Employee Equity: The Option Strike Price

A few weeks back we talked about stock options in some detail. I explained that the strike price of an option is the price per share you will pay when you exercise the option and buy the underlying common stock. And I explained that the company is required to strike employee options at the fair market value of the company at the time the option is granted.

The Board has the obligation to determine fair market value for the purposes of issuing options. For many years, Boards would do this without any third party input. They would just discuss it on a regular basis and set a new price from time to time. This led to some cases of abuse where Boards set the strike price artificially low in order to make their company's options more attractive to potential employees. I sat on many Boards during this time and I can tell you that there was always a tension between keeping the strike price low and living up to our obligation to reflect the fair market value of the company. It was not a perfect system but it was a decent system.

About five years ago, the IRS got involved and issued a rule called 409a. The IRS looks at options as deferred compensation and will deem options as taxable compensation if they don't follow very specific rules. Due to rampant abuse of the deferred compensation practices in the late 90s and early part of the last decade, the IRS decided to change some rules and and thus we got 409a. The 409a ruling is very broad and deals with many forms of deferred compensation. And it directly addresses the setting of strike prices.

409a puts some real teeth into the Board's obligations to strike options at fair market value. If the strike prices are too low, the IRS will deem the options to be current income and will seek to collect income taxes upon issuance. Not only will the employee have tax obligations at the time of grant, but the company will have withholding obligations. In order to avoid all of this, the Board must document and prove that the strike price is fair market value. Most importantly, 409a allows the Board to use a third party valuation firm to advise and recommend a fair market value.

As you might expect, 409a has given rise to a new industry. There are now many valuation firms that derive all or most of their income doing valuations on private companies so that Boards can feel comfortable granting options without tax risk to the employees and the company. This valuation report from a third party firm is called a 409a valuation.

The vast majority of privately held companies now do 409a valuations at least once a year. And many do them on a more frequent basis. When your company grants options, or if you are an employee and are getting an option grant, the strike price will most likely be set by a third party valuation firm.

You'd think this system would be better. Certainly the IRS thinks it is better. But in my experience, nothing has really changed except that companies are paying $5000 to $25,000 per year to consultants to value their companies. There is still pressure on the companies to keep the prices low so that their options are attractive to new employees. And that pressure gets transferred to the 409a valuation firms. And any time someone is being paid to do something, you have to question how objective the result is. I look at the fees our companies pay to 409a valuation firms as the cost of continuing to issue options at attractive prices. It is the law and we comply. Not much has really changed.

There is one thing that has changed and it relates to timing of grants. It used to be that the Board could exercise a fair bit of "judgement" around the timing of grants and financing events. If you had a big hire and a financing planned, the Board could set fair market value, get the hire made, and then do the financing. Now that is so much harder to do. It takes time and money to get a 409a valuation done. Most companies will do a new one after they conclude a financing. And most lawyers will advise a company to put a moratorium on option grants for some time leading up and through a financing and do all the grants post financing and post the new 409a. This has led to a bunch of situations in my personal portfolio when a new employee got "screwed" by a big up round. It behooves the Board and management to be really strategic around big hires and financing events to avoid these situations. And even with the best planning, you will run into problems with this.

If the company you are joining is early in its development, the strike price will likely be low and you don't have to pay too much attention to it. But as the company develops, the strike price will rise and it willl become more important. If the Company is a "high flyer" and is headed to a big exit or IPO, pay a lot of attention to the strike price. A low strike price can be worth a lot of money in a company where the value is rising quickly. In such a situation, if there has been a recent 409a valuation, you are likely in a good situation. If the company is a high flyer and is overdue for a 409a valuation, you need to be particularly careful.

This whole area of option strike prices is complicated and full of problems for boards and employees. It has led to a growing trend away from options and toward restriced stock units (RSUs). We'll talk about them next week.

#MBA Mondays

Comments (Archived):

  1. William Mougayar

    How about vesting periods as another factor. I know that we have discussed this before. Should vesting periods be similar for options and RSU’s?

    1. fredwilson


    2. Mark Essel

      Good question, also if an early liquidity event occurs it can seriously cut down on vesting. Full vesting on liquidity events must be an important negotiating point.

