This chapter includes sample letters used in assisting clients with the myriad of issues and activities that arise in the context of engaging directors and hiring employees, not the least of which are compliance with employment tax withholding requirements and avoiding employment law issues.
These letters cover the full circle of life for employment, from pre-employment to termation, including:
Employment laws vary by state, so readers should refer to resources in their own jurisdiction in drafting the types of correspondence included in this chapter.
In California, the California Chamber of Commerce is an excellent source for current employment law requirements, mandatory provisions for employee handbooks, and workplace posters compliant with all mandatory state and federal posting requirements, which should be replaced annually to remain compliant. Other state chambers of commerce may provide similar resources.
One of the biggest issues in connection with the use of stock options or stock grants as incentives for key contractors and employees in a privately held entity is determining the fair market value of a company’s stock. Sample letters in this chapter address the valuation issue and provide some guidance for the same.
However, the securities law requirements in connection with the issuance of stock or stock options should not be overlooked. Please refer to Chapter 8 for additional material relating to securities law compliance.
Invitation to Join Board of Directors
{Date}
{Name}
{Company Name}
{Address}
{City, State, Zip Code}
RE: Invitation to Join the Board of Directors of COMPANY
Dear {Salutation}:
In our capacity as Directors of the Board of COMPANY, we are delighted to offer you a seat on our Board. If you accept our invitation, we will appoint you at our next meeting on DATE, effective immediately. If you do accept, please plan on attending that meeting. This appointment shall convey to you all of the rights and privileges granted to Board Members by the charter documents of COMPANY (Company).
The Board has agreed that upon acceptance of this offer of appointment you will be granted a non-statutory stock option under the federal income tax laws to purchase up to _________ shares of common stock under the COMPANY Stock Option Plan (Plan) with a per share exercise price of ___________ ($_____). The option will be evidenced by a standard stock option agreement and will be subject to the terms and conditions of that agreement and the Plan under which the option is granted. Such terms and conditions will include, but not be limited to, a maximum term of 10 years subject to earlier termination following your cessation of appointment and vesting of 30% of the option shares upon written acceptance of this offer of appointment, with the remaining 70% of the option shares vesting monthly over the 36-month period commencing upon your initial attendance at a Board meeting. The shares purchased under the option will be subject to certain transfer restrictions and repurchase rights of the Company as set forth in the Plan.
As a member of the COMPANY Board of Directors, we anticipate you would aid us in (i) raising funds from angel and institutional investors, (ii) human resource identification and recruitment, and (iii) other corporate development issues. The only fixed time commitment would be to attend our quarterly Board meetings.
We hope that you will accept our offer by signing and dating this letter in the space provided below. We at COMPANY look forward to working with you.
This letter is the complete and exclusive agreement between the parties and supersedes all prior agreements relating to the subject matter hereof. This agreement can be amended or modified only by a writing signed by the appointee and an authorized agent of the Company.
Cordially,
COMPANY
OFFICER
I hereby accept my appointment to the COMPANY Board of Directors as outlined above:
Date: __________Signature: _______________________
Invitation to Join Nonprofit Board of Directors
{Date}
{Name}
{Company Name}
{Address}
{City, State, Zip Code}
Dear {Salutation}:
This firm serves as outside general counsel to COMPANY. On behalf of the Board of Directors of COMPANY, I am delighted to extend you an invitation to become a member of COMPANY’s Board.
For your reference, enclosed please find copies of the following COMPANY documents:
Mission Statement;
Articles of Incorporation;
Bylaws; and
Conflict of Interest Policy
As a Board member, we anticipate you will aid us in (i) establishing grant guidelines, (ii) approving grants, and (iii) attracting charitable contributions from donors. COMPANY currently pays reasonably incurred travel expenses in connection with directors’ attendance at Board meetings, but no other compensation for their efforts on behalf of the COMPANY.
The Board hopes that you will accept its offer by signing this letter in the space provided below and returning it to us via fax or e-mail no later than DATE.
