Non-employee stock options mark to market

What’s the difference between an ISO and an NSO?

[The following is not intended to be comprehensive answer. Please consult your own tax advisors and don’t expect me to answer specific questions in the comments.]

Incentive stock options (“ISOs”) can only be granted to employees. Non-qualified stock options (“NSOs”) can be granted to anyone, including employees, consultants and directors.

No regular federal income tax is recognized upon exercise of an ISO, while ordinary income is recognized upon exercise of an NSO based on the excess, if any, of the fair market value of the shares on the date of exercise over the exercise price. NSO exercises by employees are subject to tax withholding. However, alternative minimum tax may apply to the exercise of an ISO.

If shares acquired upon exercise of an ISO are held for more than one year after the date of exercise of the ISO and more than two years after the date of grant of the ISO, any gain or loss on sale or other disposition will be long-term capital gain or loss. An earlier sale or other disposition (a “disqualifying disposition”) will disqualify the ISO and cause it to be treated as an NSO, which will result in ordinary income tax on the excess, if any, of the lesser of (1) the fair market value of the shares on the date of exercise, or (2) the proceeds from the sale or other disposition, over the purchase price.

A company may generally take a deduction for the compensation deemed paid upon exercise of an NSO. Similarly, to the extent that the employee realizes ordinary income in connection with a disqualifying disposition of shares received upon exercise of an ISO, the company may take a corresponding deduction for compensation deemed paid. If an optionee holds an ISO for the full statutory holding period, the company will not then be entitled to any tax deduction.

Below is a table summarizing the principal differences between an ISO and an NSO.

* The option cannot be transferable, except at death.

* There is a $100,000 limit on the aggregate fair market value (determined at the time the option is granted) of stock which may be acquired by any employee during any calendar year (any amount exceeding the limit is treated as a NSO).

* All options must be granted within 10 years of plan adoption or approval of the plan, whichever is earlier.

* The options must be exercised within 10 years of grant.

* The options must be exercised within three months of termination of employment (extended to one year for disability, with no time limit in the case of death).

* However, the difference between the value of the stock at exercise and the exercise price is an item of adjustment for purposes of the alternative minimum tax.

* Gain or loss when the stock is later sold is long-term capital gain or loss. Gain or loss is the difference between the amount realized from the sale and the tax basis (i. e., the amount paid on exercise).

* Disqualifying disposition destroys favorable tax treatment.

* The income recognized on exercise is subject to income tax withholding and to employment taxes.

* When the stock is later sold, the gain or loss is capital gain or loss (calculated as the difference between the sales price and tax basis, which is the sum of the exercise price and the income recognized at exercise).

Useful chart. and quick summary. One addition for ISO taxes: When ISO exercise triggers AMT, tax credit available for use in future tax years, and when the ISO stock is sold, another very complex AMT adjustment. You might want to see the ISO or NQSO sections on myStockOptions, particularly for annotated examples of Schedule D for tax return reporting.

We need to issue equity warrants in lieu of cash for both contractors, landlords, and employees of our startup. We are pre-series A financing so would like to issue $ based warrants to be converted at the series A share price. However, we also would like to minimize the personal income tax liability to the individuals as it is really the intention of the warrant to pay them in stock which they would only owe captial gains tax on sometime in the future.

My question is: Should these warrants be structured as stock grants or stock options to be converted to common stock at series A funding? If grants, wouldn’t the individual be liable for the full value of stock at income tax rate at series A converstion? if options, should strike price simply be at par value as there is no real FMV of stock?

Please help clarify the typical equity warrant issued pre-series A financing in lieu of cash.

1. Typically, most companies would issue an option to purchase common stock to these people at a low exercise price equal to fair market value. I generally don’t recommend an exercise price of less than $0.02/share, as the IRS would likely take the position that the stock was simply granted to the person because the exercise price was too low, resulting in immediate tax on the value of the underlying stock. Keep in mind that a stock grant (i. e. recipient gets the stock for free) result in tax to the recipient on the value of the stock.

2. Options may be fully-vested in the case of landlord, or subject to a vesting schedule in the case of service providers.

