It’s a common question: Does the startup board have any flexibility when it comes to setting the strike price for options?
The short answer is no. The board has very little flexibility when it comes to setting the strike price.
Let’s break down why that is.
The dangers of underpricing stock options
Boards should be extremely wary of incurring liability or underpricing stock options only to have to reverse that pricing later on once the company is successful and goes through an audit.
If a company underprices their options and then auditors figure that out later, this will result in cheap stock scrutiny.
And even though they’re non-cash, cheap stock charges will show on a company’s profit and loss statement. So you want to avoid this if possible.
The role of the 409A valuation
When the IRS instituted 409A valuations many years ago everyone in venture capital was up in arms because they were expensive to do. Everyone was usually pricing each share at a penny and calling it a day.
However, the IRS realized boards were systematically underpricing stock options. For instance, companies would price shares at a penny instead of the fair market value. And at a penny a share, the management team would exercise their options, paying the penny a share. Then, with each incremental increase in value, they would be taxed at the capital gains tax rate, which is typically around 20%. While the ordinary income tax rate runs closer to 35% to 40%.
That’s a huge tax difference if you exercise early and treat everything as capital gains.
Once the IRS realized what was happening and how much in tax revenue they were losing, they instituted the 409A requirement.
The 409A valuation must be done by a third-party, accredited valuation provider. It can’t just be your board acting as a valuation firm and pricing the shares.
Thankfully, the cost of a 409A valuation has come down considerably.
It’s not only an IRS requirement, it’s smart and avoids the liability of cheap stock charges down the road.
Being safe and conservative will pay off in the long run.