Legal Requirements of Establishing the Strike Price: Determining the Fair Market Value of Stock in a Start-up or Early Stage Corporation when Granting Stock Options

August 24, 2020

By: Ryan M. Tharp

This article is intended to help founders of start-up or early stage corporations value shares of the corporation’s common stock in connection with granting stock options to employees or service providers. If your company is a limited liability company, you should talk to your accounting or legal advisors before granting options to purchase membership interests – this article does not apply to LLCs. Further, this article assumes that the corporation’s common stock is not publicly traded.

A common way to incentivize employees and other service providers is to grant stock options. A stock option is a right to purchase a certain number shares of the corporation’s common stock at a pre-determined price (often called the “strike price,” “exercise price,” or “option price”). Stock options are classified under the federal tax code as either “incentive stock options” (ISOs) or “non-qualified options” (NQOs), depending on whether the recipient is an employee and whether certain other requirements are satisfied.

One principal common to all stock options is that the strike price should equal or exceed the fair market value of the shares on the date the option is granted. For incentive stock options, this is a statutory requirement. For non-qualified options, if the strike price is less than the fair market value of the shares, the option may be subject to penalties related to deferred compensation – which most people would prefer to avoid.

This rule seems simple enough on its face. But it requires the corporation to value its stock, which can seem surprisingly complex for a start-up or early stage corporation. 

This article discusses the legal requirements for valuing a share of common stock as part of setting the strike price. This article does not address the various valuation methods that may be used. Common valuation methods include multiples of annual recurring revenue or EBITDA, public company comparables, book value or liquidation value, and so forth.

IRS Requirements for Valuations for Incentive Stock Options

Let’s start with incentive stock options. The tax code requires that the strike price of an ISO must equal or exceed the fair market value of the stock on the date the option is granted. If the ISO requirements are not met, the option automatically becomes a non-qualified option.

The IRS has issued regulations under tax code §§ 421 and 422 (these sections apply to incentive stock options generally) which provide some guidance. First, the regulations provide that the strike price “may be determined in any reasonable manner.” 

Next, the regulations provide that if the strike price is determined “in good faith,” the option will be treated as an ISO even if the strike price is mistakenly below the fair market value of the stock. Whether the determination was made “in good faith” depends on all relevant facts and circumstances. 

An ISO valuation must take into account “nonlapse restrictions” on the shares, but must not take into account “lapse restrictions.” A nonlapse restriction is a permanent limitation on the transferability of the shares, such as rights of first refusal in favor of the corporation. A lapse restriction is any other restriction, e.g., forfeiture or vesting restrictions.

Basically, the IRS regulations require a reasonable valuation method used in good faith, taking into account any permanent restrictions on the shares. While not a tax code requirement, the valuation should be in writing and should succinctly state the supporting rationale and facts relied on.

IRS Requirements for Valuations for Non-Qualified Options
      Basic Rules: § 409A Regulations

The regulations for establishing the strike price of NQOs are similar to the rules for ISOs, but they provide more guidance and rely on regulations under tax code § 409A, which broadly deals with deferred compensation.

First, the IRS regulations require that the strike price be determined “by the reasonable application of a reasonable valuation method.” In other words, the IRS recognizes that there are many different reasonable valuation methods, but some may not be reasonable to use in the corporation’s unique situation. 

Second, regardless of the valuation method chosen, “all available information material to the value of the corporation” must be considered. The IRS provides a list of factors that may be applicable to the valuation:

  1. the value of tangible and intangible assets of the corporation;
  2. the present value of anticipated future cash-flows of the corporation;
  3. the value of competitors’ equity interests, if they can be established in a non-discretionary and objective manner (i.e., prices of publicly traded shares or amounts paid in arm’s length private transactions);
  4. recent arm’s length transactions involving the sale of the corporation’s stock (e.g., the price paid for shares of the corporation’s stock in a recent equity financing); and
  5. other relevant factors, including:
    • control premiums, 
    • discounts for lack of marketability, and
    • whether the valuation is used for other purposes (i.e., whether the valuation was used for a financing round or a redemption).