    3. JLM

      I think that vesting periods are a very important element of making ISOs work as YOU intend them to work.I like 4-5 year cliff vesting. Sure, it’s a tough standard but it is true to the objective of management — the golden handcuffs and creating a stable work force for a protracted period of time.Remember, as the Plan Administrator, you can waive any condition of the Plan at your discretion.ISOs are just one element of a balanced compensation plan and though folks have historically seen them as the pot of gold at the end of the rainbow, that is simply no longer true.Reality is a MFer.

  2. ErikSchwartz

    This is what I don’t understand about the Google Exodus to Facebook.Technically it’s a pre-ipo company, but in reality it’s raised money at valuations that make it difficult to have a real windfall for someone whose gets a current strike price.I would guess twitter and zynga have similar issues. How does really high strike prices affect recruiting? Do you end up recruiting like a public company?

    1. reece

      great question (exactly what i wanted to ask).

    2. fredwilson

      Google is worth 200bn. Over the next five years what can it be worth? Maybea double from there?Facebook is worth 35bn in the secondary market. Using the 409a tactics Imentioned the board might be able to strike options at a 20bn valuation. Ihonestly don’t know what FB’s 409a is right nowBut FB might be worth 100bn in five years so depending on how all of thisplays out it might be 5x on FB versus 2x on GoogleFor a superstar like Lars you might be talking 1mm to 2mm of sign on equityYou can do the mathTwitter and Zynga are even better options for superstars because they stillhave 10x or more upside

      1. ErikSchwartz

        Both 2X and 5X are public company kinds of numbers. To echo Mike Arrington’s excellent article yesterday, they’re not “Pirate Numbers” http://techcrunch.com/2010/…In the old days the reason you got into a company about to IPO was not to make 5X. You start when it’s worth almost nothing and you get out when it’s worth a lot. Getting in when it’s worth a lot and getting out when it’s worth more is trader thinking, not start up thinking. Frankly, those were the people that killed YHOO, the people who came in thinking let’s not screw up, let’s take no risks, let’s not rock the boat (even when the boat needs to be rocked). Now I suppose the world has changed, and companies go public MUCH later (if at all).FWIW For perspective, Facebook right now as a private company is worth 10x what Yahoo! was worth the day it IPO’d

        1. David Semeria

          Excellent comment Erik.

      2. davidthomas8779

        Facebook has been granting Restricted Stock Units for a while. Sought and received approval from the SEC to do so. http://www.sec.gov/division

      3. Dan Walter - Performensation

        An example of the problems relating “investor value” to 409A value…In 2007 MicroSoft invested $240Mil in FaceBook. The press immediately announced that it meant that FB was valued at ~$15Bil. At the same time FB had been valued for 409A at around $160Mil. (that’s right, Billions versus Millions). http://www.msnbc.msn.com/id…Projecting 409A values by using secondary markets or recent large investments can be risky. As companies get larger, more established and easier to compare to publicly traded peers (like FB is now) the 409A values start taking on more of the feeling of publicly traded companies.Fred is right in his frustration with this process. The old process was also critically flawed, but no more so than 409A valuations in a random volatile market. Many private companies currently have employees holding underwater stock options sue to unrealistically optimistic valuations when 409A become the law of the land. A more conservative approach now means that many companies have low-valued options in a time that may be a precursor to a growing IPO or Secondary market.No process will ever be accurate. The most we can hope for is the the 409A process becomes consistent over time.

  3. LIAD

    IRS rationale sounds whack.”board’s can’t be trusted to set fair market value so we’ll allow them to assign a 3rd party of their choosing to do so. We can’t see any way that system could be manipulated”Are the 409a valuation co’s regulated and quasi-appointees of the IRS (like liquidators) or are they just accountants who are happy to sign valuation documents?Have there been public cases of the valuation co’s being found guilt of setting artificially low prices, either at the quiet behest of the board or due to wanting to be known as the “friendly valuation co?” Industry seems ripe for corruption.Quis custodiet ipsos custodes? – who guards the guards?

    1. fredwilson

      the fox is guarding the hen house

    2. RichardF

      “se custodiet se contra ipsos”or “Nescio. Custodi coast?” if you prefer Homer

  4. Ken Hirsh

    Great stuff. Do be clear, a 409a valuation can be significantly lower than a recent funding valuation and even a current secondary market valuation?

