(This article also appeared in the Bloomberg Corporate Law Journal and can be accessed by clicking the pdf link above.)
Employee option grants have long been a staple of the recruitment and compensation of employees at venture-backed companies. However, changes in the regulatory and enforcement environment in recent years have made the option grant process more complicated and often more perilous than it has been in the past. This article reviews the primary regulatory issues that companies should consider when granting options and suggests some best practices for doing so.
I. Valuation of the Company’s Stock
One of the most important and inherently difficult aspects of option grants by a venture-backed company is determining the fair market value of the company’s shares. The determination of the correct fair market value is crucial for both tax and accounting reasons.
On the tax side, use of the correct fair market value is necessary to ensure an option is a valid incentive stock option, and more importantly, to ensure that the option is exempt from the onerous provisions of Section 409A of the Internal Revenue Code (the Code). Section 409A accelerates the taxation of options to time of vesting and imposes penalty taxes on the income recognized, unless the option has an exercise price not less than the fair market value of the underlying shares (or unless certain other exceptions apply—which is not usually the case for options granted by venture-backed companies).
On the accounting side, knowing the correct fair market value is necessary to properly determine and reflect the accounting charge for the option in the company’s financial statements. This becomes particularly important at the time of an initial public offering (IPO), because the Securities and Exchange Commission (SEC) will review the compensation charges taken for options granted in the 12-18-month period prior to the IPO. If the SEC challenges the valuation used by the company, the IPO process could be slowed and, in the worst case, the company could miss its window to go public.
In light of the importance of correctly valuing the stock underlying option grants, many companies now hire independent valuation consultants to determine the fair market value of their stock. The use of an independent valuation by a qualified appraiser offers the protection of a safe harbor exemption from Section 409A. In addition, a rigorous, contemporaneous independent valuation is strong evidence to counter any challenges by the SEC related to the compensation charges included in a company’s financial statements.
Once a company makes the decision to use independent valuations, the next issue is how often the valuation should be updated. The Section 409A safe harbor provides that the valuation can be relied upon for 12 months, unless its later use is grossly unreasonable. No guidance yet exists on how to apply this standard. However, it is advisable to obtain a new valuation prior to the end of the 12-month period following the effective date of the current valuation if there is a significant event in the company’s history—such as a new round of financing, revenue greatly in excess of (or below) plan, achieving positive cash flow, achieving profitability, a biotech company successfully completing phase II or phase III trials, engaging in serious discussions concerning a possible acquisition of the company, and other important milestones in a company’s lifecycle. If the company expects an IPO in the next 12–18 months, quarterly valuation updates are generally appropriate.
II. Issues Relating to the Timing of Option Grants
Because there is no public trading market for venture-backed companies that establishes a fair market value for the company’s stock on a daily basis, venture-backed companies are not susceptible to most of the option timing problems that have plagued many public companies. However, there are several issues relating to the timing of option grants that venture-backed companies should be mindful of.
New Hire Grants
Many venture-backed companies have historically delegated to the CEO the authority to grant options to newly hired employees—typically subject to limits or guidelines on the number of option shares for each position within the organization—on the date the employee starts work at the company. The new-hire option grants by the CEO were typically made with an exercise price equal to the fair market value of the common stock as determined by the Board of Directors at the most recent Board meeting. Since the adoption of Section 409A, the old practice of granting options between Board meetings at the fair market value last set by the Board now creates too great a risk that those options—particularly the ones granted shortly before a Board meeting—will be determined to have below-fair-market-value exercise prices if the Board concludes at the next Board meeting that the fair market value has increased.
Take for example the following fact pattern: the Board determines, based on either an independent valuation or its own internal analyses, at an April 15 Board meeting that the fair market value of the common stock is $.60 per share; the CEO grants options to new hires on April 25, May 20, June 15 and July 10, all at an exercise price of $.60 per share; and the Board determines at the July 15 Board meeting—taking into account recent developments and the company’s operating results for the June 30 quarter—that the fair market value of the common stock is $.90 per share. Assuming the April 15 determination of fair market value was sound and well documented, the April 25 grants (and maybe even those from May 20) would likely be deemed to be at fair market value. However, it may be quite difficult to convince the IRS or other regulators that a share of common stock that was worth $.90 on July 15 was worth only $.60 on July 10.
