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Employee Stock Option Valuations

Hi, Is there any real logic for a private company to price it's emloyee options above the 409A valuation price? It seems like that simply takes incentive/value from employees, and I'm not sure how much it actually transfers in the event of an exit as I assume receipts of exercise options would be included in the acquisition valuation.

Answers

Topic Expert
Jim Timmins
Title: Managing Director
Company: Teknos Associates
(Managing Director, Teknos Associates) |

I have seen boards of directors set the strike price of stock options above the value indicated in a valuation report and have heard three main reasons for this: (1) that the board believes that the value in the most recent valuation report reflects an anomaly (perhaps because of a recent decline in the price of a prominent publicly traded competitor or even the sector) and the things will "go back to normal" shortly; (2) that the board does not want employees with more years of service to be demoralized by new employees working alongside them and holding options with lower strike prices; and (3) that the company is preparing for a high value exit event (e.g. an IPO), knows that there will be a lot of scrutiny (e.g. by the SEC), and wants to forestall any potential questions and problems about the issue.

EMERSON GALFO
Title: CFO
Company: C-Suite Services
LinkedIn Profile
(CFO, C-Suite Services) |

Aside from Jim's excellent response, I will add the timing or age of the 409A valuation report and the executed (or ongoing) initiatives put in place after the report. These initiatives could have added more value to the company. I should point out tho that valuation experts normally anticipate/telegraph the value of these current and future initiatives in their reports so the number should not be too far off.

As a commentary, Boards should be able to defend and communicate or explain (open) the basis of the stock/strike price to their employees. Even in private companies, the days of open communication and open information is gaining ground.

Topic Expert
Jake Feldman
Title: Managing Director
Company: Global TaxFin Advisory Group LLC
(Managing Director, Global TaxFin Advisory Group LLC) |

409A valuation reports are not always diligently prepared even though good money was paid for them, so the IRS could challenge the valuation in hindsight and say the company's value was higher. Consequently, that would mean the options were granted at a bargain value and income assessed to the employees along with taxes. So, it may be safer to be more conservative and set a strike price that's higher than the 409A value.

Of course, on the other hand, the Board may just be cheap and not want to grant value to the employees that's diluting insider owner's interest.

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