The next meeting of the Board of Directors will be held on DATE at ____ AM/PM. You may participate by telephone by calling _____________ and entering _____ as the conference code.
If you have any questions, please do not hesitate to call me directly.
Very truly,
FIRM NAME
Lawyer Name
Enclosures
I hereby accept my appointment to the COMPANY Board of Directors as outlined above:
Date: __________Signature: _______________________
Checklist for Employment Law Compliance
{Date}
{Name}
{Company Name}
{Address}
{City, State, Zip Code}
RE: Checklist for Employment Law Compliance
Dear {Salutation}:
As you know, the human resources element of a growing business is complicated and fraught with potential liability for those who are careless or uninformed. The following is a checklist outlining some of the most important areas where you may find you need assistance to properly manage the growing number of employees at COMPANY.
With laws changing constantly, your existing policies and forms should be revisited on a regular basis. Please do not hesitate to call me with any questions or for assistance with regard to any of the above.
Very truly,
FIRM NAME
Lawyer Name
Background Checks on Prospective Employees
{Date}
{Name}
{Company Name}
{Address}
{City, State, Zip Code}
RE: Background Checks for Prospective Employees
Dear {Salutation}:
To follow up on our telephone conversation this morning, the following are some guidelines for conducting background checks on California employees.
Employee background checks are governed by both federal and state law. The applicable federal law is the Fair Credit Reporting Act (FCRA) (15 U.S.C. §§ 1681 et seq.), which you can access online at http://www.ftc.gov/os/statutes.fcra.htm, and the applicable state laws for California employees are the California Investigative Consumer Reporting Agencies Act (ICRAA) (California Civil Code § 1786 et seq.), and, where a credit report is included, the California Consumer Credit Reporting Agencies Act (CCRAA) (California Civil Code § 1785 et seq.). However, this area of law changes rapidly, so any policy COMPANY adopts should be reviewed periodically for continuing compliance.
The California law is broader in scope than the federal FCRA, as it covers employers who conduct background checks in-house (as opposed to using an outside agency), something the FCRA omits, but the rules are more stringent when an outside agency does the background check than when the company performs its own checks in-house.
In general, a California employer must provide notice and obtain an employee’s prior consent to conduct a background check, and the employer must provide the employee with a copy of the results.
Best practices call for the observance of the following procedures in connection with California employees:
A. If an employer intends to conduct an in-house background check, the employer must:
B. If the employer conducts background checks in-house, the job application form or a related document should include a box for the employee to check indicating that he or she (or applicant) wants a copy of public records obtained in the investigation.
C. If an outside agency will be used to perform the background check, the employer must also give the employee notice that:
D. If the employee wants a copy of the report, it should be sent within three business days of the date the employer receives it. The report may come from the employer or from the screening company.
E. Finally, the employer must give the employee a “pre-adverse action notice” along with a copy of the background report before an adverse action is taken, such as termination of employment, as well as a “post-adverse action notice,” telling the employee how to dispute any inaccurate or incomplete information in the report. There is a Federal Trade Commission publication called Using Consumer Reports: What Employers Need to Know, available online at http://www.ftc.gov/bcp/edu/pubs/business/credit/bus08.shtm, that may prove useful should you decide to get a background check on an employee. I have enclosed a copy for your convenience.
F. The CCRAA also gives employees certain rights when a credit report is requested as part of an employment background check. Some examples:
If you do use an outside agency for your background checks, they should be able to help guide you through this process.
Please don’t hesitate to call me with any questions or if you need forms for complying with any of the above.
Very truly,
FIRM NAME
Lawyer Name
Enclosure
Offer Letter to Prospective Employee
{Date}
{Name}
{Company Name}
{Address}
{City, State, Zip Code}
Dear {Salutation}:
COMPANY is pleased to offer you a full-time position as an at-will employee of the Company on the terms and conditions set forth herein. Subject to the approval of the Board of Directors, you will hold the position of TITLE of the Company and will have all of the duties normally attendant to such a position. We would like for you to begin work as of DATE.