The best practice, instead of authorizing the CEO to make new-hire grants on the date of hire, is for the Board at each meeting to make option grants to all employees who started with the company since the date of the last Board meeting, at an exercise price equal to the fair market value as determined at that meeting. If the company wishes, the vesting period for those options can commence on the date of hire (rather than the date of grant), so the delay in the option grant has no effect on vesting. The disadvantage to this approach is that the option exercise price cannot be fixed or communicated to the employee during the recruiting process or when he or she starts work. However, in light of the risks involved to both the company and the employee in following the alternative approach, this is probably an unavoidable inconvenience.
Venture-backed companies should avoid the practice of granting options by the written consent of the Board of Directors for several reasons. First, for the reasons described above, options should be granted only at Board meetings at which a determination of the fair market value of the common stock is made. Second, any delay in obtaining one or more signatures to the written consent calls into question the date on which the option was actually granted and thus increases the risk that the fair market value of the common stock exceeded the exercise price on the actual date of grant. Third, while there is generally objective evidence to establish when a meeting of the Board of Directors occurred, it is often difficult or impossible to demonstrate that a written consent was actually executed on the date set forth in the written consent. Using written consents leaves the company open to a potential challenge that it back-dated option grants in order to use a lower fair market value.
Grants in Advance of Significant Transaction
Option grants made during a period when the company is engaged in discussions regarding a potential significant corporate transaction, such as an acquisition or an IPO, can also raise concerns. For example, suppose the Board of Directors determines on September 1 that the fair market value of the common stock is $1.00 per share; the company is contacted on September 15 by a buyer concerning a possible acquisition; and the company signs a merger agreement on October 20 under which it will be acquired by the buyer for a purchase price of $2.00 per share. Even if the $1.00 fair market value was based on an independent appraisal or a rigorous and objective internal valuation analysis, any options granted with a $1.00 exercise price after the commencement of the acquisition discussions (and particularly after the purchase price was first discussed) may not withstand an IRS claim that those options were granted with below-fair-market-value exercise prices. In addition to the tax and accounting problems that could result, such grants could also expose the Board to claims from shareholders that granting below-fair-market-value options (particularly ones that provide for some acceleration upon an acquisition) while engaged in acquisition discussions improperly diluted the existing shareholders and represented a breach of the Board’s fiduciary duties, though such claims would be less likely to succeed if the Board explicitly took the compensatory elements of those grants into account in approving those grants.
The best way for a company to proceed in this situation will depend on the particular facts, including how likely the company perceives the acquisition to be, by how much the proposed acquisition price exceeds the fair market value as most previously determined by the Board, how critical the proposed option grants are, and the tax and regulatory issues associated with granting discounted options. In some cases, the best approach will be to defer all option grants until the deal is signed or discussions terminate. In other cases, proceeding with the option grants at an increased exercise price (and running the risk that the options will be overpriced if the deal does not go through) may be advisable. Companies should coordinate closely with their counsel to carefully consider the facts and risks to determine the most prudent approach.
III. Rule 701 Compliance
Rule 701 under the Securities Act of 1933 provides an exemption from the registration requirements of the federal securities laws for offers and sales of securities by non-public companies pursuant to employee benefit plans or other written compensation agreements. Rule 701 is the Securities Act exemption typically relied upon by venture-backed companies in granting options and issuing stock under their employee stock plans.
Overview of Rule 701
Rule 701 only applies to offers and sales of securities that are compensatory in nature and is not available in connection with capital raising transactions. In addition to covering sales to employees and directors, Rule 701 may be relied upon to exempt offers and sales of securities to consultants or advisors of the company if, among other things, they are natural persons and provide bona fide services that are not in connection with a capital-raising transaction. The use of Rule 701 in transactions involving “consultants and advisors” (which includes advisory board members) has been an area of focus by the SEC, and companies should therefore consult with counsel before issuing securities to consultants or advisors in reliance on Rule 701.
The aggregate sales price of securities that may be sold in reliance on Rule 701 in any 12-month period may not exceed the greatest of the following:
- 15% of the company’s total assets; or
- 15% of the outstanding securities of the class being offered.
