Stock Compensation for Start-Ups + Valuation Implications with 409(A)/83(B)

Business owners often seek to align the long-term prospects of their company with the interests of key employees and members of management. In addition to the direct sale or issuance of company shares to these employees, other mechanisms for aligning interests are available, including incentive stock options, restricted share awards, performance agreements, phantom stock plans, etc.

The world of employee stock compensation is vast and can be complicated. With that in mind, we will focus on equity incentive compensation plans common in early-stage and development-stage private businesses (start-ups).

Common Forms of Stock Compensation for Start-Ups

Hiring and retaining high quality employees is imperative for companies in the start-up phase. While most start-ups likely have a dedicated founder or two, the build-out of other key employees such as software engineers or experienced executives can be challenging when capital is limited and profitable operations are years away. Therefore, many employees are paid non-cash compensation in exchange for their services. Three of the most common forms of non-cash compensation used by start-up companies are stock options, restricted stock awards and stock appreciation rights.

1. Stock options

A stock option is a financial instrument that gives the holder the right, but not the obligation, to buy a share of stock at an agreed-upon price at a future date. With a stock option, the employee can share in the appreciation in value of company stock above the option exercise price. The two types of stock options are incentive stock options, which are granted only to employees, and non-qualified stock options. We will focus on non-qualified stock options granted to employees for the purposes of this discussion.

2. Restricted stock awards (RSAs)

RSAs are a form of compensation by which the employee is granted actual shares of stock in a company. While the shares are initially restricted, the restriction is gradually lifted as the shares are earned (share vesting). The vesting schedule is outlined in the grant documents and often includes a vesting cliff followed by monthly or annual vesting. RSAs are typically issued to early employees when the fair market value of common stock is very low.

3. Stock appreciation rights (SARs)

Stock appreciation rights are a form of stock compensation, without stock ownership, by which the employee compensation is linked to the appreciation in stock value. At vesting, the company can elect to pay the employee in cash or stock (less common). The main benefit of this type of compensation is the lack of dilution to the company’s existing stockholders.

Tax Considerations – Section 409(A)

As can be expected, there are tax consequences to both the employee (service provider) and the company (service recipient) in establishing stock compensation plans, whether in the form of corporate stock, LLC units, or partnership profits interests. Prior to the passage of the American Jobs Creation Act in 2004, the rules related to stock compensation were relatively lax. However, given the exploitation of certain stock option loopholes by well-known companies approaching bankruptcy in the early 2000s (i.e., Enron), the IRS included a much more stringent regulation known as Section 409(A) in the 2004 Act.

In a nutshell, Section 409(A) establishes a framework that limits the ability of taxpayers to defer compensation under non-qualified deferred compensation plans (NQDCP) by imposing strict requirements, which can include limitations on vesting and payments of awards. Given the breadth with which Section 409(A) was written, many other types of non-traditional compensation plans fall under its purview, including certain stock options and SARs.

If the NQDCP does not meet the Section 409(A) requirements, the taxpayer (service provider) will be immediately taxed on the non-complying deferred compensation plus interest and an additional 20% tax penalty. The granting of non-cash compensation meets the safe harbor for 409(A) treatment (i.e., is exempt) if it meets the following conditions:

• Stock options: Exercise price of the option at grant date is greater than or equal to the fair market value of the stock at that date (in other words, not “in the money”)
• Restricted stock awards: Generally, are not subject to Section 409(A) unless certain provisions are present
• Stock appreciation rights: Base price for the SAR at grant date is greater than or equal to the fair market value of the stock at that date (not “in the money”)

The main takeaway relating to stock options and SARS as it pertains to Section 409(A) is that the exercise or base price at the date of grant must be greater than or equal to the fair market value of the underlying security for it to qualify as deferred compensation and thereby be non-taxable at the date of grant. Once the stock option or SAR is exercised, the difference between the fair market value at exercise and the exercise price or base price is taxed as ordinary income. In the case of a stock option, once the stock is later sold, the proceeds over the basis will be taxed as a capital gain (or loss).

Tax Considerations – Section 83(B)

Restricted stock awards are generally considered to be property subject to a “substantial risk of forfeiture.” While the employee will receive actual shares of stock in the company, the risk of forfeiture will be implicit until the property is earned and the employee owns it outright. If the employee does not satisfactorily provide the required services or certain milestones are not achieved, the company typically has the right to repurchase the RSA shares at a significant discount to fair market value.

The Section 83(B) provision in the tax code allows for the recipient of RSAs to, within 30 days of receipt, file the Section 83(B) election for the shares to be taxable at the grant date rather than at the vesting date(s). While it is normally preferable to defer taxes, in the context of a start-up, if the company is expected to grow rapidly, it may be more advantageous for the employee to pay taxes at the grant date fair market value as this amount may be significantly less than the fair market value at the later vesting date(s).

After the Section 83(B) election is made, the employee will not pay taxes until the stock is sold, at which point either a capital gain or loss tax will be applicable. The downside to making a Section 83(B) election is the potential to pay tax on what could later become worthless stock. Although, often, the stock has little to no value at the date of grant, and therefore the tax consequences are minimal.

Typical Valuation Procedures

To comply with IRC Sections 409(A) and 83(B), a fair market value indication is usually required for the securities in question. The IRS defines fair market value as “the price that would be agreed on between a willing buyer and a willing seller, with neither being required to act, and both having reasonable knowledge of the relevant facts.” Normally a fair market value indication is only needed at the time of grant for an RSA to comply with Section 83(B). As it relates to granting stock options or SARs, the IRS has indicated a 409(A) valuation is valid for up to 12 months after the effective date or until a material event occurs (i.e., round of financing or other noteworthy event).

Depending on the stage and financial profile of the start-up company, the three core valuation approaches still apply. If the company is at a very early stage, prior to any revenues or third-party financing, the asset approach may be most appropriate. This is usually the case when there is limited or no data relevant to the market or income approaches.

The income approach, whereby a projected future cash flow stream is discounted back to a present value as of today, is generally the preferred approach to use. However, oftentimes reliable prospective financial information is not available, precluding the use of the income approach. As a company gets closer to profitability or once the projections become more reliable, the income approach can be the most appropriate approach.

Once the company has started to gain traction operationally, or third-party financing has been secured, the market approach is a common approach to use. Early-stage businesses are usually valued based on a multiple of revenue. In contrast, the valuation of later-stage start-ups tends to be based upon cash flow or earnings before interest, taxes, depreciation and amortization (EBITDA), although a multitude of metrics can be used.

The guidance of a professional valuation advisor becomes especially important when considering the various types of equity that can be issued by start-ups. In a typical valuation with a simple capital structure, once a value indication of the overall company equity is derived, a per-share value can easily be calculated by dividing the equity value by the total shares outstanding. For start-ups, the capital structure is seldom simple, with investors requiring special provisions including preferred stock, convertible debt, and warrants, among others. These additional intricacies require consideration of the waterfall proceeds to each class of equity holder upon a liquidation, often necessitating the use of complex option pricing models.

Conclusion

If your company or start-up is experiencing any growing pains similar to what is outlined above, from the question of tax implications for stock compensation plans or the valuation of securities within a complex capital structure, please do not hesitate to contact us. Lutz has experience in these matters and is available to help.