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“Think you know options? Think again!”

A stock option is a contract that gives the recipient (usually an employee) the right to purchase stock in the company at a specified price (the “strike price”) by a specific date. The employee is under no obligation to buy, or “exercise”, any or all of the options. Typically, but not always, options will “vest” over time and you can only exercise options that have vested. If an

“THINK YOU KNOW OPTIONS? THINK AGAIN by Sanjay Gandhi �1

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Sanjay Gandhi, GC of Oxford Valuation Partners explains the Top 5 Pitfalls of Options for start-ups from C-coprs to LLCs.

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employee leaves the company, or is fired, they typically have 90 days to exercise their options that have vested or they forfeit them. They will typically forfeit completely any unvested options.

Companies establish stock option programs as part of an overall employee compensation plan for several key reasons. Option programs can boost employee morale and help attract talented, skilled workers who are motivated to help the company improve and succeed. Employees holding options to purchase shares feel more like owners or partners in the business and are invested in the company's success. In addition to being a benefit for employees, stock option plans are cost-effective for companies with the only significant costs to the company being the lost opportunities to sell some stock at market value in the future and the expense of administering the plan.

Options are a key currency in early stage companies, who often make a bargain with staff of below-market/lower cash compensation in exchange for a share of the company’s future success. It’s a critical incentive to attract talent while the company is cash poor.

Unlike stock, options aren’t taxed until they are exercised, as long as they were issued at or above the fair market value of the underlying stock (usually common stock). Options, though not actually stock, are typically counted as part of the “fully diluted” stock of a company.

Despite the importance of options, and their key role in aligning the interests of the company and employees, we see on a daily basis a litany of pitfalls that companies fall into when navigating the landscape that can come back to bite you. We’ve shared some of the top ones below.

Top 5 Pitfalls – Options

1. Setting the strike price too low…or too high

2. Not “legally” granting options on time – are your options real?

3. Ignoring ISOs vs. NSOs

4. Forgetting 83(b) - Restricted Stock vs. Options

5. Poorly navigating LLC incentives

“THINK YOU KNOW OPTIONS? THINK AGAIN by Sanjay Gandhi �2

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Setting the option strike price too low…or too high.

Under Section 409A of the Internal Revenue Code (IRC), a company must issue options granted as compensation at a strike price at or above the fair market value of the underlying stock as of the grant date. If the strike price is too low, the recipient will face significant adverse tax consequences, and the company will have tax-withholding responsibilities. While sometimes ignored in the earliest stages, if the company is ultimately successful, any underpriced options run the risk of later being cancelled if they don’t pass audit, or are red-flagged in an M&A diligence review, all of which can have painful consequences for the option holders and the company alike. It’s not something you want to see and can be avoided with some expert counsel early on.

The other thing we often see is companies setting the price much higher than necessary. Sometimes, in an effort to save costs, companies or their advisors will set the strike price themselves rather than using external expertise. In these cases they often use the most recent preferred round price, or another sometimes random benchmark that “keeps them safe”. The strike price can often be multiples higher than needed, which unnecessarily penalizes employees.

Occasionally some companies just issue all options at a $0.01 strike price, sometimes for years, which causes the “too low” problems noted above. A company can establish a defensible fair market value of the underlying stock by obtaining an independent appraisal from well-qualified experts.

Ask for our white paper on 409A valuations

TOP I S SUES

1. Too Low – falls afoul of the law, taxconsequences for employees now, rejection onaudit/M&A

2. Too High – penalizes employees who aremaking sacrifices to join the company, killsincentive

Forgetting to issue options on time – are your options real?

Stock options offer employees the opportunity to benefit from the increase in the company’s value over time. As a company meets key milestones, the value of the company will increase, and the value of the underlying shares of stock will also increase. It’s easy for management to get caught up in the myriad daily responsibilities of running and growing a business and forgetting to take the necessary legal steps to translate “promises” into actual grants of options in a timely fashion. These steps go beyond an oral promise or a promise in an employment letter. A legal grant of options typically requires a written Board resolution (as per the Company bylaws) and formal option grant documentation. Every month we talk to founders who made promises to early staff members that they would get options, but never got around to legally issuing them, and now have a funding round about to close. At that moment, it can be too late to give early staff the benefit of issuing options at the “pre-money” strike price (e.g. pennies), which they were expecting, and they must get the much higher post-money price. As soon as a company has a term sheet in hand, it has entered a valuation zone that requires nuanced and prudent navigation.