Your initial rate of compensation will be ______________ Dollars ($_____) per year, paid bimonthly in accordance with the Company’s regular payroll procedures.
Upon completion of _____ (___) months of service, you will be eligible to participate in all benefits established for management-level employees of the Company.
Your employment pursuant to this offer is contingent upon you executing the enclosed At-Will Employment, Confidential Information and Invention Assignment Agreement, and upon you providing the Company with the legally required proof of your identity and authorization to work in the United States.
Your employment with the Company, should you accept this offer, will not be for any specific term and may be terminated by you or by the Company at any time, with or without cause and with or without notice, as more fully described in the At-Will Employment, Confidential Information and Invention Assignment Agreement. Any contrary representations or agreements that may have been made to you are superseded by this offer.
As an employee of the Company, you will be required to comply with all Company policies and procedures. In particular, you will be required to familiarize yourself with and to comply with the Company’s policy prohibiting unlawful harassment and discrimination and the policy prohibiting the use of, or being under the influence of, drugs or alcohol while at work, except as prescribed by a physician. Violations of these policies may lead to immediate termination of employment.
If you accept this offer of employment, you agree that during your employment and for 12 months after you leave the Company, you will not solicit or encourage, directly or indirectly, any employee or consultant of the Company to leave the Company, to reduce his or her duties or time commitment to the Company, or to perform work for any other person or entity, as set forth more fully in the At-Will Employment, Confidential Information and Invention Assignment Agreement.
If you wish to accept this offer, please sign below and return the fully executed letter to us, along with the executed At-Will Employment, Confidential Information and Invention Assignment Agreement. You should keep a copy of this letter and the At-Will Employment, Confidential Information and Invention Assignment Agreement for your records.
We are looking forward to having you join COMPANY. If you have any questions, please call me at TELEPHONE.
Very truly,
COMPANY NAME
OFFICER
Enclosure
Employment Taxes and Payroll Services
{Date}
{Name}
{Company Name}
{Address}
{City, State, Zip Code}
RE: Employment Taxes and Payroll Services
Dear {Salutation}:
In response to your request for a summary of COMPANY’s payroll withholding requirements, now that it is planning to hire employees, please note the following:
Federal Income Tax and Social Security Withholding. COMPANY will be required to withhold income tax and Social Security tax from taxable wages paid to its employees. Funds withheld must be deposited in certain depositories accompanied by a Federal Tax Deposit Form 8109. An Employer’s Quarterly Federal Tax Return (IRS Form 941) must then be filed before the end of the month following each calendar quarter. Any officer of COMPANY or other person obliged to withhold taxes may become personally liable for a 100% penalty if he fails to pay the withheld funds to the Internal Revenue Service.
California Income Tax and Unemployment Insurance. COMPANY will also be required to withhold California income tax from its employees’ taxable wages. Within 15 days after becoming subject to the personal income tax withholding requirements, the employer must register with the California Department of Employment Development (EDD). A booklet titled Employer’s Tax Guide for the Withholding, Payment and Reporting of California Income Tax may be obtained from the EDD and is available on its website. Forms for unemployment compensation insurance are mailed automatically to all employers registered with the EDD.
Federal Unemployment Tax. The federal Unemployment Tax Return (IRS Form 940) must be filed and any balance due must be paid on or before January 31 of each year. Details may be found in IRS Circular E, the Employer’s Tax Guide, which is available on the IRS website.
Workers’ Compensation. All California employers must either be insured against workers’ compensation liability by an authorized insurer or obtain from the Manager of Industrial Relations a Certificate of Consent to Self-Insure. The required insurance may be obtained through the nearest local office of the State Compensation Insurance Fund, or it may be placed with a licensed workers’ compensation private carrier.
As we discussed, it probably makes sense for COMPANY to use its banks’ payroll service to help ensure that COMPANY complies with all withholding requirements and to facilitate the timely submission of employment taxes and returns. Another alternative would be for COMPANY to subscribe to the payroll service offered through its bookkeeping software.
Please do not hesitate to call me if we can assist COMPANY in complying with the above or any of the other legal requirements for employers discussed at our meeting.