    1. johnmccarthy

      The 409a is valuing the Common Stock, in order to determine the common option strike price. Discounts of the common per share value to the preferred stock value are usual given the benefit that preferred has over common ( liquidation preference, dividends, etc)

    2. fredwilson

      yesyou get what you pay for :))))

    3. Mark Essel

      Huh, I had assumed valuations were all related, would be odd to have a 409a and an investor round that are highly different. But I guess based on timing that could be the case. How much squeeze room in company value is there?

      1. Brian Alwine

        There is a LOT of “squeeze room” in company values. In a couple of recent small company valuations I’ve performed for litigation purposes, the expert on the other side and I differed by 100% (e.g. $1 million company value versus $2 million value). Amazing thing is we even agreed on the projected long-term earnings stream. The difference was nearly all in the discount rate/weighted average cost of capital assumptions. I personally believe many in my profession have erred in overselling the science side of what we do. A lot of folks are fooling themselves into being precisely wrong rather than approximately right..

  5. Ken Hirsh

    Also, do people ever use 409a valuation firms to value financing rounds?

    1. fredwilson

      no, because investors know they are bullshit

      1. Adrian Bye

        lol.. thats the key right there

  6. baba12

    “About five years ago, the IRS got involved and issued a rule called 409a. The IRS looks at options as deferred compensation and will deem options as taxable compensation if they don’t follow very specific rules. Due to rampant abuse of the deferred compensation practices in the late 90s and early part of the last decade, the IRS decided to change some rules and and thus we got 409a”.This is a classic case of private enterprise abuses it’s role and responsibility and then the government has to step in.Sure as you state the system was not perfect but it worked until it started to be abused.It is is the case in every sector of society, businesses feel they can manage and be fair until there are enough who abuse it, thus we have to have government step in.I am sure you Mr.Wilson were not always happy with the board decisions when you were part of one and had to price options unfairly ( you conscience wouldn’t allow it)When USV invests in a startup does USV try to help the startup make sure they do the right thing always in terms of how they treat the employees or how to or not to cook the books etc.I am just wondering besides investing and opening doors (networking) does a VC like USV ( since not all VC’s are similar) play a role in helping a company be a role model etc.Since third party valuations are compulsory does USV have a in house team or has a partnership with a firm that does this service for all the portfolio companies USV has, would think you would want to lower operating costs and if you can offer it as part of a service it maybe cheaper for all concerned.

    1. fredwilson

      we try, but we do not control our portfolio companies

      1. baba12

        Don’t have to control but you can always define rules of engagement in terms of how you see the world.Lot of companies feel they can play in the grey areas of accounting and taxes. Sure they are not breaking any rules but to knowingly always do the right thing only when forced to do so is a cop out.I wish USV played in the sustainable mobility field Id have approached you for advice and possibly asked USV to kick the tires around to see if they would be interested in investing. But that is another story.Principles matter. When there were no rules defined the Board had a fiduciary responsibility sure but also they had to define the rules that were fair ( to everyone) and if that had been done there would never have been an rule defined by the government. Whether the new rule 409a is fair or not is not up for debate ( it can always be refined) but as a board member if you don’t agree with the valuations prior to this rule was there a recourse available at all.I am guessing valuation companies are also using projections and so there is no science, then the question is how good the art needs to be to fool the IRS and also potential new employees.

  7. Mark Essel

    Update, just read this related post on 409as and IPOs from Don Dodge: the Link.Tricky stuff, this cat and mouse of taxation and options. Look forward to how RSU’s avoid the additional overhead of many 409a valuations a year.So far it lookalike a headache for the board to identify the value of a rapid growth business. Can’t lowball it or you face tax pains, over estimate value and the company faces a downround in a short building phase.The worst part of 409a has to be the effect on hiring. There are only so many top pros that are in the market, that if your startup doesn’t strike with an irresistible offer, another company will.

  8. Matt A. Myers

    Sounds like a load of bull to me!I wonder if this is just the first step and they’re planning to implement more stringent rules after some time once infrastructures are in place.

