409A Valuations – Employee Stock Option Plan Solutions

In my previous article, I talked about why 409a valuations are necessary, especially for startups who want to recruit top-talent employees and incentivize them to stay. Stock options are a great way to motivate early startup employees to work hard when there isn’t enough capital to afford paying higher salaries. However, when an employee passes away, becomes disabled, or leaves the company after their stock options vest, it is usually required that they exercise those options within a short period of time or else they are forfeited . As a result, there is potential for those ex-employees to face a large up-front tax bill in order to receive the fruits of their labors.

Potential Options
Employees could exercise their options and then sell some of the stock on the secondary market or back to the company in order to foot the tax bill. However, some startups, like Uber and Pinterest, have been prohibiting employees from selling their stock on the secondary market. Uber has been offering regular tenders, but at a price point below the fair market rate. While some may consider that to be unfair, it is certainly a much better position to be in than employees at other companies, like Pinterest and AirBNB, who don’t necessarily have the cash on hand or revenue structure to offer regular buybacks.

Under the current tax code, stock options are taxed on the paper gain/loss at the time of exercise. However, most other investments are taxed at the time their capital gain/loss is realized. Because there is potential for mature startups to be overvalued due to optimistic expectations, perhaps another consideration could be to reform the law to tax the gain/loss realized at the time of sale of the stock obtained through option exercise post-IPO.

Allowing stock option exercise periods to extend for a period of at least 12 months post-employment under certain circumstances is one way to reward valued employees the opportunity to come up with the cash to pay the up-front tax bill.

Another possibility would be to issue forward contracts in lieu of stock options. Essentially the company writes a contract that declares they will sell an employee X number of shares for $X at a certain date in the future. Sometimes the employee is initially given all or a portion of the money up-front to exercise the forward contract, pay the appropriate taxes, and then pocket the profits. The forward contracts could be structured to include upside shares (buyer splits the upside with the seller above a pre-determined price) as a way to incentivize employees to continue working hard to add value to the business.

Those private companies that don’t want their shares to be trading amongst the general public should consider issuing restricted stock units in the place of stock options. When a restricted stock unit vests, taxes are paid and the remaining shares (net of tax) are granted to the employee. If the employee leaves the company, the taxes have already been paid and they don’t have to worry about paying any additional money to receive their full compensation.

Not all Employee Stock Option Plans (ESOPs) are created equally and can be tailored to best fit your firm. Deal Capital provides 409a valuations and tailors ESOPs to reward your valued employees with the gift of liquidity and still sustain a healthy revenue structure.

Josh Barnhouse
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