Finally, a valuation method that was reasonable in the past may not always be reasonable in the future. For example, if the corporation is now involved in important litigation or was issued a patent for a new invention, a prior valuation method may not be reasonable if it does not account for the new information. Further, a valuation is generally good for 12 months after it was conducted, unless there is a material change in the corporation which would require a new valuation.

Is a NQO valuation fundamentally different from an ISO valuation? Practically speaking, probably not – but the NQO regulations do provide more context for making the determination.

Like an ISO valuation, a NQO valuation should be in writing and should succinctly state the supporting rationale and facts relied on.

     Presumption of Reasonableness (a/k/a Safe Harbor)
The § 409A regulations for NQOs go a step further and provide for a “safe harbor.”
What is a safe harbor? If a corporation does not qualify for the safe harbor and the IRS challenges the valuation, the corporation must prove that the valuation was reasonable. If the corporation fails, the valuation is deemed unreasonable – and the option may be subject to penalties. But if the corporation qualifies for the safe harbor, the valuation is presumed reasonable. That means the burden of proof shifts to the IRS and the IRS must prove that the valuation method was grossly unreasonable. If the IRS fails, the valuation is deemed reasonable.
How do you qualify for the safe harbor? There are three ways:

  1. Get an independent appraisal. A quick search for “409A Valuation” returns many companies offering these appraisals. Online cap table management platforms often offer these appraisals for an additional monthly fee to existing subscribers. Accounting and valuation firms also provide these services. Fees start at about $1,000 and go up from there.
  2. Use a formula. The formula must meet certain requirements, including that it also be used for certain other purposes (for example a redemption or cross-purchase). The formula must be based on the corporation’s book value, multiples of revenue, or some combination thereof.
  3. Prepare a written report.
    • This option is only available to a start-up corporation that has no material trade or business, whose shares are illiquid (i.e., not publicly traded), and which is not planning a sale of the corporation or to go public within a certain time after the valuation. 
    • The report must be made in good faith and must apply the relevant factors discussed above. 
    • The person who prepares the report must be qualified based on the person’s “significant knowledge, experience, education, or training” – generally meaning five years of relevant experience in business valuation or appraisal, financial accounting, investment banking, private equity, secured lending, and so forth. If you would rely on the person’s advice with respect to the value of the corporation in deciding whether to buy or sell the corporation, and the person otherwise meets the requirements for qualification, the person is probably qualified.

Practically speaking, option #1 is the easiest way to qualify for the safe harbor, but it can be expensive for a start-up or early stage corporation. Option #2 is not commonly used by start-up or early stage corporations. Option #3 is attractive, but its limitations can make it impractical – it only applies to certain corporations and must be performed by a qualified person, which may require hiring a service provider, the cost of which may be comparable to option #1.

However, it is important to remember that you are not required to qualify for the safe harbor. Provided the strike price was determined by the reasonable application of a reasonable valuation method and all information material to the value of the corporation was considered, the requirements should be satisfied. However, in some cases, it may make sense to qualify for the safe harbor. For example, some venture capital investors may require a safe harbor valuation as a condition of making an investment.

How do the ISO and NQO regulations interact?
All options are either ISOs or NQOs. Options are only ISOs if they satisfy certain requirements, some of which are discussed above. All other options are NQOs. This means that if you intend to grant ISOs but fail to satisfy a requirement, the options are NQOs and subject to the NQO/§ 409A valuation requirements addressed above. If the options qualify as ISOs, however, tax code § 409A does not apply.

Practically speaking, the ISO valuation requirements under tax code §§ 421 and 422 and the NQO valuation requirements under tax code § 409A probably get to the same place 99% of the time. Since the NQO/§ 409A valuation requirements are more thorough, and since an option which fails as an ISO is automatically a NQO, it is wise to follow the NQO/§ 409A valuation requirements when issuing ISOs.

If you have questions about granting stock options or other types of equity incentives, contact the attorneys at Fairfield and Woods, P.C.

This article is published for general information, not to provide specific legal advice. The application of any matter discussed in this article to anyone's particular situation requires knowledge and analysis by a lawyer of the specific facts involved.