Lately, I’ve been seeing a fair amount of companies start to grant shares to employees only to realize that the shares are so expensive that it’s going to be nearly impossible for the employee to come up with the tens of thousands of dollars necessary to buy the shares. In some cases, these companies are considering granting the shares at a price lower than what they are currently worth. However, there are some things to consider before you decide whether letting your employees buy discounted shares is a good idea.
Before we dive in to the ramifications of granting shares for a purchase price that’s below fair market value, let’s review these three essential concepts of purchase price, fair market value, and par value.
Par Value: Par value is the lowest amount for which a share of stock can be sold by the company according to applicable state law. It’s listed in your Certificate of Incorporation. At a minimum, the grant price needs to be par value. As an example, if your par value is $0.0001 you could grant shares at a price as low as $0.0001 but could not grant them at a price of $0.
Fair Market Value (FMV): This is what it sounds like—the value of the share. It is determined by either an external valuation report called a 409A or a reasonable valuation method.
Price Per Share: This is the price actually paid for the shares by the person awarded the grant. It is usually equal to fair market value, but not always.
The Difficulty of a High Purchase Price
Sometimes, the fair market value gets so expensive (let’s say it’s $2 per share) that a grant of 200,000 shares becomes prohibitively expensive to purchase ($400,000). In this case, many startups think about granting the shares below fair market value.
However, if you could just grant shares worth $400,000 at little or no cost to the employee, everyone would be doing it. It would be a great recruiting tool. And they’re not. So what gives?
NOTE: we’re talking restricted stock here. We’re not talking about options. As a general rule, options cannot be issued below FMV.
Granting shares below FMV gives your employees a huge tax headache. There is a tax event on the spread between the purchase price and whatever FMV is at the time of grant. Let’s run through a few scenarios.
In the example below, the employees make an 83(b) election. An 83(b) election comes into play if the shares are purchased before they are vested, whether you grant shares at FMV or not.
If you’re not familiar with an 83(b), an 83(b) allows you to write to the IRS when you have an RSA with vesting (among other circumstances) and ask them to tax you now, instead of later when vesting occurs and the FMV may be higher (learn more about 83(b)s). Assuming your company is doing well and your FMV is only going up, employees are usually better off if they file an 83(b).
Let’s say you’re a company whose stock currently has a FMV of $2 per share and you want to grant 200,000 shares to your lead engineer. If she purchases the shares and files an 83(b), the difference in her taxable income can be substantial depending on the price per share paid.
If you set the purchase price at $2 (the FMV) as expected, the employee will be taxed on the FMV of $2 minus the purchase price of $2 ($2-$2=$0) for each share. So although she'll have to pay $400,000 for the 200,000 shares, she’ll get taxed on income of $0 at the time of the grant.
If, instead, you set the purchase price at a modest one cent per share, she will be taxed on the FMV of $2 minus the purchase price of $0.01 ($2-$0.01=$1.99) for each share. She’ll pay $2,000 for the 200,000 shares, but she'll get taxed on income of $398,000 at the time of the grant.
Without an 83(b) election, it's likely the taxable amount would be even higher (assuming the value of your company only goes up) because she will be taxed when the shares vest as opposed to when they were purchased.
Other Solutions to High Purchase Price
So far we’ve discussed the complications of granting the shares at a purchase price that’s less than FMV. If you find yourself in a situation where a high FMV is making stock purchase impossible for your employees, there are other options, such as giving the employees a loan to purchase the shares (although if you don’t expect them to pay it back this could be an issue being left open on your balance sheet), or giving the employee money to purchase the shares (although this would also be taxed as income), yet all options come with risks and complications that you should speak to an advisor about.
Setting the price at something other than fair market value is tricky and you should consult with your lawyer before making a hasty decision. Your employees will certainly appreciate it!