A number of special rules apply to the calculation of these limits, as summarized below.
- Determination of Aggregate Sales Price. “Aggregate sales price” means the sum of all cash, property, notes, cancellation of debt or other consideration received or to be received by the company for the sale of the securities. There are several nuances to the calculation of aggregate sales price. Perhaps the most significant of those is the fact that the “sales price” of an option is determined when the option is granted (without regard to when the option becomes exercisable) and must be valued based on the exercise price of the option. If an option expires unexercised or is cancelled, it still counts against the limits (because a sale was deemed to occur on the date of grant).
- Total Assets Limitation. A company may elect to measure its total assets as of its latest year-end balance sheet or, if more favorable, as of its most recent subsequent balance sheet date.
- Outstanding Securities Limitation. The outstanding amount of the class of securities being sold limitation is measured as of the company’s latest year-end balance sheet or, if more favorable, as of its most recent subsequent balance sheet date. In calculating the outstanding amount of the class of securities being sold, you may treat as outstanding the securities underlying all currently exercisable or convertible options, warrants, rights or other securities, other than those issued under Rule 701.
The company must provide the recipient of a stock award made in reliance on Rule 701 with a copy of the plan and the agreement (such as the option agreement) under which the award is made. The company must also provide the recipient with any other disclosure needed to satisfy the antifraud provisions of the federal securities laws. In addition, if sales made under Rule 701 exceed $5 million in any 12-month period, the company must provide additional disclosure, including a summary of the plan, risk factor disclosure and GAAP financial statements.
It is important to note that the increased disclosure requirements that apply if sales exceed $5 million are applied retroactively to all sales (which, for options, includes grants) made in the applicable 12-month period and not just to those that occur after the $5 million threshold has been exceeded. Therefore, a company that does not provide all the disclosures that would be required if the $5 million threshold was passed must make certain that it does not pass that mark, as doing so would result in the retroactive loss of the Rule 701 exemption for prior offers and sales in that 12-month period.
There are several steps that a venture-backed company granting options or issuing stock under an employee stock plan should take in order to help ensure that it can avail itself of the benefits of Rule 701. First, the company should establish administrative procedures and controls to ensure that recipients of awards under the plan receive copies of the plan and the award agreement, as well as any other documentation that the company concludes it must provide. Second, the company should maintain a log of all transactions that it intends to exempt under Rule 701 and maintain a running tally of the aggregate sales price and amount of securities sold in any rolling 12-month period. Third, the company should review this information in connection with any proposed stock awards intended to be covered by the Rule 701 exemption, both to assess whether the limits described above are complied with, and to assess whether the $5 million threshold—triggering additional and potentially burdensome disclosure requirements—would be exceeded.
IV. Blue Sky Issues
In addition to complying with federal securities law requirements for offers and sales of securities under stock option plans, venture-backed companies must monitor compliance with state securities or “blue sky” laws in the states in which employees receiving stock options reside. Individual states have widely varying requirements, ranging from no filing requirements (e.g., Massachusetts) to mandatory notice filings (e.g., California) to actual regulatory “merit” review of option terms and offerings (e.g., Maryland). These requirements are set forth both in statutes and in rules and bulletins of corporate regulators such as the California Commissioner of Corporations. Failure to comply may result in, among other consequences, governmental action or rescission rights for holders.
California is one state in particular where careful attention must be paid to compliance with the rules governing option grants. An employee stock option plan under which grants are made to California residents must be qualified with the California Commissioner of Corporations or satisfy an exemption from the qualification requirement. If there are fewer than 35 plan participants, a company can rely on the general exempt securities offering exception in Section 25102(f) of the California Corporate Securities Law, provided the option recipients meet the business relationship or sophistication requirements of the exemption. However, most venture-backed companies rely on the compensatory benefit plan exemption under Section 25102(o) for convenience (one filing for the plan) and flexibility (no 35 participant limit).