TO P I S S U E S

1. Promising options but not legally grantingthem - these “options” aren’t real

2. Delaying the granting of promised options/stock and then getting over-run by a fundingevent - the strike price will jump

“THINK YOU KNOW OPTIONS? THINK AGAIN by Sanjay Gandhi �3

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Understanding the differences between ISOs and NSOs

Start up stock options typically come in one of two varieties: ISOs and NSOs. Incentive Stock Options (ISOs) are regulated by IRC Section 422, which lays out the requirements for an equity instrument to qualify as an ISO. ISOs are only available for employees and must be granted pursuant to a shareholder plan. If the rules of an ISO are followed, they offer highly preferential tax treatment for the holder ( long-term capital gains). Non-statutory Stock Options (NSOs) have fewer regulations and restrictions than ISOs. NSOs can be offered to advisors, service providers, and others affiliated with but not employed by the company. However, NSOs are taxed under both ordinary income and capital gains. 

TO P I S S U E S

1. Know the difference between ISOs and NSOs

2. To get the benefits of ISOs, you have to strictlyfollow the rules

83(b) - Restricted Stock vs. Options

Restricted stock can be a good alternative to options as a means of employee compensation in early stage companies for several reasons. Restricted stock may better accomplish the goal of motivating employees to behave in the best

interest of the business since the employees are actually receiving shares of stock of the company. This is often given out to co-founders, key employees or advisors that join the company some time after it’s founded. Restricted Stock typically comes with a vesting schedule, like options, so that a recipient’s interests are aligned with the company’s long-term success. Under IRC Section 83(b), employees receiving restricted stock can pay tax immediately, instead of as the stock vests, if they file an 83(b) election within 30 days of the grant. This enables them to pay tax when the value of the company is at a lower point or its lowest point. As with other time-based restrictions, we speak with founders every month who miss the 30-day deadline and try to manufacture a painful “cleanup” as the company’s value is skyrocketing. The main disadvantage of restricted stock is that it’s immediately taxable upon vesting, so the recipient may end up paying tax even if the company ultimately fails and the shares cannot be sold.  Equally, the recipient must possess the necessary cash to pay the applicable taxes at the time of the grant.  Thus, restricted stock issuances are not appealing unless the value of the stock is sufficiently low that tax impact is minimal as is generally the case early in the company’s life. Some other ways this is alleviated is where companies make loans or pay bonuses to employees in order to cover the tax payable from the stock grant.

TO P I S S U E S

1. You have to file the 83(b) within 30 days ofthe grant

2. Taxes are payable for stock grants – whichrequires a valuation of the stock, similar tovaluations to set the strike price of options

3. There may be ways to retrieve tax paid onrestricted stock if the company later failsand the stock becomes worthless

“THINK YOU KNOW OPTIONS? THINK AGAIN by Sanjay Gandhi �4

Ask for our white paper on ISOs vs. NSOs

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Options for LLCs? LLC to C-corp conversions – what

happens to profits interests

Limited Liability Companies (LLCs) have grown in popularity as a vehicle through which entrepreneurial companies operate their business. An LLC shares many corporate characteristics, but most are taxed as partnerships which can allow founders to have special tax  benefits. LLCs, when treated as “pass-through” entities, are not subject to a company-level tax (as with C-corps) and may enable more tax deductions. This can be useful, for example, when founders want to be able to offset the losses from early years against income from other sources. We have seen LLCs used in cases where a company starts out as a services/consulting business prior to a shift to a more product-oriented or SAAS-focused business model to drive growth and valuation multiples.

The LLC structure has clear benefits, but also faces significant challenges in the area of equity compensation. Within an LLC, ownership is expressed by membership interests or units rather than stock. As a result, it’s more challenging for LLCs to issue stock options, or provide restricted stock. However, like corporations many LLCs want to reward employees or service providers with an equity stake in the company. The most commonly recommended approach to sharing equity in an LLC is to issue  "profits interests." A profits interest is comparable to a stock appreciation right, and acts similarly to an option with an exercise price equal to the value on the grant date. It is not literally a profit share, but, like an option, it gives the recipient a share of future appreciation of the business, typically paid out upon a liquidity event (or at a point in time). Vesting requirements can be attached to this interest. Options to purchase profits interests can also be granted.

