Stock Options: Have They Lost Their Luster?

Editor’s note: Linda Markus Daniels is a member of the Technology Group of Ward and Smith, P.A.

RALEIGH – In April of this year, the IRS released its long awaited and lengthy interpretations of Internal Revenue Code Section 409A, setting forth new rules (the "Regulation") related to, among other things, the issuance of non-statutory stock options ("NSOs"). The Regulation includes a significant tax penalty related to the issuance of NSOs with an exercise price less than the fair market value of the underlying stock as of the date of the grant. While incentive stock options ("ISOs") have always been required to be granted with an exercise price of fair market value, the circumvention of this requirement by issuing NSOs well below the fair market value price has been used widely to provide incentive compensation to key corporate players.

With the new Regulation, however, not only is this effectively prevented, but the company issuing the stock option must be certain that fair market value is accurately established to avoid risk of the tax penalty.

How Difficult Is It to Determine Fair Market Value?

Until issuance of the Regulation, fair market value could be set by the Board of Directors in good faith–and, in fact, that remains a possibility today in establishing stock value for the exercise price related to the issuance of ISOs. Under the Regulation, however, a company risks the tax penalty if it does not set the exercise price for an NSO based on one of the safe harbor tests set forth in the Regulation, implementation of which can be costly to the company.

The safe harbor tests include a requirement that the valuation be undertaken by a person of appropriate knowledge, experience, education, or training and that the valuation take into account the following factors: the value of tangible and intangible assets of the company, the present value of the company’s anticipated future cash flows, the market value of the stock or equity interest in other entities engaged in substantially the same business, recent arm’s length transactions involving the sale of such stock, and other relevant factors such as control premiums or discounts for lack of marketability. Thus, the board can no longer simply make a good faith determination of the value of the company itself, even if it undertakes its analysis and decision based on these factors. In order to fall within the safe harbor, the Board is now required to retain the services of a qualified appraiser–although under some circumstances this appraiser can be an employee of the company.

Why not Rely on ISOs to Avoid this Expensive Valuation Process?

Since ISOs are not subject to these valuation restrictions, it seems at first glance that the logical conclusion is simply to use ISOs instead of NSOs. Unfortunately, ISOs may be granted only to employees of a company. Consequently, companies must continue to rely on the issuance of NSOs if options are to be granted to directors or consultants in connection with their services to the company.

In addition, in order to qualify as an ISO, the option must comply with a number of other restrictions set out in the applicable tax statutes and regulations, restrictions which are not imposed on NSOs and are often too restrictive to achieve the intended purpose of the option grant. These additional ISO restrictions include:

• The option may not be granted prior to the initial date of the optionee’s employment or extend beyond three months after the termination of the optionee’s employment.

• The option price must be the fair market value of the underlying stock as of the date of the grant, except with respect to any optionee holding more than 10% of the shares of the company (aggregated to include all members of the optionee’s family), in which case the price must be at least 110% of the fair market value.

• No option may be exercised until six months after it is issued.

• The term of the option may not exceed ten years, except with respect to any optionee holding over 10% of the shares (aggregated to include all members of the optionee’s family), in which case the term may not exceed five years.

• Options may not be transferred except upon death of the optionee.

• Employees exercising the options must hold the stock until the latter of two years after the date of the grant of the option or one year after the exercise of the option.

• The aggregate fair market value of stock with respect to which ISOs are exercisable for the first time by any optionee during any calendar year (based on the fair market value of the stock at the time of the grant of the options) may not exceed $100,000.

As a further concern, there are many circumstances under which options originally granted as ISOs subsequently fail to qualify as such. Common examples are extensions of the option term for more than three months after the optionee’s termination of employment, and the sale of stock purchased upon exercise of an ISO within less than one year after exercise of the option. In these and other instances where the protections granted to the holders of ISOs no longer obtain, if the price for the option was not set in accordance with Section 409A, then the holder of the disqualified ISO could be subject to the tax penalty under the Regulation if the exercise price is found not to have been the actual fair market value as of the date of the grant.

Are There any Other Limitations Being Imposed on Options?

Since options are a form of equity, they are subject to federal and state securities laws in the same manner as any issuance of stock. In most instances, there is an exception at the state level for options granted to employees, officers, directors, and individual consultants of the company under a plan approved by the company’s shareholders. At the federal level, the SEC has issued Rule 701, which provides an exemption for the issuance of options granted to employees and consultants (including board members) of a non-public company, provided that the aggregate exercise price of the stock options granted by the company under Rule 701 plus the aggregate offering price of the securities of the company sold during any consecutive 12-month period in reliance on Rule 701, does not exceed the greatest of (i) $1 million, or (ii) 15% of the total assets of the company, measured as of the company’s most recent annual balance sheet date; or (iii) 15% of the outstanding amount of the class of securities being sold in reliance on the Rule, measured as of the company’s most recent annual balance sheet date. Any options that cannot meet these requirements, must be granted pursuant to a different exemption, which exemption may be difficult to find.

Conclusion

A combination of the tax and securities laws and regulations is making it harder and harder to use compensatory stock options. The risk of "getting it wrong" and ending up with tax penalties is high, and the compliance cost to avoid this risk may be too much for start-up companies to bear–even with some reduced standards that have been implemented for them. ISOs are not available for all (or perhaps most) desired compensatory option uses, and it is likely only a matter of time before the valuation requirements for NSOs are applied equally to ISOs. The days of penny options are over–but are all options going to follow in the same path as a result of what many see as over-regulation? Is a tech company tradition dying a regulatory death?

© 2007, Ward and Smith, P.A.

This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.