3. Options and warrants mechanically work the same way in that they are a right to purchase stock in the future. They are called options when they are compensatory.

4. A warrant to purchase yet to be issued Series A stock at the Series A price is somewhat odd, unless bundled in connection with a convertible note or as a kicker on debt. The number of shares to be issued would be $X/Series A price. At the time this warrant is issued, the value of the warrant strikes me as income.

5. What it seems like you are trying to do is promise to issue Series A stock worth $X at the time of the Series A. This would result in the taxable income of $X to the recipient at the time the Series A is issued. If the person is an employee, it seems like there are also some 409A issues because this may be deemed deferred compensation.

I am starting a company that today is nothing more than an idea. I have taken no funding and have no product (or revenue) yet. I incorporated a Delaware company one month ago with shares that have a par value of $0.001 each. I issued myself 1,000,000 shares for $1,000. I will likely raise a small round of angel funding once I have a proof of concept. I now have the agreement of someone to help me in an advisory capacity create that proof of concept and I will grant him an NSO as compensation. I understand the NSO must be “fair market value” but given that the company has no value today should the exercise price be the par value (i. e. $0.001) or something higher?

Sam – I would set the exercise price at something like $0.02/share or higher. See rationale in comment above.

Hey Yokum – this is a great post!

Please consider the following scenario:

the us-based ‘start-up’ is 6 years old and an employee (no US citizen / on an H1-B work visa) has been working for the company for almost 4 years. he was one of the early employees and received quite a chunk of SARS for a low strike price. The company is private and an s-corp (foreign ownership is not possible) so the SARS are not vesting into options. what will now happen upon termination of the employment contract? can the employee excercise his vested SARS for cash at the current fair market value strike price of the company OR will he lose all SARS? If he cannot excercise, will the company keep the SARS until a liquidity event occurs? Does he have to follow the regular exercise schedule? What happens if the company converts into a C-corp in the next future? Will his SARS automatically convert to options?

McGregory – I assume that you are talking about stock appreciation rights, as opposed the virus. Virtually no silicon valley venture-backed startups use SARs instead of stock options, so it is difficult to speak in generalities as to how SARs work. Basically, you have to read the SAR document carefully.

We have a non qualified stock option plan for an LLC. Vesting and exercise was to occur at a liquidation event such as an acquisition or sale, which we thought might occur within a year, to alleviate the possibility of low level employees vesting and exercising options and becoming a member of the LLC and accompanying tax issues – K-1's etc. As our time horizon is growing, we wanted to include a 3 year vesting period. Question is, upon vesting, would our employees face a taxable event. We did have a valuation done, and the exericise price was set above the value at grant date to avoid any 409a issues.

LJ – There is no such thing as a “standard” option plan for an LLC, so it's hard to generalize without seeing the actual documents as it depends on what kind of LLC interest was granted. Please ask your own lawyers who set up the option plan and the operating agreement.

I'm not quite clear on that response. You seem to be saying that warrants would never be used to compensate contractors, but rather NSOs?

As a contractor considering receiving a percentage of my compensation as equity, I'm confused about the idea of receiving options in lieu of cash. It seems to me that I should be granted stock in exchange for cash I don't receive, not the option to buy stock. I understand that an option to buy later at today's price has some value, but that value is not necessarily related to the current price. In other words, if I'm owed $100, then 100 options to buy stock at $1.00 isn't necessarily a fair alternative to $100 cash. The stock value would have to double before I could hand over $100 in order to get $200 back, netting $100.

It seems like the original poster above was indeed trying to figure out how to compensate contractors with stock. In your response section 5, are you suggesting a stock grant? And that couldn't be done until the Series A, and would be treated as taxable income?

I think I've learned enough now to answer my own question: Assuming that the FMV of the stock isn't measured in pennies, then options aren't well suited for direct compensation (although they still work fine as a “bonus” for employees). The stock would have to double in value to provide the intended compensation. Stock grants are no good, either, because they will have large tax consequences. The solution is to issue warrants priced at $0.01 per share, which can be done legally regardless of the current FMV of the stock. Of course, thanks to the ridiculous IRS position of them wanting taxes before the stock is actually sold (!!), it normally won't make sense to exercise the warrants until you can sell at least some of them to cover the tax bill (just like options, except possibly ISOs with their special tax treatment).

