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Pre-IPO stock options granted by a spinoff

by contributor Brian Holmen | Published November 9, 2011 at 2:20 PM

One of the issues that a corporate parent, known here as Parent, must consider when it spins off a subsidiary corporation, known here as SpinCo, is how to incentivize SpinCo's service providers (such as its employees and directors) who will contribute to SpinCo's future success. A common approach to address this issue is to grant prespin equity awards under Parent's equity plan, with SpinCo assuming some of these awards following the spinoff. In the context of a two-step spin (an initial public offering of up to 20% of SpinCo's common stock followed by a distribution of SpinCo's remaining stock to Parent's stockholders), a Parent may also cause SpinCo to grant pre-IPO equity awards to its service providers, often in the form of stock options. One rationale for this latter approach is that recipients may benefit from a greater upside on their pre-IPO stock options if SpinCo's stock significantly increases in value in connection with the two-step spin. While this approach may benefit award recipients, there are a number of potential pitfalls that a Parent must consider before implementing such a program. This article briefly summarizes a few of these pitfalls.

A nonstatutory stock option must be granted with an exercise price that is equal to or greater than the fair market value of the issuer's common stock on the date of grant for the option to be exempt from Internal Revenue Code Section 409A tax rules governing deferred compensation arrangements. Because of the lack of a market to determine fair market value of a private company's common stock, such a company must obtain a valuation of its stock. Section 409A requires that any such valuation must be determined by a "reasonable application of a reasonable valuation method" that accounts for "all available information material to the value of the corporation." (The tax rules governing incentive stock options, which also must be granted at or above fair market value, allow a private company to value its common stock using "any reasonable valuation method.")

When a SpinCo grants stock options to its service providers in the context of an anticipated two-step spin, the valuation used to establish the options' exercise price necessarily must account for the possibility of the contemplated transactions to comply with Section 409A. Even if the valuation accounts for this possibility, if SpinCo's IPO price greatly exceeds the exercise price of stock options granted shortly before the IPO, it is possible that the IRS could challenge the valuation methodology and determine that SpinCo granted discounted stock options that are subject to Section 409A. A discounted stock option that has standard terms would not comply with Section 409A, and failure to comply with Section 409A can result in the optionee incurring income taxes and excise taxes as the option vests, regardless of whether the optionee exercises the option.

When a SpinCo grants stock options during the period beginning approximately 12-18 months prior to an anticipated IPO, the Securities and Exchange Commission will review SpinCo's accounting charges for those option grants. If the SEC determines that SpinCo did not adequately account for the stock options (that is, a determination that SpinCo issued cheap stock) it may require SpinCo to restate its financial statements to increase the compensation charge associated with the options. Such an accounting restatement arguably could be construed as a tacit admission that SpinCo granted discounted stock options for purposes of Section 409A (that is, the value of SpinCo's common stock on the date of grant is not accurately reflected in the exercise price).

To reduce these risks, a SpinCo contemplating pre-IPO grants of stock options should obtain an independent valuation of its common stock in connection with each grant and make the option grants at or close in time to each applicable valuation date. Each valuation should be performed by a highly qualified appraiser, and the valuation should thoroughly document all of the factors that the appraiser considered in determining the value of SpinCo's common stock. To address the SEC's cheap-stock concerns, SpinCo's IPO registration statement should provide a thorough explanation of the process through which it valued its common stock and explain any events that subsequently impacted the value.

Nonstatutory stock options granted by a subsidiary corporation to service providers who perform direct services solely to a parent corporation (an upstream grant) are not exempt from Section 409A. For this reason, if SpinCo intends to grant stock options to service providers who also perform direct services for Parent, SpinCo should ensure that the grants are designed to compensate the recipient for direct services provided to SpinCo. For example, a pre-IPO grant of SpinCo stock options to a SpinCo director who is also an officer of Parent could be characterized in part as an upstream option grant to compensate the recipient for services provided to Parent; this risk is increased if the grant is large relative to the services performed for SpinCo.

Pre-IPO stock options granted by a SpinCo to officers who become covered employees following the IPO will not qualify as performance-based compensation for purposes of Code Section 162(m) unless the options are granted by a compensation committee composed solely of two or more outside directors. For purposes of this rule, the outside directors of a publicly traded company constitute the outside directors of each member of its affiliated group, such as a wholly owned subsidiary. Because a Parent cannot grant SpinCo equity awards, a common approach to comply with this guidance in the context of a two-step spin is to appoint Parent's compensation committee members as the pre-IPO members of SpinCo's compensation committee.

Code Section 162(m) provides transition relief that, if satisfied, exempts equity awards that are granted prior to SpinCo's first annual meeting that occurs more than 12 months following its IPO from the requirement of stockholder approval of any performance goals applicable to those awards. Given this short time frame, there is a good chance that SpinCo's pre-IPO equity plan will remain in effect long enough for SpinCo's public stockholders to vote on any performance goals incorporated into the plan that will apply to future equity grants. For this reason, Parent and SpinCo should review then-current proxy advisory firm guidance in designing SpinCo's equity plan. This issue is especially important in light of the IRS' recent statement that it will no longer automatically recommend approval of 162(m) proposals relating to equity plans of newly public companies.

To qualify as a tax-free distribution under Code Section 355, a Parent must distribute "control" of SpinCo to its stockholders in the spinoff. For purposes of this requirement, control is defined as ownership of stock possessing at least 80% of the combined voting power of all classes of stock entitled to vote and at least 80% of the total number of all other classes of stock. In a two-step spin with up to 20% of SpinCo's common stock offered in an IPO, it is important that any SpinCo options that are granted prior to a spin do not become exercisable until after the spin to ensure that Parent may distribute control to its stockholders in the spinoff. The precise terms under which any such option will vest and become exercisable can have significant accounting consequences, and these issues should be evaluated when designing the option terms.

While there may be a potential upside in having SpinCo grant pre-IPO stock options to its service providers in the context of a two-step spin, such an approach also implicates a number of issues that must be considered. Any Parent considering such an arrangement should consult its legal and accounting advisers early in the process.

Brian Holmen is a partner in the Los Angeles office of Jones Day, where he is a member of the firm's employee benefits and executive compensation practice.

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