Very truly,
FIRM NAME
Lawyer Name
Enclosure
Differences Between Independent Contractors and Employees
{Date}
{Name}
{Company Name}
{Address}
{City, State, Zip Code}
RE: Employee versus Independent Contractor
Dear {Salutation}:
As we recently discussed, the rules for determining whether someone is an employee versus an independent contractor are the source of a lot of confusion. The Internal Revenue Service will, at least in some cases, give you a ruling on the issue (use Form SS-8). The form lists 12 criteria the IRS uses to decide the employee/contractor issue:
1. The right to control the activities of the person. As the general rule suggests, the most important factor used by courts and the government to judge whether someone is an employee or an independent contractor is this right to control. This is the right to control the how, not the end result. Also, remember it is the right to control that is determinative, not actual control.
2. Who supplies the tools?
3. Who supplies the place where the work will be done? (If the person is going to work on your property on a regular and continuing basis, you will have an uphill battle proving that the person is an independent contractor and not an employee—but it is possible.)
4. What costs are borne by the worker: Does the worker bear any risk of bad checks? Must the worker pay state licensing fees? Does the worker buy his or her own supplies?
5. Can the worker profit from his or her own managerial skills? Can the worker make a profit over and above the value of his or her time, or will the total income be limited to a relatively fixed amount?
6. What special skills are provided? The more skill the worker has, the better your chances of calling him or her an independent contractor.
7. Is the relationship long-term or short-term? Long-term relationships tend to look like employer/employee relationships; short-term ones look like independent contractor relationships.
8. Is the service ancillary to your business? For example, having your office building cleaned is ancillary to your business. On the other hand, routine typing in an office would not be ancillary.
9. How are the payments structured? Fixed pay for certain times (hourly, weekly, etc.) tend to look like employer/employee relationships. Pay for the job tends to look like an independent contractor arrangement.
10. Do your fringe benefits apply to the person? If you elect to give the person some or all of your fringe benefits, it may be very difficult for you to call the person an independent contractor.
11. How do the parties treat the transaction? This is not determinative—even if both parties agree that the relationship is an independent contractor one, the IRS can say differently. However, it is a factor.
12. What is the custom in the trade or industry? Painters, plumbers, carpenters, public stenographers, doctors, lawyers, accountants, etc., are traditionally treated as independent contractors by the people for whom they perform services. Thus, your arguments for these kinds of people are much stronger than if you are talking about some other type of work.
There is a lot of litigation on this issue, and the legislature regularly debates whether the law should be clarified or the powers of the Internal Revenue Service curtailed or expanded to recharacterize independent contractors as employees. Ultimately, you will have to analyze each case independently to determine the best, most appropriate designation for each new hire.
Please do not hesitate to call me with any questions with regard to the above.
Very truly,
FIRM NAME
Lawyer Name
Enclosure
Forwarding an Employee Handbook
{Date}
{Name}
{Company Name}
{Address}
{City, State, Zip Code}
RE: Employee Handbook
Dear {Salutation}:
Enclosed please find the first draft of the COMPANY Employee Handbook for YEAR for your review and consideration.
In your review of the enclosed draft, please keep in mind that the terms in the following provisions of the employee handbook are mandatory under California and/or federal law:
The remaining provisions are recommended and/or carried over from COMPANY’s Employee Handbook from last year. I look forward to your comments and changes.
The mandatory Illness and Injury Prevention Program (IIPP) document is still in progress. I will forward a draft to you shortly. In the meantime, please do not hesitate to call me with any questions or changes with regard to the above.
Very truly,
FIRM NAME
Lawyer Name
Enclosure
Forwarding Illness and Injury Prevention Policy
{Date}
{Name}
{Company Name}
{Address}
{City, State, Zip Code}
RE: Illness and Injury Prevention Program for COMPANY
Dear {Salutation}:
Attached please find a draft Illness and Injury Prevention Program (IIPP) to go with the updated Employee Handbook for COMPANY employees located in California. The attached draft contains the minimum elements required by law, plus the security and violence sections referenced in the Employee Handbook. Please feel free to add to this as appropriate.
