In the intricate world of equity stock options, good intentions can sometimes pave the road to unexpected consequences. Picture this: older stock options priced at market value, coexisting with a new plan grounded in fair market value (FMV). Meanwhile, an overly aggressive valuation approach lurks in the shadows. As Steve Liu, Head of Shareworks Valuation Services, underscores the paramount importance of accurate valuation reports, a critical oversight emerges among French companies. These companies find themselves struggling with inconsistencies stemming from misaligned strike prices from the past, triggering a ripple effect of discontent among employees in the future. Let's explore the complexities of these scenarios, with concrete examples, as we dissect the repercussions and explore strategies to navigate the turbulent waters of equity compensation.

We will frame this article around the identification of two scenarios:

(i) having older stock options with exercise prices set at the current market price, while introducing a new stock options plan with exercise prices at Fair Market Value (FMV), and

(ii) adopting an excessively aggressive discount valuation approach.

Many experts share a similar outlook as Liu and emphasize the significance of the valuation report, which remains relevant in various contexts such as secondary transactions, tax matters, audit reviews, and especially in the pre-IPO phase. Accuracy is paramount in these situations.

Living with the Good Intentions of the Past

Recently, numerous French companies, including investors and lawyers, have acknowledged a critical oversight in their previous equity stock options plans. They realized that the strike prices set for these plans did not reflect the fair market value. This realization comes at a time when these companies are contemplating the implementation of FMV calculations for their upcoming BSPCE (Bons de Souscription de Parts de Créateur d'Entreprise) plans. Consequently, this has led to a situation where management faces inconsistencies, and former employees feel cheated, as they were vested with shares at a strike price higher than those granted to new hires.

Take, for instance, a Series B company that established three different BSPCE pools for all existing employees during the last valuation round. The first plan had a strike price of 10€ per share, the second at 20€, and the third at 40€. However, during a new fundraising round, the management realized the need to align the BSPCE strike prices with the fair market value. In this round, the issue price for investors was set at 80€ per share. According to the valuation report, the new BSPCE strike price was determined to be 30€. This adjustment has demoralized current employees, as they now see that the earlier strike prices were overvalued and the new plan offers a more advantageous rate (30€) compared to the previous one (40€).

This situation has inadvertently led to a disparity where one group of employees holds high-priced options while another, joining mere days or weeks later, benefits from significantly lower priced options, despite no substantial change in the business.

In this situation, the management has no choice other than to cancel and replace the previous plan to fix the issue in order to mitigate employee resentment and management inconsistency.

This example is even more complex in case of a down-round. Inevitably, such a change should be made and should be well communicated, so that anyone feels such a change is an opportunity for everyone.

Living with the Consequences in the Future

For early stage companies where an audit is more than two years away, the reality is there is less risk having an aggressive discount compared to larger, more established companies. Having said that, there will come a time when that window closes, as it inevitably does when you build a successful company. When it happens, you will face a significant step-up to a more accurate FMV as you come off a too-aggressive discount and are effectively forced into a clean valuation.

Now again you’ve inadvertently created a situation where one group of employees has very low-priced options and another group—some who will have started only days or weeks after the early group—with significantly higher priced ones, even though the business hasn’t changed that materially. Now you have a world of “haves” and “have-nots,” because inevitably, employees will talk to each other and resentment can then build up. This issue will stay with you, coming up every time you have compensation discussions involving those employees.

Adverse Tax Consequences

As expected, if your strike price is too aggressive , the tax administration could negate the BSPCE mechanism, resulting in important tax consequences for both the company and the beneficiaries. For instance, tax administration will re-qualify the BSPCE as salaries that will incur social charges to be paid by the company and will trigger a taxable event at the level of the beneficiaries.

For example, if you have granted 50,000 shares having a total adjusted value of €1M, the company will have to pay roughly 400,000€ in social charges and at least 10% penalties additionally. This is why reaching the safe harbor is key for any appraiser.

Valuable Conclusions

Within the complex landscape of equity stock options, the collaboration between good intentions and bad consequences serves as a cautionary tale for companies navigating the relationships between valuation and compensation. As we reflect on the scenarios identified in this article, it becomes evident that careful attention to detail and proactive measures are necessary to avoid disparities and building trust among employees. By learning from past oversights and adopting more consistent strategies for the future, companies can navigate the challenges of equity compensation with greater fairness for all.

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