  9. kenyan

    Really interesting. I work in Environmental impact assessments and assurance work for sustainability reports. We do for those reports what the 409a consultants do for strike prices. Always had an underlying issue with the fact that we are paid to put a stamp on a company’s environmental, social and governance reporting.A personal first: I have never seen the word “behooves” used before. I’m an English Lit major. Shows how much i paid attention at Uni!

    1. fredwilson

      did i use it right?

      1. kenyan

        “behoove – be appropriate or necessary; “It behooves us to reflect on this matter”Yes I think so! 🙂

  10. Reid Curley

    Fred, I am looking forward to your post on RSUs next week. Options-based equity compensation seems to be on its way out, at least for the ranks below senior management. The 409a valuation provisions are part of that, but a bigger factor is that the cost of calculating the expense to recognize under FASB 123R (large) is totally out of proportion to the benefits stakeholders get from knowing that number (none). Finally, it is very hard to take advantage of the favorable tax treatment of ISOs unless your company is going public. Given the dearth of IPOs these days, that is the small minority of cases.

    1. Dan Walter - Performensation

      I think what we are seeing is a more balanced approach to equity compensation. This is due in part to things like 409A and FAS 123R, as you mentioned. I believe it is far more based on the fact the market is proving itself to be truly volatile, as it did every decade prior to 1988, and every decade after 1999.Volatility creates huge uncertainty in stock options. It can create enormous upside and zero-value downside.It is important to remember that Volatility also impacts RSUs. They seem great when the future looks a bit dim, but once the sun comes out everyone with RSUs is envious of those with options.As with most with most things in life a good rule is: Moderation in all things, including moderation.

  11. JLM

    Great post and absolutely pitch perfect in tone and content.The larger issue here is that — perhaps because of real world abuses, mind you — government sees itself in the role of essentially regulating the creation of wealth through entrepreneurial endeavors.They have a legitimate interest in taxing wealth but not really in its creation. They should take the attitude of allowing it to be created and THEN taxed. Every penny of it. They have no legitimate interest in its creation.Given some of the abuses, I cannot fault them on the underlying sentiment as it relates to the abusers — hell, Apple was playing with the effective date of Jobs’ options. The guy doesn’t really need them.All of these Boards know better. I do. You do. They do. But still, they cannot resist the temptation to color outside the lines.The abuses have invited the regulation and it is not a narrow view. It is SOx and 404 and deferred comp (one of the most valuable and underused concepts in creating motivating compensation) and options accounting and just the sheer complexity of what is a very simple concept — allowing folks to get rich.”Allowing” makes me want to puke — they should be encouraging and assisting and cooperating in the creation of wealth because that is where their revenue comes from.I would bet that most Boards and “C” management spend at least 25% of their time screwing around with such regulatory concerns.They are not doing this in China and those electrons running around the Internet don’t know from whence the money comes.America needs to turn its business entrepreneurial pioneer spirit loose again and get the hell out of the way.Tomorrow will be a big step in that direction?

    1. PhilipSugar

      “deferred comp (one of the most valuable and underused concepts in creating motivating compensation)”Can you expand on this????Every time I’ve had people propose this I felt like I was getting totally “sold to”….probably because they wanted to manage other parts of my money. I always have kept business and personal separate…..my banks have always wanted my personal money as well as my business.Funny in that I learned that lesson when I gave my accountant personal checks instead of company checks and had to scramble when the first ones started to bounce.I know people will say this doesn’t scale, but I think below $50M you should sign every check personally……seriously its an hour or two once a month….and you really understand where the money is going.

  12. davidu

    Fred — It’s worth mention that as your option price creeps upwards, it becomes (for better or worse) a form of handcuffs for employees.If your option price is $0.50/share and you grant a new exec 200,000 options then it will cost them $100,000 to leave your company once vested. At $0.01/share, your early employees can exercise themselves and bolt.That’s why early Facebook employees are gone, but ones who showed up in 2008 and 2009 are forced to stay or forfeit their options. The alternative of purchasing them and selling them quickly creates a massive tax hit, which is why almost nobody does it.As a consequence, there are already people at Facbeook who want to quit but can’t afford to.Understanding this dynamic as it relates to recruiting senior folks is critical as your company scales up.