The IIPP does not have to be distributed with the Employee Handbook, but it has to be available upon request and should be posted in the employee section of the COMPANY website. There are blanks in the draft where we need to insert the name of the designated program administrator. I wasn’t sure who that would be.
Please do not hesitate to call me with any questions or changes with regard to the above.
Very truly,
FIRM NAME
Lawyer Name
Enclosure
Requesting Information for Employment Agreement
{Date}
{Name}
{Company Name}
{Address}
{City, State, Zip Code}
RE: Terms for Employment Agreement
Dear {Salutation}:
I received your request for an Executive Employment Agreement for COMPANY’s new OFFICER. However, it would be helpful to have a few more details about the proposed terms of employment. Specifically, if you have discussed any of the following terms with OFFICER, please let me know what has been discussed, or what you want to provide with respect to each:
If you and OFFICER have agreed on any other terms, please let me know what they are so that I can memorialize them in the agreement. Any terms discussed but not included in the written agreement will not be part of the agreement, and therefore will not be enforceable.
Alternatively, if you do not intend to provide OFFICER with a specific term of employment, the position could be formally offered by way of an offer letter for employment at will, stating the initial position, salary, and stock option grant, in which case the bulk of OFFICER’s employment terms will come from COMPANY’s Employee Handbook. In either case, OFFICER will be required to enter into COMPANY’s standard Confidential Information and Invention Assignment Agreement.
Please let me know which way you wish to proceed, and provide as much detail as possible with regard to the terms identified.
Very truly,
FIRM NAME
Lawyer Name
Avoiding Harassment Claims
{Date}
{Name}
{Company Name}
{Address}
{City, State, Zip Code}
RE: Avoiding Harassment Claims
Dear {Salutation}:
In further response to your recent inquiry, harassment is a form of discrimination that violates Title VII of the Civil Rights Act of 1964. Title VII applies to employers with 15 or more employees, including state and local governments. Offensive conduct that is sufficiently severe or pervasive to alter the conditions of the victim’s employment and create a hostile working environment is actionable under Title VII. Harris v. Forklift Systems, Inc., 510 U.S. 17, 21–22 (1993).
Harassment is also actionable under California Civil Code Section 51.9, which provides in part that a person is liable in a cause of action for sexual harassment where there is a business, service, or professional relationship between the plaintiff and defendant and the defendant has engaged in verbal, visual, or physical conduct of a sexual nature or of a hostile nature based on gender that was unwelcome and pervasive or severe. There is no safe harbor for smaller employers under Section 51.9.
According to the U.S. Equal Employment Opportunity Commission (EEOC), prevention is the best tool to eliminate harassment in the workplace. All employers should clearly communicate to employees that harassment will not be tolerated. They can do so by providing training to their employees and by establishing an effective complaint or grievance process and taking immediate and appropriate action when an employee complains. In California, such training has become mandatory for employers with 50 or more employees or service providers. See new California Government Code Section 12950.1. Prudent smaller employers will voluntarily comply.
Please do not hesitate to call me to discuss this further.
Very truly,
FIRM NAME
Lawyer Name
Enclosure
Using Stock Options Versus Stock Grants; Option Pricing
{Date}
{Name}
{Company Name}
{Address}
{City, State, Zip Code}
RE: Equity for COMPANY Officers
Dear {Salutation}:
As we discussed on the telephone this morning, using stock options to provide some equity compensation to the officers of COMPANY would be preferable to giving them stock grants outright because of the tax treatment. If you were to issue stock, COMPANY would have to value it for accounting purposes, and the recipients would have to include the value in their taxable income for the year.
