Granting employee stock options (ESOs) according to section 409A; Who is covered by section 409A? How is the exercise price determined? What are the most important factors to consider?
American citizens, regardless of their actual place of residence, and US taxpayers are obligated to pay taxes on vested ESOs. However, some ESOs may expire without being exercised. In other words, the employee may be subject to income tax on their options regardless of whether they receive any income from them. Those who were granted options under section 409A of the American Internal Revenue Code can postpone the payment of taxes until the day of the actual exercise. So how exactly can you take advantage of this benefit? We at S Cube of IBI Capital, a leading provider of hi-tech valuations, certified by the largest worldwide appraisers association NACVA, recognized by the American authorities, are here to provide answers to the most frequently asked questions.
Who does the code apply to?
The code applies to anyone who pays US taxes. American citizens wherever they are in the world, anyone who is a USA resident, anyone who has a green card, anyone required to submit a US tax return. It doesn’t matter if the company granting the options is an American or Israeli company or was incorporated in any other country. The question is where the taxpayer received their options. For the avoidance of doubt, the code also applies to employees with dual citizenship. This includes those employed by an American subsidiary of an Israeli company and employees with American citizenship who live in Israel and are employed by an Israeli company.
Is it possible to claim ignorance of the law?
American Companies that grant options to employees in the United States, or Israeli subsidiaries, are required to comply with the 409A regulations. If they do not meet the requirements, they will be subject to penalties from the American Tax Authority.
However, Israeli companies that grant options to employees required to submit a US tax return sometimes intentionally or unintentionally ignore 409A requirements. If the regulations are ignored, they may become American Tax Authority evaders. This status entails severe sanctions, including high fines and interest. Therefore, it is important for Israeli employees with American citizenship, who were granted options, to verify with the company’s management that the requirements of 409A were met. Nonetheless, even if the exposed employee wishes to handle this issue on their own, they cannot, since a company valuation is required. This valuation requires information that the vast majority of employees do not have access to.
How is the exercise price determined?
In order to comply with the American regulations, it is necessary to hold a valuation of the company’s shares. This is an assessment of the value of the company’s ordinary shares, whose value is necessarily lower than the preferred shares. According to the code requirements, the exercise price must be at least the Fair Market Value (or FMV for short) for ordinary shares of the company. As a result, the exercise price should be at least the value of the ordinary stock as determined by a valuation performed by an appraiser, preferably one with an appropriate certification.
The ESOs exercise price can be increased for various HR reasons, which usually occur when companies have performed a Down Round – a fundraising round with a lower value than previous rounds. Usually in such cases, the value of the ordinary stock will be lower than the value estimated from previous fundraising rounds, making it difficult to grant according to the current value. In order to prevent a situation where a new employee receives options at a lower exercise price as compared to options a senior employees received, which may create a feeling of deprivation, the options can be granted at an exercise price higher than the value of the ordinary stock determined as part of the valuation.
Until when is a valuation valid according to the 409A rules?
In accordance with section 409A, employees may be granted options with an exercise price determined according to a valuation for a maximum period of one year following that valuation date, which reflects the company’s estimated value at the time of the valuation. As an example, if a valuation was performed in December 2021, but the value was estimated as of September 2021, then options can be granted based on the share price determined in this valuation until September 2022 the latest. Why the latest? Section 409A states that if a significant event occurs within the company that may affect its value, the valuation needs to be reassessed even if a year hasn’t passed since the last valuation.
If so, what is considered a significant event? Significant events include various transactions, such as a fundraising round or secondary transaction, but there are also other events that may impact the company’s value, such as business model changes. Therefore, if there is any doubt, it is recommended to consult a professional.
How do secondary transactions affect the exercise price?
It is common for secondary transactions to impact stock values, but the degree depends on the transaction structure and the identity of the sellers. Therefore, before closing a secondary transaction, it is best to consult about expected effects, whether they can be minimized and how.
Should Israeli employees be granted options at the same exercise price?
Although Israeli employees are not required to comply with the 409A regulations, and they can be granted options at any exercise price the company chooses, there are two key considerations that lead most companies to choose to grant all employees ESOs with the same exercise price (FMV). First, most companies do not want to create feelings of deprivation among employees and therefore grant everyone ESOs with the same exercise price. In addition, most investors and board members prefer not to grant options at a very low exercise price, as to avoid a situation where everyone who leaves the company exercise their options. In this regard, it should be remembered that options with an exercise price of one penny are indeed the greatest benefit that can be given to employees as part of the options granting, but from an economic point of view, there is really no difference between options with a zero-exercise price to ordinary shares.
Until when can a valuation be based on a funding round?
Fundraising rounds are substantial transactions that are carried out in company shares and therefore serve as a value indicator for the purposes of calculating the company’s ordinary stock value. For this purpose, the most common valuation method used is OPM, which is based on the B&S model for option value pricing. Considering that it is the highest level of value indication (a transaction between a willing buyer and a willing seller), the valuation cannot be based on the DCF or Multiple methods when there is a fundraising round. Accounting rules regard the DCF and Multiple methods as inferior value indicators as compared to a transaction between a willing buyer and a willing seller. Raising capital through convertible loans (such as SAFE, CLA, etc.) does not necessarily represent a value indication on the highest level, and accordingly it is not necessary for valuation purposes, unless the company’s management believes that the conditions established as part of the fundraising (mainly the Valuation Cap) represent the company’s fair value estimation.
However, a fundraising round from 2020, for example, would not be reliable as a 2022 value indication. That is, regardless of the actual valuation date, the specific company value calculation date for the purpose of 409A must be close to the transaction date. In some cases, this date may be postponed a month or two after the actual transaction date.
In which cases can valuations be based on the DCF or Multiple methods?
In the absence of a relevant value indication, if the company is able to provide a cash flow forecast, the DCF method (Discount Cash Flow) may be used, while the cash flows predicted by the company’s management have a substantial effect on the valuation. If the company’s management is unable, for various reasons, to provide a multi-year cash flow forecast, but the company has substantial revenues or profit, a valuation can be performed using the Multiple method, which is based on the value of similar public companies, as much as possible, in relation to data such as revenues, EBITDA, net profit, and net financial debt.
Beyond the exercise price, which should be determined by a qualified appraiser, complying with the criteria required under the rules of the American tax regulation 409A is an issue that involves various subtleties and raises various questions, some of which we have answered here. For any additional questions, you are welcome to contact Roni Birenzweig, Senior Analyst and Head of 409A, S Cube (roni@s-cube.co.il).
What is stated in this article is provided for informational and general purposes only and should not be considered complete and/or exhaustive information of all aspects involved in employee stock options according to 409A, etc. What is stated does not constitute legal, financial, taxation, economic advice, or a substitute for any professional and personal advice. S Cube and/or the IBI Group and/or any of the group companies will not be responsible for any loss or damage caused to any third party due to reliance on the above information.