Currently, Section 25102(o) has a number of requirements that apply to options granted to California residents, including (i) the grant of the option must be made in compliance with Rule 701, (ii) a maximum option term and plan term of 10 years, (iii) a prohibition on transferability of options except by will, laws of descent and distribution or as permitted under Rule 701, and (iv) a mandated post-employment termination exercise period of at least 30 days (or six months in the case of death or disability) unless such employment is terminated for “cause” (as defined by applicable law or the terms of the option, the plan or employment contract). These requirements are typically memorialized in the plan itself or in an addendum applicable to California grants. It is therefore critical for a venture-backed company to consult with California counsel before granting options to California employees.
Venture-backed companies that grant options to employees outside of the United States should also ensure that they are complying with the securities laws of the applicable foreign jurisdiction.
V. Modifying Options
Venture-backed companies are occasionally inclined to modify the terms of outstanding options. Before a company undertakes such an action, it should consider the possibility that the modification of the option could cause the option to be treated as a nonqualified deferred compensation plan for purposes of Section 409A, cause an incentive stock option to lose its status or result in additional accounting charges.
The final regulations under Section 409A provide that certain modifications can cause an otherwise exempt option (i.e., one that was granted with a fair market value exercise price) to become subject to the penalty provisions of that section. For this purpose, a modification includes any change in the terms of an option or an option plan that may provide the optionholder with the direct or indirect reduction in the exercise price of the option, an additional deferral feature, or, except as described below, an extension of the option exercise period. These changes are treated as modifications regardless of whether the optionholder in fact benefits from the change in terms.
Extensions of the option exercise period can be designed to avoid a modification of the option. The regulations permit an extension of the exercise period for an in-the-money option (where the exercise price is below current fair market value) to a date that is no later than the earlier of (i) ten years from the date the option was granted and (ii) the original expiration date of the option. Options with exercise prices at or above then fair market value can be extended indefinitely under Section 409A.
The acceleration of the vesting of an option generally does not trigger the application of the penalty provisions under Section 409A although accelerating the vesting of an option that is subject to 409A because the exercise price of the option was lower than the fair market value of the stock on the date of grant could, depending upon the option’s terms, trigger such penalties.
Incentive Stock Options
Any modification, extension or renewal of the terms of an incentive stock option (ISO) is considered to be the grant of a new option. The new option will qualify as an ISO only if it meets all of the ISO requirements on the deemed new grant date. For example, if an ISO is modified when the exercise price is less than the fair market value of the stock, the modified option would not be treated as an ISO.
A modification is defined to be any change in the terms of the option or the plan under which the option was granted that gives the optionholder additional benefits under the option regardless of whether the optionholder in fact benefits from the change in terms. For example, an extension of the period during which the option may be exercised is a modification regardless of whether the optionholder in fact benefits from the extension. A change in the option to accelerate the time at which the option may be exercised is not considered a modification; however, the acceleration of vesting may result in a partial loss of ISO status if the acceleration causes more than $100,000 worth of stock, calculated based on the exercise price, to become vested in any year.
For accounting purposes, any change in an option that increases the value of the option, for example, by decreasing the exercise price or extending the exercise period, is likely to result in a charge to earnings reflecting the increased value of the modified option. In addition, certain changes to the option terms could cause the option to be accounted for under the less favorable liability rules.
VI. Traps for the Unwary
Venture-backed companies should structure their option plans and practices with an eye to minimizing interpretational challenges and operational difficulties. The issues discussed below are frequently encountered by venture-backed companies.
Venture-backed companies often have provisions in their option plans or agreements that accelerate option vesting in connection with change-in-control events. Many companies use a single trigger, such that the change in control itself will cause a partial or full acceleration. Other companies use a double trigger, in which the options accelerate only if there has been both a change in control and termination of the optionholder’s employment under specified circumstances, such as a termination without cause or a “good reason” resignation. Double triggers may be a sensible approach for companies that want to ensure that their valuable employees remain for at least a transition period after the change in control. However, double-trigger provisions that require the company or its Board to determine the nature of an employment termination, particularly when the provisions allow employees to resign for “good reason,” can create difficult interpretational issues or invite disputes. For example, while some elements of “good reason,” such as a required relocation, are objectively determinable, others, such as “an adverse change in employment responsibilities,” are more subjective, particularly for non-executive level employees. Companies should therefore carefully consider the group of employees to whom double-trigger acceleration will be offered; for example, it may be appropriate to limit such acceleration to the management team. Alternatively, companies may want to limit the second trigger to terminations by the company (and not good reason resignations) if the second trigger will be offered to those beyond the management team.
