When corporations grant stock options, which are critical for attracting talent, how can they determine the value of common shares? A privately owned corporation’s only option for providing tax-free options to its employees is to use a 409A valuation. In this article, we explain how to determine the strike price of stock options using a 409A valuation.
409a valuation and stock options strike price
Getting a 409A valuation not only finds the fair market value of a company’s shares but is also used to determine the strike price of your stock options for your employees. A stock option agreement’s strike price (or exercise price) is the preset price per share to purchase stock. The strike price is usually set lower than what people believe the stock to be worth in the future, implying that selling the stock later could be profitable.
What is a 409a valuation?
A 409A valuation is an impartial appraisal of your private company shares that determines the value of the stock. A 409A valuation is a regulatory requirement for companies that offer deferred remuneration to their employees, whether traditional or non-traditional.
Importance of doing 409a valuation for your business
Obtaining a 409A valuation permits your firm to comply with all tax rules and prevent IRS audits, which can result in legal concerns, tax issues, and even interference with the company’s operations if problems develop. Furthermore, the expense of hiring advisors or lawyers to defend your organization as the dispute drags on would be far higher. More importantly, your firm’s employees would suffer the most as a result of urgent tax concerns.
What is the stock options strike price?
The strike price is the predetermined future predetermined price at which the derivative contract will be exchanged. Call and put options are the two forms of options contracts. The striking price of call options refers to the price at which the asset is purchased. The striking price for put options is the price at which the asset is sold.
Why do companies need to determine strike prices for their stock options?
An employee stock option plan gives you the right to buy a certain number of shares of company stock at a set price called the “grant price” (also known as the “exercise price” or “strike price”) over a set period of time. Your options have an expiration date and a vesting date. You cannot exercise your options before the vesting date or after the expiration date. When the stock’s current market price exceeds the grant price, your options are considered to be “in the money”.
How is a 409a valuation important for employees?
This value is done for employment tax purposes. The amount payable to the IRS when an employee pays taxes on stock compensation is calculated using the 409A valuation report. Every year, in addition to any significant corporate events such as the issue of shares or a new investment round, the 409A valuation is re-evaluated.
In this scenario, the 409A employee valuation is critical so that the corporation is aware of the cost of the option being offered to the employees. The IRS requires this because they do not want the corporation just to assign any value to the company’s options.
How to determine a 409a valuation and strike price of stock options?
Many organizations use Stock Options as equity compensation to attract and hire the best employees for their teams. Stock options are intended to encourage employees, directors, consultants, and advisors to contribute to the development of a more valuable firm by providing them with the potential to share in the company’s financial upside as future equity owners.
Stock option plans and grants are more complicated than they appear on the surface. They include a variety of securities, tax, corporate and employment law issues, all of which necessitate proper compliance and administration in order to avoid legal difficulty and retain the stock option grants’ value. Each Stock Option’s Exercise (or strike) Price is a critical component in evaluating the Stock Option’s potential value. The Stock Option may not be a suitable incentive tool if the Exercise Price is set too high, as the grantee’s potential upside may be limited. If the Exercise Price is set too low, the grantee may be liable for taxes (more on that below).
Calculation of 409a valuation
Calculation of a 409a valuation is when the issuing of fresh equity, secondary sales, or a significant change in your company’s financial status are examples of these events. Finally, if a company is planning an IPO, a 409A Valuation should be performed more frequently, such as quarterly or even monthly. The first step in a 409A valuation is to calculate the enterprise value. This is done by using the following approaches:
- Income approach – The income technique, also known as the discounted flow method, analyzes the company’s long-term financial projections to determine expected income levels, which are then discounted back to present value.
- Market approach – The company is compared to a group of publicly traded companies in its industry that are similar to it. This appraisal aids us in arriving at a quantitative figure for the company’s worth. In other words, it’s a road map for firms to follow when it comes to valuing their private shares.
- Cost approach – To establish the enterprise value of a corporation, this method employs replacement costs or the appraised value of all of the company’s assets and liabilities.