In connection with the issuance of stock options, a determination of the fair market value of COMPANY’s common stock will also help it avoid potential deferred compensation liability, which can arise when stock option exercise prices are below the current fair market value of the stock at the time of issuance. Because COMPANY has a CPA that is experienced in early-stage companies, you can probably put together a reasonable valuation for purposes of your stock option pricing without too much expense. Other clients of mine have recently been using the Illiquid Start-Up approach, which comprises the following:
A presumption as to the reasonableness of a company’s valuation is available to companies that adopt one of the valuation approaches set forth in Internal Revenue Code (IRC) regulations in connection with IRC Section 409A. One of these prescribed approaches seems particularly well-suited for COMPANY—namely, the prescribed methodology for valuing the “illiquid stock of a start-up corporation.” A start-up corporation is a corporation with no publicly traded stock that has been in business for less than 10 years. A valuation of illiquid start-up stock will be considered reasonable if five requirements are satisfied:
1. The valuation is evidenced by a written report;
2. The valuation takes into account the General Valuation Factors described below;
3. The valuation is performed by a person with significant knowledge and experience or training in performing similar valuations;
4. The stock being valued is not subject to any put or call right, other than the company’s right of first refusal or right to repurchase stock of an employee (or other service provider) upon termination of service; and
5. The company does not reasonably anticipate an IPO, sale, or change in control of the company within 12 months following the equity grant to which the valuation applies.
The General Valuation Factors specified in the regulations are:
a. the value of tangible and intangible assets of the company;
b. the present value of future cash flows;
c. the public trading price or private sale price of comparable companies;
d. control premiums and discounts for lack of marketability;
e. whether the method is used for other purposes; and
f. whether all available information is taken into account in determining value.
However, even if a valuation applies these factors, it will not be considered reasonable if it is more than 12 months old. In addition, significant events occurring even before the 12-month anniversary will require the valuation to be updated. Examples of such events include the possibility of (or plans for) a future investment in the company by an outside investor, an initial public offering or sale of the company, resolution of material litigation, or the issuance of a patent.
The fact that COMPANY may complete a financing in the coming months does not preclude you from using this approach. However, once the financing is completed, you will need to update the valuation before issuing additional options.
Enclosed is an example of a written valuation report done by another one of my clients (I redacted the identifying information). Although I can’t make any representations as to whether this particular report would withstand IRS scrutiny, I thought it might be helpful for you to see how another start-up approached the problem and discuss the same with COMPANY’s outside CPA firm. The report was prepared in-house by the company’s CFO, with the guidance of its outside CPA firm.
Please do not hesitate to call me with any questions in regard to the above.
Very truly,
FIRM NAME
Lawyer Name
Enclosure
Forwarding a Stock Option Plan to Client
{Date}
{Name}
{Company Name}
{Address}
{City, State, Zip Code}
RE: Stock Option Plan
Dear {Salutation}:
Enclosed please find a draft Stock Option Plan for COMPANY for your review and consideration prior to submission to the Board of Directors and shareholders for approval. The plan provides for both Incentive Stock Options (ISOs) and Non-Statutory Options (NSOs or “non-qualified” options), as well as for Stock Purchase Rights, so it is very flexible.
Also enclosed, please find a draft memorandum to be shared with directors, shareholders, and/or employees to provide a summary of the law governing stock options and the purposes and policies of the proposed plan. In most cases, a combination of ISOs and NSOs is the best way to provide incentives for all valued contributors to a company.
Because many provisions regarding option grants are prescribed by statute, we often refer to specific sections of the U.S. Internal Revenue Code in the plan and the memorandum. All references to the “Code” refer to the Internal Revenue Code.
You should note that the memorandum should not serve as a substitute for personal tax advice for grantees, as an individual’s tax situation may differ greatly from the norm. Furthermore, the memorandum only covers major issues and does not address all of the U.S. tax rules. Nor does the memorandum address state or foreign tax consequences, which also may be significant. Finally, the memorandum assumes that option holders will pay cash to exercise their options. Other rules apply if option holders pay their exercise price in stock.
Please do not hesitate to call me with any questions or changes. I look forward to hearing from you.
