stock option grant being cancelled because strike price greater than FMV and replaced with a new grant at a higher strike price

Question

I've been working at a startup for a few months and was granted stock options as part of my compensation package. The company is not public. The grant has been approved by the board and has already been issued.

Last week I received an email from the CEO who wrote that an independent valuation was done on the company to determine the fair market value of its common stock, which is subsequently used for setting the exercise price assigned to options. The valuation report indicated that all stocks options issued after a specific date earlier this year should have been valued 2.7 times higher per share (the FMV is still measured in cents, not dollars, so isn't that huge of a jump). The email was sent to all employees who were issued stock options that "should" have been granted with a higher strike price (everyone was on the BCC: line, so I don't know specifically who this effects but I can guess because I know who was hired in this time frame).

The letter stated that the board recently approved options at the lower price per share which "would put you and the company at risk of tax issues with IRS in the future if left unattended."

Given this, the Board wants to terminate the option recently granted and issue a new grant with the higher pricer per share. The number of shares in the new grant will be increased by 27% to makeup for the difference in value.

This sort of rubs me the wrong way. Part of me thinks that I like my job a lot and my salary is good so I should just go along with it. Part of me feels like the Company/Board screwed up and they're changing the terms of my compensation, which I don't think is cool. I'm not sure what questions to ask of the CEO/company.

• What could the tax issues with the IRS be? I thought (but not totally certain) that the tax treatment of an ISO option was based on difference between exercise price and FMV at the time of the sale.

• What should I take into consideration to determine whether a 27% increase in shares is a fair exchange for an increase in 270% increase in strike price.

Answer 1

What could the tax issues with the IRS be? I thought (but not totally certain) that the tax treatment of an ISO option was based on difference between exercise price and FMV at the time of the sale.

This is an accounting issue. There were times not so long ago that companies actually did these things on purpose, to boost the stock grant values for their employees (especially senior employees). They would give a grant but date it with an earlier date with a more favorable valuation. This is called "backdating", and it brought companies down and CEOs into criminal courts.

In addition, only reasonable compensation is allowed as a deduction for the company, and incorrectly set strike price may be deemed unreasonable. Thus, the deduction the company would take for your compensation can be denied, leading to loss of tax benefit (this was also a weapon used by the IRS at the time against companies doing backdating).

Last but not least, company that has intentions of going public cannot allow itself such a blatant disregard of the accounting rules. Even if the mistake was not made on purpose (as it sounds), it is a mistake that has to be corrected.

What should I take into consideration to determine whether a 27% increase in shares is a fair exchange for an increase in 270% increase in strike price.

Did you know the strike price when you signed the contract? Was it a consideration for you?

For most people, the strike price is determined at the board approval, since the valuations are not public and are not disclosed before you actually join, which is already after you've agreed to the terms. So basically, you agreed to get 100 sheets of toilet paper, and instead getting 127 sheets. So you're getting 27 sheets more than you initially agreed to. Why are you complaining?

In other words, options are essentially random numbers which are quite useless. By the time you get to exercise them, they'll be diluted through a bunch of additional financing rounds, and their value will be determined for real only after the IPO, or at least when your company's stocks are trading OTC with some reasonable volume. Until then - it's just a number with not much of a meaning.

The FMV does matter for early exercise and 83(b) election, if that is an option, but even then - I doubt you can actually negotiate anything.

Answer 2

Both you and the Company were probably benefitted by this decision. Specifically an option grant that was not FRV or more would require you to recognize the option as income whether you had exercised it or not. Additionally a host of other 409A tax issues/penalties could have been levied against you as an employee recipient. I certainly appreciate your concern about a change in compensation, but this is one where Corporate America likely saved your bacon.