    1. JLM

      “…it becomes a form of handcuffs for employees…”Of course, that is exactly how they are supposed to work, no?Nobody is being “forced” to do anything. This is simply the market forces sorting out the priorities of the employer’s interests v the employee’s interests using ISOs as the medium of exchange.The age of entitlement is over both because the market has changed but also because the utility of stock options as the pot of gold at the end of the rainbow has waned.

  13. ShanaC

    This is unfortunate for employees -how are you as the employee supposed to judge if/when there is an overdue 409a?According to this post as well, abuses didn’t dissipate as much as expected. So what was the point of this?

    1. Dan Walter - Performensation

      Most companies do 409A valuations annually or quarterly. If you are an employee looking at a new company you may want to ask what frequency the company uses and when the last valuation was performed. You still won;t have any real idea what the next valuation will provide, but at least you will understand where the company is in the process.

      1. ShanaC

        That’s pretty good advice

  14. Ivan

    For very early stage companies – especially pre funding or those where seed round was raised as convertible debt (which doesn’t “price” the company) – it’s worth considering just selling stock outright to early employees and subjecting it to a Company repurchase right. 409a doesn’t apply because you’re not granting an option so Board’s have a little more flexibility in exercising judgment on pricing. You still have audit risk but that’s the same risk that has always been present for private company boards; at least you’re away from the ugly penalties imposed by 409a. The company repurchase right can lapse over the same time as the right to exercise an option would normally vest so that you get the same result from that standpoint.The reason I say this only really helps in early stages is that as the price goes up, employees can’t handle the tax burden of getting the shares in exchange for services (immediately taxable as compensation) or, if buying the shares, can’t come up with the cash. At some point, the only choice is options where the tax event can be deferred until such time as there is liquidity from an exit to cover it.It’s not perfect in that there are companies who don’t want to have too many early stockholders among the employees since it tends to add unaccredited stockholders that can complicate a stock based M&A event, but it’s really no different than permitting employees to early exercise options which many companies routinely do.Last note – companies/Boards need to be mindful that there is another major constituency here and that is public company acquirors. They tend to be extremely conservative about 409a practices and fearful of assuming any 409a liabilities when they acquire private companies. That can be reason alone to jump through the hoops of getting a third party appraisal so that you’re not doing the two step when your prospective buyer digs into due diligence on this issue.

  15. Ethan Stone

    Sadly, this is a great post. I say “sadly,” because I agree that the 409A valuation industry probably hasn’t been worth the trouble. That said, it’s worth emphasizing the one area where Fred pointed out that it has made a difference: Issuances right around a financing. I remember having to stand up to a client in the late 90s whose investment banker convinced the client to take him on as CFO a day before the first round of financing, granting him stock options with a strike price at a tiny fraction of what the investors were already contractually obligated to pay (yes, for preferred stock with a liquidation preference, but that’s worth only so much). The client was upset and the banker was apoplectic, but there really wasn’t any honest ambiguity in the situation. I would have preferred to tell them to leave me alone and try to convince a valuator, which they probably couldn’t have done. Also, that was an easy situation, in that they were trying to do something completely outrageous. Similar situations where the parties were less greedy (i.e. the undervaluation was evident, but not flamboyant) put those of us who were trying to give honest advice in a harder position. So I agree that the pressure is still there and that the valuators know which way to skew their valuations to please their clients, but requiring valuations probably puts a brake on the worst of the abuses. As I said at the outset, however, it’s not at all clear if curbing those abuses is worth the cost. As Fred’s post and the above anecdote indicate, the basic legal framework hasn’t changed and most of us were honestly trying to keep things within reasonable compliance before. So adding another layer of paid mumbo jumbo might not have changed much.

  16. Guillermo Ramos Venturatis.com

    Fred, It would be great to have a post on how to correctly value (and price) companies

  17. davidthomas8779

    Two additional points:1. The taxation for a discounted stock option under Section 409A occurs at the time of vesting, not at the grant of the option. The tax is based on the spread at vesting and normal federal income taxes will apply, in addition to the federal 20% penalty tax and for California taxpayers, the California 20% tax. The problem that this presents is that for a company with increasing value, the potential liability is unbounded because you can’t determine in advance the spread at vesting and use that to decide if you want to take some valuation risk.2. Although there are more private companies granting restricted stock units now, this just means more than the zero private companies who granted them before. There are separate issues that arise when granting private company RSUs (beyond the scope of this blog comment other than to point out up front that they are not a panacea).[I feel obligated to make myself look like an ass by pointing out that even if you’re my client, my blog comments are not legal or tax advice.]

