. I will compare it to options later.

You may want to incent employees by giving them stock. Here is an example. Easy Company decides to incentivize one of its employees by giving her a stake in the company. It then grants to Jane 100,000 shares (assume for the purposes of this example that the shares have a fair market value of $.01 per share). Two things follow. First, Jane owns the stock and, in our example, has no particular incentive to stay of the sort associated with vesting. Second, Jane has income equal to the value of the shares of stock she has been given. In this example she has income of $1,000. Easy Company must report (and withhold taxes for) this income on Jane’s Form W-2  for the year in which she was given the stock, and Jane must pay tax on that income. Now, $1,000 of income does not seem like much, but if the stock had a fair market value of $1.00 per share, Jane would have $100,000 of income on which she would owe tax. If her marginal tax rate is 40%, then she has to pay $40,000 of tax to the feds.

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