Very truly,
FIRM NAME
Lawyer Name
Enclosures
Forwarding Notice of Options Issuance for Filing
{Date}
{Agency Name}
{State Name}
{Address}
{City, State, Zip Code}
|
RE: |
California Corporations Code § 25102(o) Notice for COMPANY |
Dear Sirs:
Enclosed please find an original and two copies of the Notice of Issuance of Securities Pursuant to Subdivision (o) of Section 25102 of the California Corporations Code submitted on behalf of COMPANY in connection with the issuance of compensatory non-statutory common stock options. Please return one copy with your acknowledgment of receipt in the enclosed self-addressed, stamped envelope.
Also enclosed, please find a check in the amount of $250 made payable to “Department of Corporations” for your filing fee.
If you have any questions with regard to the above, please do not hesitate to call me directly. Thank you.
Very truly,
FIRM NAME
Lawyer Name
Enclosures
Fowarding an Option Grant and Making an 83(b) Election
{Date}
{Name}
{Company Name}
{Address}
{City, State, Zip Code}
RE: Stock Option Grant and Opportunity to Make an 83(b) Election
Dear {Salutation}:
Enclosed please find a Notice of Stock Option Grant and Stock Option Agreement for the non-statutory stock options (NSOs) granted to you in connection with your service on the Company’s Board of Directors. Please review the enclosed documents and, if they meet with your approval, sign page 5 of the Stock Option Agreement and return it to me at your earliest convenience.
In connection with the attached, you may wish to consider making an election under Section 83(b) of the Internal Revenue Code. The decision whether to make an 83(b) election and the filing of the election, if made, is your individual responsibility. Please consult your own legal or tax advisors in making this determination. A sample form for making an 83(b) election is attached for your convenience.
An 83(b) election must be filed with the Internal Revenue Service by an option holder within 30 days of the date of the NSO grant. Briefly, you may wish to exercise an election to be taxed at the time you acquire your NSOs pursuant to Code Section 83(b), so the taxable income realized at the time of grant is the last income event until you exercise the options (as opposed to at each vesting interval in the absence of an 83(b) election). If the exercise price at the time of grant is equal to the fair market of the underlying stock, no tax will be due at the time of grant if an 83(b) election is made. In the absence of an 83(b) election, there may be no tax due at the time of grant, but by the time the options vest, the company’s stock value may have increased, thereby giving rise to tax liability upon each vesting interval.
As you may already know, the 83(b) election must be filed as follows:
1. At the IRS location where the taxpayer files his/her/its federal income tax returns;
2. Within 30 days after the execution of the agreement pursuant to which the stock/options which is/are the subject of the election is/are issued;
3. By registered or certified mail, return receipt requested;
4. Provide a copy of the election to the Company; and
5. It is suggested that you keep at least three copies of the election (for filing with your state and federal tax returns for the year in which you make the election and for your files).
Please do not hesitate to call me with any questions in regard to the above.
Very truly,
FIRM NAME
Lawyer Name
Enclosures
Pricing Stock Options in Privately Held Entity
{Date}
{Name}
{Company Name}
{Address}
{City, State, Zip Code}
RE: Pricing Stock Options
Dear {Salutation}:
As we recently discussed, the exercise price for your employees’ incentive stock options should be set at the current fair market value of the underlying stock. The following is a discussion of how to determine the current fair market value of your stock in light of the fact that the company is privately held (i.e., there is no established market for the stock).
By way of background, there have been some changes in the law recently (the adoption of Internal Revenue Code Section 409A in particular) so that stock options that are awarded an exercise price below the fair market value of the underlying stock as of the grant date are considered “discounted stock options” and constitute “deferred compensation,” which can result in adverse tax consequences to the grantee and tax withholding obligations for the company that issues them.
Discounted stock options under Section 409A. Under Section 409A, any stock option having an exercise price less than the fair market value of the underlying stock determined as of the option grant date constitutes a deferred compensation arrangement that typically will result in the referenced adverse tax consequences and tax withholding obligations. Such stock options are referred to as “discounted options.” The adverse tax consequences include taxation at the time of option vesting rather than the date of exercise (or later in the case of incentive stock options), a 20% additional tax on the optionee in addition to regular income and employment taxes, and a potential interest charge. The issuing company is required to withhold applicable taxes at the time of option vesting and, possibly, additional amounts as the underlying stock value increases over time.