  18. paramendra

    How Companies Get Valuated http://goo.gl/fb/W25kZ Android is not fragmented, what is really screwed up and fragmented is how companies get valued.

  19. mattmcknight

    Another quick note is that with some of these things, you get them to show their work and you have a formula you plug in the values to next year, with whatever market wind adjustment you find most correlated.

  20. Prokofy

    What I wonder about is the effect of all these employee stock options on the actual value of the company. On the one hand, giving empoyees stock options seems the right thing to do, it seems fair. On the other hand, if a company has not yet reached the IPO stage, it can be terribly misleading and create a completely false picture.Given that so few companies are reaching the actual IPO stage, at least in the world I watch of virtual worlds, social media, etc. I wonder whether this entire artificial bubble of non-IPO companies is being formed.There is the valuation of what Facebook or Second Life stock is worth based on what employees sell it for when they leave, but is this really a reliable business indicator? There’s something infantalizing about this, and also authoritarian, keeping a company from real public scrutiny to see what it is really worth on the real market, and endlessly keeping it in the magic circle of VCs.For example, there’s Linden Lab and Second Life, not a public company, and 9 years old with the beta beginning in 2003. The employees got these shares that aren’t real shares. And the investors did too. Then they sell them when they leave. And SharePost publicizes this (although not the names). Then when a whole bunch of people are fired (30 percent of the staff) bunches of staff sell out, and the valuation declines sharply.But…the company isn’t *really* devaluing. Perhaps it’s doing the right thing by shedding excess staff that it bulked up with when it was under management that was trying to force it into some social media/art direction that wasn’t appropriate and way too much was spent on consulting, design, making a new browser, etc. Then it corrects course, cuts the staff, but is still as a company making a profit, more than the per capita of Facebook — if you could look at worlds and games as countries with GNP, Second Life would have a higher GNP than any of these companies because it makes real bank by having an economy with sales of land (server space) and commissions on content and currency, and is also a platform for the users to make money (so unlike Facebook and Twitter unless you are some SEO goon or s/m guru hawking your largely unnecessary services). But because of this staff massacre, the shares devalue, and you get headlines describing the loss of hundreds of thousands in value. Is this a *real* valuation? Or is it an artifact of this employee-shares culture that is so non-transparent and so elusive from public scrutiny?It’s as if these big social media companies, along with destroying so much else in life, have also destroyed the normal public stock markets of the world by creating this ultra-elite insular employee stock trading interface. BTW, you can’t just go and day trade for pennies on SharePost, they won’t let you.

  21. lushfun

    Is there any pushback on the 409s? to challenge the status quo?The whole ordeals seems to be set up to get more money paid to accountants and lawyers for services to some degree, and to the gov’t as well.How would a 409 apply to a seed round company? ergo someone who just incorporated and sold a seed round to investors OR divided up the company between a couple of founders OR one founder several key employees? The whole thing seems that as soon as your inc’ed.up you should shell out money you do not have for services you do not need.

  22. Michael B. Aronson

    Great post and discussion, I had wanted you to post on 409a. We deal with in in all of our companies. We just had one done for a company that had a large pref stack through multiple financing rounds and got a common valuation at about 20% of the preferred due to the public company comparables used by a major valuation firm. There are a lot of public companies that trade at low multiple for a variety of reasons.On thing that is different for us is that we do early stage medical and materials with no revenues. The lawyers usually feel that some discount can be taken with some internal valuation work but you know that if you go outside for an opinion you will get a very large discount and there is often pressure by astute CEO’s who have been there before to do so. Wish that their was a less expensive alternative to a $5k ish valuation.

  23. vinniv

    When a company issues a convertible note, does that require an updated valuation or 409a?