This is a great forum with full of useful info. We're forming a C type company. A person who has been contributing since the pre-incorporation days wants to invest in the equity just like other co-founders and then be a consultant. He is not an accredited investor. We need him but he doesn't want to be an employee or board member. Is it possible for the company to go with him? Will the stocks given to him all be NSO? Thank you very much – Raghavan.

Raghavan – I would just issue and sell common stock to him at the same price as other founders. Please keep in mind that if he has a day job, there may be limitations on his ability to purchase stock.

Thanks, Yokum! Is there any way you could expand on your comment 'if he has a day job, there may be limitations on his ability to purchase stock'? Can NSO be assigned to a non-employee who may be an advisor to the start up but may have a full time job elsewhere? Thanks again. Raghavan.

Thanks, Yokum! Is there any way you could expand on your comment 'if he has a day job, there may be limitations on his ability to purchase stock'? Can NSO be assigned to a non-employee who may be an advisor to the start up but may have a full time job elsewhere? Thanks again. Raghavan.

Hi Yokum – is there any scenario in which a company can extend the 90-day exercise period for ISOs for a departing employee? Can the nature of the relationship with the employee be changed to an advisor and thereby not trigger the exercise period? Are there other ways of structuring/changing the relationship, assuming the company was willing to go that route?

Mark To Market - MTM.

What is 'Mark To Market - MTM'

Mark to market (MTM) is a measure of the fair value of accounts that can change over time, such as assets and liabilities. Mark to market aims to provide a realistic appraisal of an institution's or company's current financial situation.

In trading and investing, certain securities, such as futures and mutual funds, are also marked to market to show the current market value of these investments.

BREAKING DOWN 'Mark To Market - MTM'

Mark to Market in Accounting.

Mark to market is an accounting practice that involves recording the value of an asset to reflect its current market levels. At the end of the fiscal year, a company's annual financial statements must reflect the current market value of its accounts. For example, companies in the financial services industry may need to make adjustments to the assets account in the event that some borrowers default on their loans during the year. When these loans have been marked as bad debt, companies need to mark down their assets to the fair value. Also, a company that offers discounts to its customers in order to collect quickly on its accounts receivables will have to mark its current assets account to a lower value. Another good example of marking to market can be seen when a company issues bonds to lenders and investors. When interest rates rise, the bonds must be marked down since the lower coupon rates translate into a reduction in bond prices.

Problems can arise when the market-based measurement does not accurately reflect the underlying asset's true value. This can occur when a company is forced to calculate the selling price of its assets or liabilities during unfavorable or volatile times, as during a financial crisis. For example, if liquidity is low or investors are fearful, the current selling price of a bank's assets could be much lower than the actual value. The result would be a lower shareholders' equity.

This issue was seen during the financial crisis of 2008/09 when the mortgage-backed securities (MBS) held as assets on banks' balance sheets could not be valued efficiently as the markets for these securities had disappeared. In April of 2009, however, the Financial Accounting Standards Board (FASB) voted on and approved new guidelines that would allow for the valuation to be based on a price that would be received in an orderly market rather than a forced liquidation, starting in the first quarter of 2009.

Mark to Market in Investing.

In securities trading, mark to market involves recording the price or value of a security, portfolio, or account to reflect the current market value rather than book value. This is done most often in futures accounts to ensure that margin requirements are being met. If the current market value causes the margin account to fall below its required level, the trader will be faced with a margin call.

An exchange marks traders' accounts to their market values daily by settling the gains and losses that result due to changes in the value of the security. There are two counterparties on either side of a futures contract - a long trader and a short trader. The trader who holds the long position in the futures contract is usually bullish, while the trader shorting the contract is considered bearish. If at the end of the day, the futures contract entered into goes down in value, the long account will be debited and the short account credited to reflect the change in value of the derivative. Conversely, an increase in value results in a credit to the account holding the long position and a debit to the short futures account.

