Six Mistakes to Avoid When Issuing Common Stock Options
October 16, 2013
Whether you are part of an up-and-coming start-up or a more established company, you’ve probably faced challenges recruiting in the
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
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
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
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
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.
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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.
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