How to Keep Employee Stock Options’ Exercise Price Low and IRC409A Compliant

Published on 16 Mar, 2016 Published under Valuation

Companies often issue common stock options as a means to incentivize employees, negotiate compensations, or enhance their employee tenures. This is especially true in early stage technology companies, where stock options are a very large part of their key employees’ compensation package.

Issuing stock options at the lowest possible exercise price makes them more attractive to potential employees. However, Internal Revenue Code 409A forbids the issuance of options at an exercise price below the fair market value of the underlying stock. Any such options issued create a significant tax liability, making them unappealing to the holding employee.

This makes deciding an employee stock options’ exercise price quite a daunting task.

The prevalent practice is to issue stock options on common stock rather than other securities in order to keep your employee options’ exercise price low. Common stock is usually the weakest security in a company’s capital structure, so options on common stock can be issued at a lower exercise price.

It’s possible to reduce that exercise price even further by issuing options on a security weaker than common stock.

Securities weaker than common stock have specific constraints. While those constraints reduce their theoretical value significantly, they do not affect the inherent benefits that an employee can look forward to, if the restrictions are carefully designed.

I’m going to discuss two such alternatives to create weaker securities that can optimize your employee stock compensation plans.

One avenue is to withdraw certain rights — especially those which are inconsequential to minority shareholders — in order to create a weaker security. An example of such a constraint would be forfeiting the right to vote. Employees would gladly trade their voting rights for a lower exercise price.

Another avenue would be to impose restrictions on the security, which are impairments for the holders, but become rights for the issuing company. Take an example of a junior common stock where the issuing company has the right to buy back the junior common stock at a deep discount through some years. Although the issuing company, an employer, would never exploit such an option while the securities stay with its own employees, the company’s right validates a significantly lower valuation of the junior common stock.

While the returns from weaker securities remain unaffected as far as the employee’s concerned, such arrangements reduce their fair market value, allowing them to be issued at significantly lower exercise prices than common stock.

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