Full acceleration of vesting upon a change-in-control event is normally easy to administer, but partial accelerations can lead to ambiguities and traps for option administrators. For example, an acceleration clause that provides that 25% of the original number of shares become vested upon a change in control should specify whether the remaining unvested portion of the option vests over a shortened vesting schedule or vests ratably over the original vesting schedule (with a reduced number of shares vesting on each vesting date).
In addition, companies should be mindful of the anomalies that can result from accelerating a specified percentage of unvested option shares, rather than a percentage of the original number of option shares, as illustrated by the following example. Employee 1 joins the company on May 1, 2009, and receives an option for 100,000 shares, which vests in four equal annual installments and accelerates as to 50% of the unvested shares upon a change in control of the company, with the remaining unvested shares continuing to vest at their original rate over a truncated vesting schedule. Employee 2 joins the company on June 1, 2009, and receives an option for 100,000 shares with the same vesting terms. On May 15, 2010, the company is acquired. At the time of the acquisition, Employee 1 would have 62,500 shares vested (25,000 shares vested on May 1, 2010, plus 37,500 shares vested upon the acquisition), with the next vesting date almost a year later (May 1, 2011). Employee 2, on the other hand, would have 50,000 shares vested upon the acquisition, and would vest as to another 25,000 shares 15 days later (on June 1, 2010, his first annual vesting date). Thus, from June 1, 2010, through May 15, 2011, Employee 2 would have more shares vested than Employee 1, even though Employee 2 started work after Employee 1.
Inadvertent Public Companies
A company with more than 500 holders of a class of equity securities may be required to register under the Securities Exchange Act of 1934 and to comply with its periodic reporting rules and certain other requirements applicable to public companies, including the Sarbanes-Oxley Act, even if the stock of that company is not publicly traded. Many venture-backed companies may not realize that stock options are regarded as a separate class of equity securities for this purpose, and that having 500 optionholders, even without a large number of stockholders, may require the company to comply with the reporting and other public company requirements despite the absence of a true public market.
Late in 2007, the SEC adopted a new rule (Rule 12h-1(f)) providing an exemption from the registration requirements of the Exchange Act for compensatory employee stock options (even if held by more than 500 persons) if those options satisfy certain requirements, including the following:
- the stock options may only be held by permitted recipients of options for purposes of Rule 701 under the Securities Act (as described above) or their permitted transferees as provided in Rule 12h-1(f);
- the stock options may not be transferred or pledged by the optionholder, subject to limited exceptions, including transfers to family members through gifts or domestic relations orders, or to an executor or guardian of the optionholder upon the death or disability of the optionholder; and
- the company has agreed in the option plan, the option agreement or another agreement to provide to optionholders the risk factor disclosure and GAAP financial statements that would be required under Rule 701 if the $5 million sale threshold under that Rule has been exceeded.
A company that contemplates making option grants to a significant number of employees or consultants should consider taking the necessary steps to comply with the Rule 12h-1(f) exemption, even if the company is not yet approaching 500 optionholders. For example, if the restrictions on transfer required by this Rule are not included in all options at the time of grant, it will generally be difficult to add them to outstanding options if the company later concludes it needs to avail itself of the Rule 12h-1(f) exemption.
Another concern for companies with broad-based options plans is the treatment of options under the laws regulating overtime pay. Venture-backed companies may be particularly prone to providing compensation through options and other equity compensation to conserve precious cash. Yet any compensation provided to non-exempt (overtime eligible) employees must be analyzed to see whether it is part of “regular wages,” the starting point for paying time and a half for hours worked in excess of the federal and state standards (commonly more than 40 hours per workweek). Federal law provides a safe harbor for some stock option grants (but not restricted stock) if the options cannot be exercised for at least six months after the date of grant absent certain circumstances (such as employment termination or a change in control) and satisfy other specified requirements. Since most options do not begin to vest until at least six months after grant, venture-backed companies generally will be able to rely on this safe harbor. Moreover, failure to comply with the safe harbor does not necessarily mean that the employer will have to count the stock option value into wages for purposes of determining overtime pay, but it is certainly a risk if options are granted to non-exempt employees. A company should consult with its counsel to confirm that its option-granting practices do not result in wages for overtime purposes.
