A Stock Option gives an employee the right to buy a certain number of shares in the company at a fixed price for a certain period, usually three to six years. The price at which the stock option is granted to the employee is called the grant price. Employees who hold stock options expect the exercise price to be lower than the market price of the underlying shares which implies that they have an opportunity to profit from buying the shares at a lower price (exercise price) and selling them at a higher one (market price).
There are two kinds of stock option plans: incentive stock options (ISOs) and non-qualified stock options (NSOs). The key differences between the two are summarized below:
- ISOs can only be granted to company employees whereas NSOs can be granted to employees, consultants, contractors, board members who are not also employees of the company, etc.
- ISOs are taxed based on capital gains. The condition for this, however, is meeting the holding period requirements set by Section 422 of the Internal Revenue Code (Code). The qualifying holding period is defined as 1 year from the exercise date and at least 2 years from the grant date. If the holding period requirement is not met, meaning the ISOs are acquired as a result of a disqualifying disposition, the proceeds are taxed as ordinary income. NSOs, on the other hand, don’t have any such holding period requirements since the profits made on exercising them are always taxed as ordinary income, which is a higher tax rate than capital gains tax.
- ISOs may be exposed to Alternate Minimum Tax (AMT) adjustment in the US, for instance in cases where the spread is too large. In some cases, AMT can be considerable enough to prohibit the employee from exercising the options due to the inability of the employee to afford the AMT taxes.
- There is no tax withholding in ISOs, instead the employee and the IRS are provided with a notice citing the spread on the ISO that is exposed to AMT by January 31st of the year that follows the exercise of said option. Situations where the employee doesn’t realize that they are unable to afford the AMT owed until a much later date are more likely to occur. In the case of NSOs, the tax withholding is calculated at the time of exercising the options, which also means that the employee cannot exercise the NSO until the tax withholding amount has been calculated. This allows the employee to understand the tax consequences of the stock option in order to make an informed decision whether to exercise the option or not.
- The spread on NSOs is tax deductible for the company offering the stock options. The spread on the ISOs is generally not tax deductible. It can be tax deductible only in a case where an employee exercises his/her options before the holding period requirements are fulfilled.
- In any given year, ISOs adding up to a total value of $100,000 should become exercisable as another requirement of the Internal Revenue Code. Additionally, ISOs should not be immediately exercisable.
Stock options are a way for companies to reward their employees for their performance, provide an incentive to align their interests with those of the company and contribute towards its growth and attract motivated employees. Smaller companies focusing on growth can use stock options to maintain cash reserves for investments by redirecting the cash from traditional compensation and replacing part of the compensation for the employees with stock options. This allows employees holding these options to access a piece of the future growth. Public firms on the other hand already have well-established benefit plans in place. These companies can make use of stock options to include the employees in ownership of the company. The dilutive effects of stock options are often very small, offset by the benefits of retaining productive employees promising future growth.
It is important for the companies granting stock options as compensation to set the exercise price of the underlying shares at or above the fair market value (FMV) arrived at by having an independent valuation performed at the time of grant. Failing to do so results in the employees holding the options, that cannot be shown to be at or above a reasonably-determined FMV at the time of grant, face tax implications on vesting at a tax rate as high as 85%.
Section 409A of the Internal Revenue Code requires the options holder to have an exercise price below the FMV at the time of grant to report taxable income equal to the spread between the exercise price and the FMV of the underlying shares as the options vest. The option holder, consequently, is taxed on the income the holder does not actually receive. In addition to the federal income and employment taxes, an additional 20% federal tax applies under these conditions. The company is required to withhold these taxes with respect to employees and failure to do so makes the company liable for these taxes, penalties and interest.
To avoid these tax implications and to qualify the stock options granted by a company to be exempt from Section 409A, it is important for the companies granting the stock options as compensation to set the exercise price of the underlying shares at or above the FMV arrived at by having an independent valuation performed at the time of grant. For public companies, the FMV of the underlying shares is determined daily. For private companies, FMV needs to be determined by an independent valuation applying appropriate valuation methodologies. The regulations under Section 409A state that if a method is applied reasonably and consistently, such valuations will be presumed to represent FMV, unless shown to be grossly unreasonable. Consistency in application is assessed by reference to the valuation methods used to determine FMV for other forms of equity-based compensation. An independent valuation will be presumed reasonable if ‘the appraisal satisfies the requirements of the Code with respect to the valuation of stock held in an employee ownership plan’. A reasonable valuation method considers the following factors:
- The value of tangible and intangible assets – The present value of future cash flows
- The market value of comparable businesses (both public and private)
- Other relevant factors such as control premiums or discounts for lack of marketability
- Whether the valuation method is used consistently for other corporate purposes
Therefore, a reasonable valuation considers the market, income and replacement cost approaches, and considers the specific control and liquidity characteristics of the subject interest. The Code also requires that the valuation of common stock for the purposes of Section 409A be consistent with valuations performed for other purposes. The valuation applies for up to 12 months. It needs to be revised earlier than 12 months when intervening events would reasonably and materially impact the FMV.
So, what makes a qualified determinant of FMV? A reliable independent valuation is prepared by an independent valuation firm with a background
in valuation and finance, has accumulated significant professional experience and holds one or more professional credentials, CVA, ASA, ABV, CBA
or CFA. The professionals at Avenue M® Advisors, Inc. possess the professional credentials, designations, knowledge and experience necessary
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