When to Value a Company – Part 3: Issuing Stock Options to Attract Top Talent
There are many stages throughout a company’s life cycle where a business valuation might be helpful, or even required by law. These include the following situations, among others:
- Raising capital to fund your new venture
- Expanding the business with equity capital
- Attracting and retaining talent by issuing shares or options to key employees
- Buying out a shareholder to settle a dispute about how the company ought to be run
- Reorganizing share capital to achieve tax planning objectives
- Determining the value of family assets in a divorce proceeding
- To assist with planning your exit strategy for retirement
- To evaluate an unsolicited offer to purchase your business
- Purchasing a business at its true value
This article is the third part in a series of articles that will describe common circumstances that give rise to the need for some sort of valuation. In these articles, we convey some of the key valuation issues that should be considered in each situation.
In part one of our series on when to value a company, we discussed raising capital to fund a new venture, and how venture capitalists value investment opportunities.
In part two of our series on the subject of when a valuation is required, we discussed raising equity capital to expand your business after it becomes profitable.
In this third installment of our valuation series, we will discuss how stock options can be used to attract and retain top talent, and what documentation needs to be in place to avoid nasty tax problems or disgruntled employees.
WHAT ARE STOCK OPTIONS?
A stock option is a contractual right to buy a specific number of shares of a company’s stock at a pre-set price, known as the “exercise price” or “strike price,” for a fixed time-period, after which they expire.
Most stock option plans come with a predetermined “vesting period”. This is a waiting period (typically three to five years) where employees continue to work for the company to “earn-out” the right to exercise the options granted. For example, if an employee is granted 100,000 stock options that vest over a four-year period, at the end of each year they have earned the right to exercise 25,000 options at the original exercise price.
There are many different features that can be incorporated into a stock option plan, such as accelerated vesting (in the event of an acquisition), or a cashless exercise (in the event of an IPO). Your corporate lawyer can assist you in designing the best plan for your needs.
WHY DO COMPANIES ISSUE STOCK OPTIONS?
Stock options are frequently used to attract talented new employees or retain existing employees. These “key employees” may have special skills, experience, or contacts that are considered mission-critical to the company’s future success. They usually know that they’re in high demand, and often receive unsolicited offers from others wishing to hire them away from you.
An attractive stock option package can provide a powerful financial incentive for staff to remain within your company as long-term, loyal employees. Stock options can also offer an emotional incentive for employees to remain, as they represent equity ownership (thus a form of prestige).
WHY DO EMPLOYEES LIKE TO OWN STOCK OPTIONS?
Stock options provide employees with an opportunity to build wealth without having to come up with the money upfront (especially if they are young and not yet established financially) or risk their personal capital.
Employees can hold onto their stock options until a future liquidity event occurs. This might include an acquisition made by another company whereby option holders are bought out at an amount equal to the difference between the stock price paid to shareholders and the exercise price for their options. Another example would be a going public transaction whereby the intrinsic value of the options is “paid out” to the holder by issuing freely tradable shares.
Case Study
The client: a biomedical engineering research and development company with over 240 patents applied for and awarded for surgical and rehabilitation devices.
The background
At the time of its engagement with Smythe, the company was owned entirely by its founder. As a reward for their vital role in the company, the founder wanted to award a portion of the shares to certain employees.
The requirement
Smythe was retained to estimate the current fair market value of the Company’s shares so that stock options could properly be priced, with the dual aim of ensuring tax compliance and keeping employees motivated.
Smythe’s role
With the net asset approach, Smythe’s advisory team valued the technology using discounted cash flow under the income approach in order to calculate future royalties. In addition to reviewing quarterly royalty revenues from the Company’s licenses, Smythe considered sales trends in the underlying products manufactured by other entities that incorporate the Company’s proprietary technology.
The outcome
Both the Company’s founder and employees receiving stock options accepted Smythe’s valuation report without contest. After implementing the plan successfully, the Company has retained Smythe for its annual stock revaluation process and the company’s founder expressed satisfaction as they found the “valuation process to be insightful, thorough and interactive throughout”.
SETTING THE STRIKE PRICE IS CRITICAL
The strike price needs to be set at the current fair market value (FMV) of a common share. This way, the option holder is not receiving any intrinsic benefit when the options are granted. If the strike price is less than the underlying FMV per common share, the Canadian tax authorities will deem that a benefit has been conferred on the employee, for which they will be assessed income taxes payable in the current year. This can be a significant burden on cash-strapped employees that can’t afford to pay income taxes on ‘unrealized’ gains.
This problem gets worse if the company’s fortunes are subsequently reversed, and the options lose some of their intrinsic value or become worthless. Needless to say, the financial distress caused by an unexpected tax liability will likely not strengthen your employee’s loyalty to the firm.
Similarly, if the strike price is greater than FMV, the options received by employees will be “out of the money,” sometimes referred to as “underwater.” This doesn’t send the right message to a highly-skilled tech worker who just received a lucrative offer from your competitor.
To avoid these risks, companies can seek advice from an independent business valuator who will determine the FMV of your stock for option pricing purposes. The valuation will be documented and presented in a report that can be submitted to the Canada Revenue Agency if you’re ever questioned about equity compensation in the future. The valuation report can be updated at subsequent intervals to ensure newly issued options are priced adequately as the company’s value changes over time.
For more information about this topic, contact one of Smythe Advisory’s Chartered Business Valuators below to see how we can help you determine the FMV of your stock for option pricing purposes.
