The option strike price is the agreed upon price of the shares offered in an option. When a person chooses to exercise their right to an option they will pay the strike price for each share. The inherent value of an option is the expectation that the strike price will be lower than the real value of the shares when the option is exercised.
As was described in previous blog posts, this structure benefits both employees and founders in a startup because it (1) offers an employee the promise of future financial gain if things go well for the company with no immediate income tax liability and (2) offers founders (and company owners) the ability to attract talented employees with little or no cash outlay.
For many years companies offered deferred compensation packages with reduced option strike prices that were actually lower than the current real market value of the shares offered in an option. Companies did this to make their compensation packages even more attractive to potential employees. Option strike prices offered below market value increased the likelihood that the options would net the employee a profit.
However, approximately ten years ago, the IRS sought to end this practice because of abuses that caused options to no longer resemble “deferred” compensation. The IRS decision resulted in the issuance of rule 409a. The agency took the position that option strike prices offered below the current market value of the company’s shares are an immediately taxable form of compensation to the employee. The practice would also obligate the company to make the requisite withholdings. Such a finding by the IRS would negate the very benefits employees and companies alike are seeking when offering options as a form of compensation.
Now companies undertake what is commonly referred to as 409a valuations. 409a valuations are performed by third party experts who determine the fair market value of a company’s shares. Companies then rely on this third party valuation to determine the option strike price they will offer their employees in deferred compensation packages. By undertaking this additional step companies protect themselves and their employees from the possibility of immediate tax liabilities, thereby preserving the benefits of offering employee stock options.
The attorneys at Moisan Legal, P.C. advise both companies and employees with respect to employee stock options. Whether you are a company offering deferred compensation packages to employees or you are an employee being offered stock options as part of your compensation, the attorneys at Moisan Legal, P.C. can help you make sense of the rules so that you can protect yourself and make the right decision.