Delayed Exercise Price for Stock Options Under 409A

[401 Chaos]

I would appreciate others' thoughts on whether an exercise price for an option that is not established until some future date will be subject to 409A if the terms do not clearly prohibit the future exercise price from being below FMV on the date of grant. For example, if an exercise price is to be set in the future in a manner that makes it very very very very very very unlikely (but not technically impossible) that the exercise price could be below FMV at the date of grant, is such an option considered a "discounted option" subject to 409A out of the gate? Is there any ability to withhold judment on the 409A aspect until actual exercise in order to determine if the option really did operate as a discounted option.

I note that the preamble to the proposed 409A regulations provide as follows:

"Thus, an option with an exercise price that is or may be below the fair market value of the underlying stock at the date of grant (a discounted option) is subject to the requirements of section 409A."

Based on that language, it seems any option where the exercise price is not set at grant and could potentially end up below FMV at the date of grant would have to be considered a discounted option when granted no matter how highly unlikely it is that the exercise price would actually end up below FMV on the date of grant.

[namealreadyinuse]

Is there any ability to withhold judment on the 409A aspect until actual exercise in order to determine if the option really did operate as a discounted option.

You would have to decide by 12/31 (or fye for non-individual service provider) to properly report on W-2/1099 and to pay excise tax, so that is the longest you can wait set the price. Also, isn't the ability to wait and see is the key determination, not what the ultimate exercise price is under the proposed regs?

[401 Chaos]

Namealready,

Thanks for your thoughts--I think we are on the same page. I was just grasping for creative work arounds in hopes of avoiding a meltdown in an existing program.

[Locust]

If the exercise price is determined by some event, such as a financing that comes through or a sale, could the arrangement be structured so that the grant is not considered made until the event? For example, we agree to grant you X options at the date of the financing at the price established by the financing. This might work if the employee was required to be in service at the date of the financing - arguably the financing event would be considered a service condition such that the options were not earned (or granted) until the financing event. On the other hand if the determinatin of the exercise price is being delayed for administrative reasons I don't think that would work, and the arrangement might have to provide that the exercise price will be no less than the FMV at the date of grant.

[Guest Harry O]

I wonder how such an option would be accounted for under FAS 123R and what the "grant date" really is for accounting purposes but that is for greater minds than mine . . .

[401 Chaos]

Locust and Harry O,

Thanks for your observations. I think you both raise excellent thoughts and concerns. In this case, the options have been granted but the exercise price is not to be established until immediately prior to a "Change in Control." At that time, the exercise price is to be determined by dividing a specific amount of money by the number of outstanding shares immediately prior to the Change in Control. The specific dollar amount was set at an amount significantly greater than the company's current value. The idea was for option holders to only share in proceeds if there is a Change in Control and if they have pushed the value of the company above the minimum floor amount. Nobody ever intended to issue a discounted option--in fact the option is just the opposite and is intended to function as a premium option with an exercise price significantly above the current fair market value. However, the exercise price clearly is not fixed on the date of grant. Given the numbers, it seems highly unlikely that the number of outstanding shares--the variable component in establishing the ultimate exercise price--will increase so much that the ultimate exercise price could ever be below the estimated FMV of the options on the date of grant but I suppose that is not technically impossible. Thus, it seems anybody looking at the exercise price provision would have to conclude that this could be a discounted option and would have to be treated as one out of the gate. That would require significant changes to the exercise / distribution provisions, of course. It seems to me this issue could be solved by adding a provision along the lines of the following to the exercise price provisions: "provided that in no case shall the exercise price be below the fair market value of the options on the date of grant." The company, however, is loathe to amend the grants unless it absolutely has to.

[Guest BBiggs]

Locust and Harry O,

Thanks for your observations. I think you both raise excellent thoughts and concerns. In this case, the options have been granted but the exercise price is not to be established until immediately prior to a "Change in Control." At that time, the exercise price is to be determined by dividing a specific amount of money by the number of outstanding shares immediately prior to the Change in Control. The specific dollar amount was set at an amount significantly greater than the company's current value. The idea was for option holders to only share in proceeds if there is a Change in Control and if they have pushed the value of the company above the minimum floor amount. Nobody ever intended to issue a discounted option--in fact the option is just the opposite and is intended to function as a premium option with an exercise price significantly above the current fair market value. However, the exercise price clearly is not fixed on the date of grant. Given the numbers, it seems highly unlikely that the number of outstanding shares--the variable component in establishing the ultimate exercise price--will increase so much that the ultimate exercise price could ever be below the estimated FMV of the options on the date of grant but I suppose that is not technically impossible. Thus, it seems anybody looking at the exercise price provision would have to conclude that this could be a discounted option and would have to be treated as one out of the gate. That would require significant changes to the exercise / distribution provisions, of course. It seems to me this issue could be solved by adding a provision along the lines of the following to the exercise price provisions: "provided that in no case shall the exercise price be below the fair market value of the options on the date of grant." The company, however, is loathe to amend the grants unless it absolutely has to.

I would think that your options are either:

1) amend the grants; or

2) ditch the program and use a cash transaction bonus program.

[Steelerfan]

Delayed comment here. These types of arrangements are exactly what 409A wants to either eliminate or be forced to comply with the 409A election and timing rules. If you want to get this fancy, then be prepared to deal with all the consequences of having potentially discounted options. Otherwise, how hard is it simply use an exercise price that coincides with the date of grant, which should be the date on which all the material terms of the option apreement are set in stone as long as notice is provided to the grantee within a reasonable period of time. Apparent need of human beings to set an exercise price that is on some date other than the date of the actual grant baffles me and is something that should have been addressed regutorily ages ago to prevent all the abuse that exists today.