ISOs: What's my option worth and when do I get it?

05 Feb ISOs: What's my option worth and when do I get it?

Madison, Wis. – Our discussion of incentive stock options (ISOs) continues by zeroing in on a few important details. Remember that the ISO is created by statute; specifically, the dreaded Internal Revenue Code.
The Code and the IRS regulations issued under the Code can be mind-numbingly complex, and the ISO rules are no exception. You should carefully review all of these critical requirements with experienced counsel. For many technology companies, however, two requirements are of paramount importance: how you must value the option and how many options can be granted. So I will focus on those issues in this column.
Valuation
One of the primary hurdles to clear to get ISO treatment for an option is that the option exercise price must be at least equal to the “fair market value” of the underlying shares on the date the options are granted to the employee. (For employees who own more than 10 percent of the company, the exercise price must be at least 110 percent of the fair market value.)
Note that I put fair market value in quotes above. Why? Because as any business owner will tell you, establishing a company’s market value is more art than science. Of course, this analysis is simple if the stock is traded on an exchange, but often closely held companies without a market in the company’s stock are issuing these options. This is true of early stage technology companies looking to attract and retain top talent.
How can a company establish fair value? The regulations provide that “any reasonable valuation” is acceptable to determine fair market value, but it must be established without regard to most stock restrictions and without any discounts for lack of marketability or minority interests. Does the IRS tell us what a “reasonable valuation” is? Of course not. The regulations do provide a safe harbor, however, if the board (which is responsible for establishing the value), makes a “good-faith attempt” to establish the value. If you think this sounds like replacing one ill-defined term with another, you’re right!
While the IRS regulations allow companies to rely on any such good-faith attempt, most companies will want to rely on the true safe harbor in the regulations: an opinion of a completely independent and well-qualified valuation expert. So, in most cases, the company will engage just such an expert (and be sure to check his or her qualifications) to establish the company’s value.
Of course, this comes with a cost. These valuations can run anywhere from $3,000 to over $10,000, in my experience. So this is a considerable barrier for the ISO. Some companies may wish to use a different “good-faith attempt” to avoid this expense, but beware of being penny wise and pound foolish. Failure to accurately establish the value (in the opinion of the IRS) will cause the ISO to lose its status and be treated as an NSO, resulting in tax consequences that likely were not intended by the company or the employee.
Size of option
One other requirement that I did not touch on in my last column is the size of the option, which can come into play for some companies. The IRS regulations restrict any ISO from being exercisable with respect to any amount over $100,000 in any calendar year. An option can vest over time to ensure that no more than $100, 000 is exercisable in any year, but companies must be careful in drafting and operating the plan to not run afoul of this rule when options are accelerated or deferred into different years.
Incentive stock options can be wonderful assets, both for the company trying to provide attractive incentives to its employees and to the employees who have options that go up in value as they help the company succeed. However, there are limitations, and it is imperative that knowledgeable counsel is used to ensure ISO treatment.
In my next columns, we will look at the relatively new 409A rules that apply to deferred compensation, then on to an overview of some other, less-common ways to compensate employees for company performance.
If you’re interested in exploring stock options in more detail, I’d encourage you to check out http://www.mystockoptions.com, which is an excellent resource.
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