I’ve decided to write a mini, 3 blog series on stock options and stock-based compensation. From my experience in Utah as an outsourced CFO,I have observed a degree of confusion on this topic. I hope to shed some light on options from both the perspective of employers and of employees. As the first article in this mini-series, I will give a broad overview of options here and explain the process of valuing stock through a 409A Valuation.

Questions I’m often asked by managers include: to whom should we offer options, what should be the exercise date, and where do we even start? Questions I have received from employees include: is it appropriate to ask for stock-based compensation, when should I exercise, and should I ever exercise early for tax purposes?

Stock Options

As competition for top talent increases, the use of stock-based compensation has increased as well. Stock-based compensation can be a wise decision for a couple of reasons: 1) it ties employee incentives to the performance to the company and 2) it can be a cheaper way to pay employees, up-front especially in start-ups where cash is tight during early and growth stages. Options give the holder the right, but not the obligation, to buy a pre-specified number of shares for a pre-specified price (usually at a discount, otherwise the option is worthless) within a certain time frame. If the company does well and the stock increases in value, employees directly benefit from their options.

Another popular form of stock-based compensation is restricted stock, wherein the company gives, rather then sells at a discount, shares of stock, usually retaining an option to retract the stock until such stock’s restrictions are lifted through a vesting schedule.. This method is much more straightforward, so I won’t go into details.

409A Valuation

Let’s look at an issue that impacts the granting company. The IRS requires any compensation via stock/options to be expensed on the income statement. The 409A valuation is the process of valuing a company’s common stock in order to issue stock options, or any other deferred compensation. Aside from being required by the IRS, the 409A Valuation will have an impact on your company’s value since it will influence both investors and employees who receive stock options.

There are two common routes to performing this 409A valuation. Your board of directors can determine a fair market value, or the CEO/CFO can conduct an in-house 409A valuation. One caution in having the board determine the fair market value is that if the IRS doesn’t believe the exercise price reflects the fair market value, then the burden of proof will technically fall to the option holder, and they will have to prove that the company was fairly valued by the board. This route is not advised.

The management-conducted 409A valuation has some significant advantages. First of all, if the CEO/CFO oversee the valuation, they will likely know more about the past, present, and potential of the business. Unfortunately, the actual calculations of the valuation are complex and go beyond the scope of this article, but they involve a model called the Black-Scholes model and can be performed using statistical software. Commonly, the CEO or management will hire a third-party firm to do the valuation utilizing the outside firm’s strategic expertise and manpower. This can increase the credibility and can be a strategic move for entrepreneurs.

It is important note is that while the 409A Valuation sets the value of the company for accounting and tax purposes, the management team can set the exercise price at their discretion for the benefit of the employee.

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If you’re interested in learning more about stock options or 409A Valuations, please contact us today to talk with one of our CFO’s.