Private Company Stock Options: An Idea Whose Time Has Come Back

Prevailing wisdom has it that stock options represent one of the unfortunate excesses of the 90s. While several practices around options at public companies during the 90s, with hindsight, have proven troubling. [1] stock options were then, and remain, important and legitimate ways of creating incentives for employees of growing private companies while conserving precious cash. With the market for mergers and acquisitions rebounding, and a selective revival of initial public offering activity in the works, it makes sense for many private companies again to consider grants of stock options to officers, directors and key employees.

In an environment of rising stock values, stock options have several attractions. They provide incentives for individuals who have the ability to enhance stock value to exert maximum efforts. They allow private companies to reward employees and others without depleting limited cash reserves. Indeed, they allow companies to save cash by substituting a portion of cash compensation with the upside potential of the stock value. Unlike bonus stock or restricted stock grants, they defer tax consequences to recipients and companies and prevent proliferation of stock ownership typically until a liquidity event occurs. Non-qualified stock options give the company a tax deduction at the time of exercise, which may mitigate a tax gain upon a sale of assets transaction.

Many private companies that survived the downturn of the last few years have compelling reasons to make current option grants. Options granted during the previous boom times may have been priced at levels that now make a payoff thoroughly unrealistic. Also, lower-priced venture capital investment rounds made during the last few years may have left very little value in the common stock, which may rank behind a large amount of preferred stock, sometimes with a multiple liquidation preference. New grants at current fair market value prices may have the benefit of reestablishing the proper incentives for the company to succeed.

Despite the ongoing debate about the proper accounting treatment of options of public companies, accounting for options of private companies remains as it was in the past. Companies granting options currently have the choice of accounting for option grants under APB 25 and the intrinsic value method, or under FASB 123 and the fair value method, and many public companies have been pressured by the markets and analysts to use the fair value method.Under the intrinsic value method, non-qualified options are generally taxed upon exercise at the difference between the fair market value of the underlying stock and the exercise price of the option, a measure that is referred-to as the spread. The spread represents both ordinary income to the option holder and compensation expense to the company. In contrast, the fair value method seeks to value the option as of the time of grant, using one of several accepted mathematical formulas, such as the Black-Scholes option pricing model. [2] Under the fair value method, the option is taxable as income and deductible as a compensation expense at the time of grant in the amount yielded by the relevant fair value formula.

Private company options are typically accounted for using the intrinsic value method, thus deferring tax consequences to recipients and companies. This treatment is particularly appropriate in the private company context, where the difference between cash and non-cash items is particularly acute. Since investors in private companies often think of their capital structure on a fully-diluted basis, the impact of option grants is typically well-understood. One pitfall to avoid in option grants is to re-price options or otherwise modify important terms during the duration of the option. Such changes to existing option terms can trigger variable compensation accounting, whereby the deferral of tax recognition on the options is lost, and the options become immediately taxable and subject to periodic revisions as their value increases or decreases. In order to avoid this adverse tax situation, companies should grant new options which are priced at the current fair market value, as determined by the board in good faith.

Due to increasing scrutiny of management compensation generally, it is likely that investors and courts will cast a more critical eye at large option grants in the future. While boards of directors have always been subject to fiduciary duties in approving option grants, recent caselaw suggests that these fiduciary duties will be viewed in a more exacting light. The Business Judgment Rule, which traditionally shields directors actions from judicial second-guessing, will be given a more restrictive interpretation. Private companies, however, have seldom faced scrutiny for excessive option grants. In the first instance, private company investors have tended to be more assertive on the front-end of option grant decisions than their public company counterparts. Also, the federal securities law exemption for option grants has generally served to limit option grants to around 15% of a companys outstanding stock. In addition, private company investors have tended to understand the need for appropriate incentives for officers, directors and key employees.

As has always been true, option documents must be carefully drafted around change of control situations. Particularly in the context of a private company, where a sale of the company is the most likely scenario for a liquidity event, option grants should be tailored to create and retain incentives for managers and employees to facilitate a change of control. The circumstances of a sale may suggest one or another treatment of outstanding and unvested options. Experienced counsel and accountants should be consulted with respect to the right treatment of options in a change of control transaction.

Current acquisition accounting methods also favor option grants under certain circumstances. Under the old pooling-of-interests accounting for acquisitions involving a stock purchase or merger, compensation paid in the form of option spread was carried backwards and forwards on the acquiring companys income statement. If the acquirer was a public company, the options would reduce reported net income. After the abolition of pooling accounting, however, the value of vested options is treated as a part of the purchase price with no corresponding expense recognition for that value in the future. Thus, a public company acquirer of a private company with substantial options would not have its earnings reduced by the value of options vested before the date of the acquisition.

Whatever the perceived problems and arguments around option grants by public companies, growing private companies should consider options an important and advantageous component of compensation for officers, directors and key employees.

This article is intended to serve as a summary of the issues outlined herein. While it may include some general guidance, it is not intended as, nor is it a substitute for, legal advice. Your receipt of Good Company or any of its individual articles does not create an attorney-client relationship between you and Sheehan Phinney Bass + Green or the Sheehan Phinney Capitol Group. The opinions expressed in Good Company are those of the authors of the specific articles.

[1] Among other things, commentators have accused some public company executives of inflating operating results in an effort to artificially raise stock prices to allow them to exercise stock options and quickly resell the underlying stock on the market and lock-in artificial gains.

[2] The Black-Scholes model represents an equation developed by two University of Chicago economics professors that posits that the value of an option depends on several variables, including the exercise price of the option, the statistical volatility (i.e. beta) of the underlying stock, the length of the option period and the risk-free interest rate. Because the statistical volatility of a private company stock cannot be ascertained, Black-Scholes has not been used to value private company options.