In 2014, the IRS increased its scrutiny of stock option pricing and began an audit program for 409A deferred compensation plans. The tax implications of incorrect pricing can be extensive, so this increased oversight makes a strong, supportable valuation process more critical than ever for privately held high-tech and life sciences companies.
Your board needs to understand the valuation process before they approve grants of stock options. To help you walk them through stock option pricing, we've detailed the process for valuing stock options after a Series A preferred stock financing (at arm's length with sophisticated investors). For privately held companies, this type of financing provides one of the best indicators of a company's market value.
Why Valuation Matters
Unsound stock option pricing methodology can have major tax consequences for your company and your workforce. If the IRS determines that you've violated IRC Section 409A and priced your options below their fair market value, your employees will be liable immediately for taxes on the value of their stock options, plus a 20% penalty. Your company will owe payroll tax on the options and, more significantly, will probably have to placate angry employees by paying their option-related taxes and penalties.
When You Need a Valuation
Per IRS rules, you need to do a 409A valuation as close to the stock option grant date as possible, and you must update the valuation at least once a year. Significant events―such as a round of financing― or changes in control, even if foreseeable, also require a new valuation.
How to Use the Option Pricing Method
The Option Pricing Method (OPM) defined in the current American Institute of Certified Public Accountants (AICPA) valuation guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation, is a common method of allocating equity value between preferred stock and common stock, and is widely used for 409A valuations. The OPM makes assumptions based on the BlackScholes model, including the time to a liquidity event, volatility and risk-free rate. Within the OPM framework, the "backsolve" method uses the price of a recent preferred stock financing, along with its liquidation rights and any special conditions, to work backwards and solve for the total equity value of the company.
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The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