For example, to hedge against falling commodity prices, a wheat farmer takes a short position in 10 wheat futures contracts on November 21, 2017. Since each contract represents 5,000 bushels, the farmer is hedging against a price decline of 50,000 bushels of wheat. If the price of one contract is $4.50 on November 21, 2017, the wheat farmer's account will be credited with $4.50 x 50,000 bushels = $225,000.

Because the farmer has a short position in wheat futures, a fall in the value of the contract will result in a credit to his account. Likewise, an increase in value will result in a debit. For example, on Day 2, wheat futures increased by $4.55 - $4.50 = $0.05, resulting in a loss for the day of $0.05 x 50,000 bushels = $2,500. While this amount is debited from the farmer's account balance, the exact amount will be credited to the account of the trader on the other end of the transaction holding a long position on wheat futures.

The daily mark to market settlements will continue until the expiry date of the futures contract or until the farmer closes out his position by going long a contract with the same maturity.

Another security that is marked to market is mutual funds. Mutual funds are marked to market on a daily basis at the market close so that investors have a better idea of the fund's Net Asset Value (NAV).

FASB Stock Option Accounting Simplification: Mark to Market Accounting for Compensation?

By Mike Gullette.

The Financial Accounting Standards Board’s latest effort to simplify accounting standards focuses on expenses related to stock option compensation. At first, the proposal appears very encouraging: companies will have the option to account for forfeitures as the options expire – that can make things easier. Further, the statutory tax withholding rate threshold that triggers liability accounting will be raised to the maximum statutory rate of the employee. This will make the employees happy, as the hassle of partially settling the award in cash no longer will be needed.

So, what’s not to like?

Currently, companies must determine, for each award, whether the difference between the deduction for tax purposes and the compensation cost recognized for financial reporting purposes results in either an excess tax benefit (ETB) or a tax deficiency. ETBs are recognized in additional paid-in capital (APIC); tax deficiencies are used to offset accumulated ETBs, if any, or recognized in the income statement. Granted, maintaining “APIC pools” to monitor accumulated ETBs is a little complex. So, FASB is proposing to eliminate the APIC pools and run everything through the income statement. Easy, but the ETBs and deficiencies, which result from movements in the price of the company stock, will not go away. As a result, bank net income may often be affected by the volatility in its company stock – a mark to market impact and one the company has little or no control over.

Bankers have never liked marking anything to market, whether it is their loan portfolio or their stock options. With razor thin margins in the current environment, it seems the last thing bankers need is an unpredictable (and unsolvable) expense running through the income statement. However, the standard, if approved, will affect all industries. So, it will be interesting to see how other industries react to the proposal.

FASB has yet to set an effective date, so any change is likely to come no earlier than 2016.

ASC 718 - Expense Allocation for Mark-to-Market Grants.

The ASC 718 Expense Allocation for Mark-to-Market Grants is calculated using the Black-Scholes-Merton option valuation model. The report covers the expense allocated during the period for which the report is generated, and includes the automatic true-up of shares as required pursuant to ASC 718-10-35-8.

Note: The big difference between the expensing of Grant Date Grants vs. Mark-to-Market Grants is the requirement that the expense for Mark-to-Market Grants is remeasured for each report period in which the grant vests. For Grant Date Grants there is only one measurement date, the grant date.

Report Format.

This report can be generated in either the CapMx standard Crystal Reports format or in Excel.

Reporting Period Setting (please see Reports Overview for details) :

Report Period From - Report Period To (as setup on the Report Periods screen)

Report Size:

Details - The ASC 718 - Expense Allocation for Market-to-Market Grants report contains the following columns:

Exercise Price per Share.

Vesting Start Date.

"Expense Vesting End Date" will be the earlier of (a) the security's Vesting End Date per its Vesting Schedule, or (b) the security's cancellation date, or (c) the security holder's termination date.

Please note that in some instances, the Minimum Disclosures values require a different computation than a similarly-named value on the Expense report. Accordingly, the "Expense Vesting End Date" on this report may not match the "Vesting End Date" on the Option Activity Detail (Minimum Disclosures) report as that report is part of the calculations for the Minimum Disclosures.