VII. Planning for IPO Disclosures
In developing policies and practices for granting options, venture-backed companies that are contemplating an IPO should consider the public disclosure requirements applicable to the IPO prospectus.
The SEC’s executive compensation disclosure rules require extensive disclosure concerning stock options in the IPO prospectus. Among the option-related matters that these rules require the IPO prospectus to cover are the following:
- The fair value of option grants, calculated in accordance with FAS 123(R), must be included in the Summary Compensation Table for executive officers covering the last full fiscal year.
- The material terms of any stock options granted in the last full fiscal year to an executive officer named in the Summary Compensation Table must be described.
- The IPO prospectus must include a “CD&A,” or compensation discussion and analysis, which is a narrative discussion regarding the company’s compensation policies, programs and practices for executive officers. The CD&A must discuss, among other things:
- the material elements of the company’s executive compensation program, including why each element (such as stock options) is included and the basis for allocating overall compensation among each element;
- the company’s polices regarding the timing of stock option grants vis-a-vis the release of material nonpublic information (e.g., does the company grant options while in possession of material nonpublic information);
- any policies or guidelines applicable to executive officers related to required ownership of company stock or retention of equity awards;
- if applicable, the reasons for providing for any acceleration of vesting of executive stock options upon a change in control of the company or termination of employment; and
- the performance factors used in any performance-based executive compensation (such as performance-based vesting of stock options), which could involve confidential commercial or financial information that a company may be reluctant to disclose.
In addition to matters covered by the executive compensation disclosure rules, there are other aspects of a company’s option grant practices that could require disclosure in an IPO prospectus. For example, the terms of stock options that are material to the calculation of the FAS 123(R) accounting charge—including any exercise prices that were below fair market value on the date of grant—may have to be described in the financial statement footnotes or MD&A. In addition, if the company has any potential liabilities relating to withholding taxes, that may have to be described in the IPO prospectus, depending on the materiality of the amounts involved.
VIII. Periodic Review and Update of Plans and Practices
In light of all of the above tax, accounting and regulatory considerations, and the ever-changing environment with regard to options, perhaps the most important “best practice” is for venture-backed companies to undertake periodic reviews of their options plans, agreements and practices.
Most venture-backed companies adopt a stock plan either at incorporation or at the time of their first round of preferred financing, and that plan quite often remains in place until the time of an IPO or other liquidity event. Often the only changes in the plan over time are increases in the number of shares available for issuance under the plan, which increases are typically approved in connection with subsequent financing rounds. Because of the timing of the increases, the company is generally (and understandably) too preoccupied with the financing process to take the time to determine whether any other changes should be made to the plan, or the company’s option grant practices under the plan, to reflect tax, accounting or regulatory changes that occurred since the plan was adopted. The failure to keep current with such changes may result in the company’s option granting documents or practices becoming non-compliant with existing law or out-of-step with current practices.
For example, as noted above, the California Corporate Securities Law imposes several substantive restrictions on the terms of options that may be granted to California residents. These restrictions were significantly liberalized in 2007. A company that has not updated its option plan in recent years may be granting options under a plan that mandates certain terms for option grants to California residents that are no longer required by California law.
In addition, some venture-backed companies may find it attractive to add “net exercise” as a method of paying the exercise price for nonqualified stock options. Under a net exercise, the option holder relinquishes a portion of the option, using the value of the “spread” in the foregone portion of the option to pay the exercise price. This approach eliminates the requirement for the optionholder to put up cash to exercise the option (other than possibly to pay any applicable tax withholdings). Companies with older plans may not be able to avail themselves of this approach, because the accounting treatment of net exercises was quite onerous under the pre-FAS 123(R) accounting rules and thus many older option plans do not permit net exercises.
Venture-backed companies should, together with their legal, tax, executive compensation and accounting advisors, periodically review their option plans, agreements and practices to ensure that they are consistent with the latest laws, interpretations and thinking related to options. Doing so will likely save significant time and expense as the company matures in its lifecycle.
Mick Bain, Bill Caporizzo, Curtis Mo, Lee Schindler and Joe Wyatt also contributed to this article.