Determine the FMV of common stock
The 409a valuation is a third-party assessment of a firm’s common stock to estimate the cost of purchasing one share of the company. This appraisal is based on the current market value (FMV). It’s a paradigm that all private enterprises should use when analyzing their own stock.
- Option pricing method – Option pricing theory calculates the value of an options contract by allocating a premium based on the calculated chance that the contract will expire in the money (ITM). Common shares would have significant value under this method solely to the extent that residual equity value remains after the preferred stock’s liquidation preference is satisfied at the time of a liquidity event. The OPM often uses the Black-Scholes Option Pricing Model to price the various call options.
- Probability weighted expected return method – The Probability-Weighted Expected Return Method is a multi-step method for estimating value based on the probability-weighted present value of distinct future scenarios. First, the valuation expert consults with management to evaluate the range of possible future outcomes for the company, such as an IPO, sale, dissolution, or continuation of operations until a later exit date.
- Hybrid method – The PWERM and the OPM are combined in the Hybrid Method. It employs probability-weighted scenarios, but with an OPM, it assigns importance to one or more of them. When a corporation has visibility into a specific departure path (such as a strategic sale), yet there are still uncertainties, the Hybrid Method may be used if that scenario fails. In this example, a PWERM with a probability assumption that the sale will go through might be used to estimate the value of the shares under the strategic sale scenario.
- Current value method – The Current Value Method subtracts the worth of the preferred classes based on their liquidation preferences or conversion values from the company’s total equity value on a controlling basis (assuming an instant sale). The remainder is subsequently distributed to common stockholders. Because the CVM is solely concerned with the company’s worth on the valuation date, it is unnecessary to make assumptions about future exit events and their timing. This method has the advantage of being simple to implement and not requiring a large number of assumptions or extensive modeling.
Because private corporations are not publicly traded on a financial exchange, DLOM only applies to them. Unlike publicly traded equities, there is no market for private stockholders to convert their shares to cash. This is referred to as “marketability”, or the ability to convert shares into cash fast. A “market” exists for publicly listed corporations.
This is due to the fact that their shareholders can sell their shares to another interested party. Because private owners can’t easily sell their shares, a discount for lack of marketability (DLOM) may be applied to a private company’s valuation. A private corporation should be valued at a lower price than a public company due to the lack of a market.
How does a 409a valuation help determine the stock options strike price?
Stock options are not included in the concept of “tax-deferred remuneration” in the United States unless specific conditions are met. Companies can largely avoid Section 409A if they award employees stock options with a strike price (the price at which the stock can be purchased) that is exactly equal to the common stock’s fair market value (FMV) at the time of the issuance. This is simple for publicly traded corporations, where the fair market value is the current stock price.
However, it is more difficult for privately-held businesses, such as startups. Provisions were added as a concession so that privately-held corporations might assess the FMV of their common shares in a fashion that the IRS would accept as acceptable — this is known as “safe harbor”.
How to choose the right strike price for stock options?
You cannot specify an option strike price that is lower than the 409A valuation’s computed FMV, but you can set a greater one. Regulatory and tax authorities are often only concerned when the strike price is set lower than the 409A valuation supported.
For the IRS, this would suggest that employees were given discounted stock options that were taxable at the time of award; for the SEC, it would signal that the company was understating its stock compensation expense to artificially increase its profitability.
In circumstances where the company’s enterprise value has decreased since the last 409A valuation, setting the strike price higher than the 409A FMV can be beneficial. When the previous 409A valuation is now far ahead of the firm’s current traction (and thus the new 409A is lower), or when the company is in a down-round situation, these are examples. To maintain employee morale, the corporation can choose to keep the strike price “flat” – the same as the previous 409A valuation.
Get experts to help to determine the right strike price with Eqvista!
The strike price is a critical decision for an options investor or trader since it determines the profitability of an option position. In order to get the right strike price, you must seek the advice of experts. Eqvista can help you there. Get a 409A valuation from as to determine the right strike price of your stock options. Contact us today to learn more!