On the Crystal version of the report, the CapMx letter value of the vesting schedule applied to the grant.

The Vesting Schedule Details legend box at the end of the report will have the complete name of each vesting schedule used on grants on the report.

On the Excel version of the report, the complete Vesting Schedule Name will appear.

The Fair Market Value as designated on the Expense Fair Market Value Table for the date that is closest to but not later than the security's date of grant.

Input from the Valuation Parameter screen.

A U. S. entity issuing an option on its own stock must use as the "risk-free interest rate" the implied yields currently available from the U. S. Treasury zero-coupon issues with a remaining term equal to the expected life used as the assumption in the model if the entity is using a closed-form model such as Black-Scholes.

“Volatility” is a measure of the amount by which a financial variable such as a share price has fluctuated (historical volatility) or is expected to fluctuate (expected volatility) during a period. Volatility also may be defined as a probability-weighted measure of the dispersion of returns about the mean. The volatility of a share price is the standard deviation of the continuously compounded rates of return on the share over a specified period. That is the same as the standard deviation of the differences in the natural logarithms of the stock prices plus dividends, if any, over the period. The higher the volatility, the more the returns on the shares can be expected to vary -- up or down. Volatility is typically expressed in annualized terms.

For securities with a vesting schedule whereby 100% of the shares vest on one, single date.

For securities with a vesting schedule whereby the shares vest over multiple dates.

Straight Line (VSD) = SL(VSD)

Straight Line = SL.

The "Measurement Type" determines the value type.

Measurement Type "Original" = Fair Value or Intrinsic Value; Measurement Type "Reprice", "Acceleration" or "Extension" = Incremental Value.

The basis for the option valuation under ASC 718, also known as the "Call Option Value per Share", and is the computation based on the grant values and the valuation parameters.

The total compensation expense of the grant award for the total vesting period of the grant (i. e., Shares Granted x Call Option Value per Share).

The percentage of shares that are not expected to vest, and, therefore, should not be expensed.

Use the CapMx "Forfeiture Rate Calculator" to obtain the historical Forfeiture Rate for a group of options.

The "Forfeiture Rate" is not part of the "Call Option Value per Share" calculation. Rather, it is applied directly to the Grant Shares.

The number of shares expected to be expensed after application of the Forfeiture Rate on the total number of shares in the grant.

Note: If the grant did not have a Forfeiture Rate applied to it, the "Projected Shares" will equal the "Shares Granted".

If the grant had a Forfeiture Rate applied to it, the "Projected Shares" will increase over each subsequent report period due to the true-up factor (see ASC 718-10-35-8). The "Projected Shares" is a reflection of the previously expensed shares plus the current period "Period Shares Expensed" plus the current period "Period True-up Shares".

The "Projected Shares" x the "Fair Value/Intrinsic Value/Incremental Value per Share".

The number of shares being expensed for the current reporting period based on the application of the Forfeiture Rate to the total number of shares in the grant.

Warning 1: Typically, there should not be a negative number in the “Period Shares Expensed” column because most negative values are related to share cancellations and, thus, appear in the "True-up" column.

Warning 2: FIN28 is accelerated expensing, so there is always a large expense in the first couple of years. Without an FR and using FIN28, the shares expensed is the largest number available (because “Projected Shares” = “Grant Shares”).

Grant Date = 04/14/09.

VS = 33% 18 months, then monthly for 24 months.

Allocation Method = FIN28.

If the grant was not cancelled during the current reporting period, the True-up Shares will reflect the additional shares that actually vested during the current reporting period, over and above the "Period Shares Expensed". This number will be a positive number.

The total of the "Period Shares Expensed" + the "Period True-Up Shares".

"Fair Value/Intrinsic Value/Incremental Value per Share" x "Period Shares Expensed".

"Fair Value/Intrinsic Value/Incremental Value per Share" x "Period True-Up Shares".

Total expense through the end of the current report period for the grants on the report.

The dollar value of the unvested shares expected to be expensed after application of the Forfeiture Rate on the total number of shares in the grant.

At the end, the report will also reflect:

Reflects the complete name of each vesting schedule applied to grants on the report.