Stock valuation and option pricing alternatives. As described below, the 409A regulations provide guidance on valuation for purposes of setting option exercise prices. Companies may adopt any of the following, with varying risks and assurances:
Status quo. A company may choose to retain its existing option pricing practice, and if the company’s option exercise prices in fact equal or exceed the fair market value of the underlying stock, Section 409A generally will not come into play. This is true whether or not the company applies any of the rules or factors set forth in the proposed regulations. However, if the company’s option exercise prices are later found to be below fair market value (e.g., in an IRS audit), the burden will be on the company to prove that its stock valuation method was reasonable. If the company’s current valuation practice makes no reference to the factors and methods set forth in the regulations, or if it uses no rational valuation method at all, it will fail to satisfy this burden, and the adverse consequences of Section 409A will apply.
Informal valuations using specified factors. A company may perform its own internal stock valuation based on specified factors set forth in the regulations as discussed below, but if the company’s option exercise prices are later found to be below fair market value, the burden will be on the company to prove that its stock valuation method was reasonable. The company can improve, but not guarantee, its chances of satisfying this burden if it employs the factors specified in the regulations.
Adopt one of the “presumptive” methods. A company may choose to adopt one of the “presumptive” stock valuation methods set forth in the 409A regulations and put the burden on the IRS to prove that BOTH (i) the company’s stock option prices were below fair market value AND (ii) the company’s application of the presumptive method was “grossly unreasonable.” The presumptive methods are described below and generally involve either a written valuation by an appraiser or other person with knowledge and experience in stock valuation or application of a binding formula.
Presumptive valuation methods. The regulations specify three methods that will be presumed reasonable if consistently used for all of an employer’s equity-based compensation arrangements. The valuation resulting from any of these presumptive methods will be considered to be fair market value and may only be rebutted by the Internal Revenue Service if the company’s application of the method is found to be “grossly unreasonable.” The three presumptive methods are:
1. Independent Appraisal. A valuation performed by a qualified independent appraiser using traditional appraisal methodologies, as would be applicable to an appraisal for an employee stock ownership plan (ESOP), will be presumed reasonable if it values the stock as of a date that is no more than 12 months before the applicable stock option grant date. However, the presumption will not apply if events subsequent to the appraisal date have a material effect on the company’s stock value.
2. Illiquid Start-up. A special presumption is provided for the “illiquid stock of a start-up corporation.” A start-up corporation is a corporation with no publicly traded stock that has conducted business for less than 10 years. A valuation of illiquid start-up stock will be considered reasonable if five requirements are satisfied:
The General Valuation Factors specified in the regulations are:
Even if a valuation applies these factors, it will not be considered reasonable if it is more than 12 months old. In addition, significant events occurring even before the 12-month anniversary will require the valuation to be updated. Examples of such events include the possibility of (or plans for) a future investment in the company by an outside investor, an initial public offering or sale of the company, resolution of material litigation, or the issuance of a patent.
3. Binding Formula. A valuation based on a formula used in a shareholder buy-sell agreement or similar binding agreement will be presumed reasonable if the formula price is used for all non-compensatory purposes requiring the valuation of the company’s stock, such as regulatory filings, loan covenants, and sales of stock to third parties. This method will not be available if the stock may be transferred in a manner other than through operation of the buy-sell or similar arrangement to which the formula price applies.
Your suggestion of pricing the options at about 10% of the price paid by recent investors is a familiar one. Many of my clients consistently used that approach until this recent change in the law, with the exception that the 10% rule of thumb was typically used where investors were purchasing Preferred Stock (with superior rights, preferences, and privileges) and the options were for the purchase of Common Stock, which provided some justification for the discrepancy.
I apologize for the lengthy correspondence. As I mentioned on the phone, there is no simple answer to the question of how to determine the exercise price for stock options.
Please do not hesitate to call me with any questions in regard to the above.
Enclosure