The initial “hurdle” rate that establishes the baseline for the employee’s share of increased value must be equal to the company’s underlying value on the date of grant. If it is, then the employee only pays tax when they receive the benefits of the profits interest upon a liquidation event or a time interval.  If the hurdle rate was not set appropriately however, then the employee may be required to pay tax immediately upon receipt of the profits interest, as the IRS may consider the instrument to be taxable income, captured by the legal doctrines of economic benefit and constructive receipt (e.g. the profits interests received were not at zero value on the date of grant). For profits interests subject to vesting, recipients can file 83(b) elections at the time of grant to ensure that future gains are treated as capital gains and not ordinary income.

Similar to issuing options or restricted stock, it is important to pay attention to valuation issues when issuing profits interests to avoid inadvertent tax pitfalls and unnecessarily penalizing employees who thought they were receiving a company incentive without having to shell out immediate and future tax payments for unrealized paper income or paper gains.  A company needs to determine the value of the entity at the time of each grant of a profits interest. The LLC also needs to account for unrealized appreciation in the LLC as of each grant date and make Capital Account adjustments to avoid significant potential tax consequences for employees upon a sale of the company.

Like an option, a profits interests is considered a security and subject to securities laws (like 701 exemptions). Unlike options, the holder of a profits interest is the owner of that interest (subject to vesting), just like shareholders in the company. As a result, they don’t need to fund an exercise price. Alternatively, LLCs can issue options to receive a

“THINK YOU KNOW OPTIONS? THINK AGAIN by Sanjay Gandhi �5

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profits interest, which effectively entitles the holder to a percentage of the company’s value as of the exercise date of the option.  In this case, the LLC would still need to do a valuation on the date of the grant, and then again on the date of exercise, to determine the future capital shift. 

To avoid some of these administrative burdens, LLCs sometimes issue phantom equity/stock instead. It’s easier to administer, can provide the same economic rights, and can also be subject to a vesting schedule. The holder has no actual equity in the company, just economic rights, and it can be structured to trigger payments only upon a change of control.  Typically, phantom equity plans are set up so that employees have rights only so long as they continue to provide services for the company, and their economic rights terminate when they leave. Money received under a phantom equity plan is taxed as income, not capital gains however, which may be less favorable for the recipient than a profits interest. 

LLC to C-corp Conversion

Often, startup companies that begin their life as LLCs will later convert to Delaware C-corporations in preparation for, or in conjunction with, raising venture capital or angel financing and adopting a more common, VC-friendly capital structure – especially with regard to option pools.  Several elements must be true in order for these

conversions to be tax-free, and typically shareholders in the LLC must receive securities of equivalent value in the C-corp.  In this transition, profits interests are typically converted into restricted stock (not options) which requires a sophisticated understanding of value within the two corporate structures.  Assuming the profits interests have got some unrealized paper gain, if you convert them into options of equivalent value they would be “in the money” options and you would fall afoul of IRC 409A.  External expertise can be useful in navigating these nuanced LLC valuation pitfalls.

TO P I S S U E S :

1. When issuing profits interests, the value of thecompany needs to be properly established oremployees are hit with immediate tax liabilityeven if they never receive a dime.

2. When converting LLCs to C-corps, you canconvert profits interests to restricted stock tokeep tax-free status and avoid falling underIRC 409A.

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“THINK YOU KNOW OPTIONS? THINK AGAIN by Sanjay Gandhi �6

ABOUT THE AUTHOR:

Sanjay Gandhi is the General Counsel of Oxoford Valuation Partners. He routinely writes and lectures on legal/regulatory issues to the start-up, venture capital and private equity communications. Prior to Oxford, he worked on a range of studies in the retail, media and telecom sectors for McKinsey & Company in New York as well as on a venture program in Asia and Africa on behalf of the United Nations Development Programme. He is a licensed attorney and has served on the executive committee of the Venture Capital and Technology group of the NY State Bar. He is also part of NY Bar sections on Securities Regulation and Taxation.