ISO Options

Quick note: I’m not your lawyer. I’m not giving legal advice in this post. Back in the olden days of venture capital, company boards had wide discretion in pricing company options. As is true today, there was a requirement that options be priced at or above the “fair market value” of the underlying stock (otherwise there would be tax consequences to the optionee and sometimes to the company as well). However the board could determine what that fair market value was and, generally speaking, there wasn’t a practical way that these valuations could be challenged. Most boards did some level of work to determine the FMV of a company’s stock but generally options were priced between 10% and 15% of a company’s then preferred price (because common equity sits behind preferred equity there is typically a discount applied to the FMV of common stock to account for this “overhang”). It was and is imprecise science but – at least in the case of venture backed startups – there wasn’t much harm in an option being priced low. It was a benefit to employees and a slight value transfer from equity holders to option holders (generally speaking in M&A transactions the value of the aggregate option exercise ends up allocated across the rest of the cap table). In a funny way it also benefitted the IRS in terms of tax collections as employees were taxed on the spread between the option and the value of the stock on exit and since these shares were typically exercised at the time of an exit were subject to short term capital gains. Higher strike prices distributes proceeds away from short term gain tax to equity holders who more typically are paying long term gains on the value that was shifted (I’m skipping a huge amount of nuance and detail here but the above is a general representation of how things work). …