    1. fredwilson

      good questionmy guess is no because there is no implied valuationbut a lawyer might have a different view

      1. davidu

        The answer is definitely yes. Even a major sales deal that dramatically changes the course of a startup could be considered to change the fair market value.Knowing you will fundraise in the future is enough to require you to stop doing option grants and to conduct a 409A.It’s all BS, but the legal language is so vague as to what constitutes a meaningful event it causes boards to generally be over cautious.

        1. vinniv

          I am in a position where I was granted options (which have fully vested) and the company recently raised funds through a convertible note. If we have a new and significantly higher valuation then I could perform a cashless exercise to pay for my vested shares (rather than paying out of pocket which I cannot afford). Any idea if there is a way to tell if a new valuation was given?EDIT: There has not been a subsequent fund raising event since the initial convertible note.

    2. Dan Walter - Performensation

      Convertible notes alone do not give rise to a need for a 409A valuation. If you issue a convertible note and then issue stock options, you may need to do a new 409A valuation. 409A is allow about “knowing” the Fair Market Value of the stock on the date of equity grant. If the convertible note can change your FMV, then you will need a new valuation.

  24. Ethan Stone

    If options have no value, why do people want them and how could they possibly serve as an effective means of compensation? The value is having a contractual right to buy stock in the future at a fixed price that might (at that time) be lower than its value. Vesting requirements lower an option’s value by lowering the chance you’ll get to exercise. A liquidation preference overhang lowers the value by lowering the chance that the option will come into the money before it expires. Voting rights have some effect although, in most cases, that’s really negligible in a private company with big block stockholders. All of that said, there’s still a current, non-zero value. I’m personally not a big fan of the Black-Scholes option valuation formula, but they’re certainly right to say that an option has a value that is different from the money you could realize right away from exercising it and liquidating the stock.How to treat that value under the tax system is a separate question. I’m not saying that the treatment of equity compensation under our income and employment taxes shouldn’t be changed to be simpler or to better incentivize innovation (although I’m very skeptical of the latter goal for the same reasons I’m skeptical of special tax incentives for small businesses, family farmers or mohair growers). There might be good reasons for treating some options differently and the compliance benefit of some rules clearly isn’t worth their cost (see my comment below), but that’s a different topic. Let’s start with reality: Options are valuable. That value should be reflected honestly in an honest accounting system and in an honest tax system.

  25. PhilipSugar

    Remember the beauty/value of an option is that it is exactly that….an option to buy. Meaning you can buy if it makes sense/don’t buy if it doesn’t. So the strike price can never be zero.Another point I’ve always made is that the strike price of the options should go exclusively to the original commons…..usually the option pool comes only out of the commons why shouldn’t the strike price go only to the commons.Having received my only 100% grade at Penn at Finance Course #6…..I can assure you I know the Black Sholes model but think its crap because it it making assumptions on the future using data from the past, and assumes a certain risk free interest rate.For example one of my classmates did a great senior thesis applying it to horseracing.However it doesn’t work if you know Smarty Jones is going to win…..its the same problem that got people in trouble securitizing mortgage backed securities.All that being said I think a SWAG is that common is worth about half of what preferred is right after a preferred round.Fred probably knows better because he’s seen the deals at Zynga and Twitter.

  26. Ethan Stone

    OK. So if you have ever been issued options, ask yourself if you would have felt a lot better if the company had offered you a roll of toilet paper instead. If not, then you personally think they have value, whatever you say for rhetorical purposes. If they have some value (more than a toilet paper roll), the question is how much and, more to the point, what’s the most efficient and fair way to tax them and account for them. Those questions are not easy and reasonable people have a wide variety of legitimate views. But it really isn’t reasonable to say that they don’t have value.

  27. Fonarkin

    Thank you Ethan! I have been asking my clients the same question. I even offered to take all these “worthless” options and warrants off their hands. Publicly traded option contracts have very specific value assigned to them. Just because they are conditional, does not mean they do not have value at the current data. It take a little more than high school arithmetics to calculate that value, but it is a very simple and basic concept in financial economics. Sorry Charlie – IRS will win this argument every time.So much hostility towards 409A does come from lack of financial knowledge, as well as the desire to maximize profits from stock options. One has consider the fact that every time you get underpriced stock options, you just taking money way from other investors, i.e. venture capitalists, founders, etc. This is why I do not understand why VCs are so against it.