What is a 409(a); why it matters to tech company stock options; how the current economy could make a huge impact on employees compensation; and what to do about it

In this three part series, Renegade Partners' Chief People Officer Susan Alban explores how startups can navigate through the Supercritical, during critical times - from the changing expectations around internal employee communications, to how to compassionately navigate layoffs, and exploring innovations in employee compensation. In part three of the series, Susan explores how the current economy could have a dramatic impact on employee compensation, and what HR and compensation executives should do about it. Part one and two of the series were co-authored by Susan Alban and Melanie Steinbach and can be found here and here.

Introduction:

As an operating partner and Chief People Officer at Renegade Partners, I work across our 18 portfolio companies on all issues relating to building great organizations and exceptional employment outcomes, including org design; talent mobility; DE&I; and compensation among others. Please keep in mind that this article is not tax, financial or legal advice; always consult your own advisors and counsel.

What is a 409(a)?

In the pre-IPO markets where Renegade Partners invests, companies issue equity, but those shares of stock or options are illiquid and as such, pricing is nuanced. Typically, there are two prices at any given time: (1) the price of preferred shares, which is typically the price per share that investors paid in the most recent round of financing; and (2) the fair market value (FMV) of common shares, which is equivalent to the most recent 409(a) valuation. Note that this article uses these terms interchangeably.

Employee stock options are typically an option to purchase shares of common stock, and as such, the strike price is equal to the 409(a) of common stock at the time of the option issuance. At the time of issuance, the strike price equals the price of common, so the options are “at the money.” The hope is that as the company appreciates, those options will eventually be “in the money” where the 409(a) exceeds the strike price of the previously issued options; at that point, the option’s value is derived from the delta between the current 409(a) and the strike price. 

But what happens if the 409(a) declines? What are the implications for employees who have stock options? How should companies respond, if at all? 

When a company’s 409(a) drops lower than where it had previously been and below the strike price of many previously issued employee options’, employees experience all or part of their equity holdings to be “underwater.” In other words, the current 409(a) now falls short of the strike price of some or all of their previously issued options. 

Most employees would not choose to exercise these options, because they are effectively the right to purchase stock at a price above the current stock price. As such, employees may believe that their equity has no value, and its incentive to retain and motivate employees will diminish. This article intends to highlight some actions that companies can take in this situation: 

Option reprice / reissue

Underwater options can be repriced with board consent, but doing so can be cumbersome and expensive, and repricing multiple times may lead the IRS to determine that you have a “floating strike price,” which would subject the company and its employees to meaningful negative tax consequences.  

As such, repricing is generally something that most companies try to do only once or only very occasionally and with experienced tax and legal counsel. As such, consider deeply the right time to reprice.  

Experienced HR and compensation executive David Wohlreich explained to me, “If you reprice too early and the 409(a) continues to decline in the future, you may have to redo this work, if it is even feasible to do so. But if you wait too long or make too small of an adjustment, you risk losing your employees to competitors.”

The reprice is generally equal to the new lower 409(a). Employees can elect to participate in the reprice or not, but it is typically to their advantage to do so. A positive feature with a reprice is that the company can reset the clock on the 10 year option life, which is likely beneficial for longer tenured employees. A negative element is that the clock is also restarted for the two-years-from-grant requirement for capital gains treatments of stock resulting in the exercise of an option. 

There is a surprising/nuanced double counting when calculating the ISO/NSO split specific to a reprice. It can result in more NSOs for certain people than might be anticipated because the options that vested in the calendar year under the original grant still count towards the $100k in addition to the “new” grant being repriced (and since in most cases a larger portion will be considered vested at the new grant date). This calculation is done automatically in Carta, but can be an unfortunate surprise if the company has not previously understood this nuance.

RSU exchange

For companies that have a high enough total market capitalization (~$1-2B+ is a decent rule of thumb), and a high enough 409(a) (~$15+), now may be an excellent time to introduce RSUs, and to enable employees to trade in their underwater options for RSUs.

RSUs are generally worth more than options, because the holder of the instrument does not need to pay any strike price to exercise and RSUs have value as long as the common stock price is worth more than $0. Therefore, you will want to work with a compensation advisor on the exact exchange rate, because it will likely not be 1:1. 

A note on broad-based RSU switchover: if your company meets the above criteria and hasn’t switched your broad-based employee equity grants from options to RSUs, you may want to do that as well. Shifting to RSUs more generally is out of the scope of this article.

Additional equity issuance

Issuing additional equity (RSUs or options) appears to be less common because it is dilutive and will create overhang on the cap table from the existing options that remain granted and not yet forfeited or exercised. 

Cash bonus

Some later-stage companies with healthy balance sheets have sought to rectify the gap in intended equity value and actual equity value that results from a depressed stock price, with one-time cash bonuses. This is less common in earlier stage businesses because they are often also in cash preservation mode during times of lowered stock prices. 

Look-outs / additional notes

Always partner directly with your board to understand preferences for different strategies, and to work through dilution implications and uses of company cash to support these strategies.

Additionally, always work with an experienced equity attorney on mechanics and methodology. Compensation consultants with relevant expertise are also very valuable in ensuring the company maximizes the positive impact of any strategies you pursue.

Please note the above guidance is not legal or accounting advice.

About Susan Alban

Susan is the Chief People Officer and an Operating Partner at Renegade Partners, where she supports the portfolio across all areas of Human Resources operational support. Susan brings deep expertise in operations and product, especially around launches, as well as a particular passion for learning about new future-of-work, people ops, and marketplace businesses