Options A Windfall For Pre-IPO Firms’ Employees?

Stock options drum up images of the dot-com era, of IPO riches reaped for getting in on the ground floor of a promising tech startup that goes public.

As reported by The Wall Street Journal, an analysis of 68 companies that gave employees options for as much as $1.5 billion in shares over the year-long period that preceded their public offerings offered them roughly a 32 percent discount off what the shares were “worth,” according to the data.

That means a hefty windfall for those employees. The implication, too, is that the shares are more highly valued by “outside” holders than by insiders. And as has been widely reported, valuations are of particular interest on the Street, with such marquee names as Uber Technologies, Pinterest and Lyft coming public.

And, we note, in at least some cases, the insiders can fare better than outside investors as time goes on. Consider the case of Blue Apron, where insiders back in October sold their shares for more than $13 each upon the IPO, but options were granted at a bit more than $3.60. That means roughly $10 a share in profit. But in the years post-public debut, a hyper-competitive meal delivery landscape and company-specific problems have torpedoed the stock to around $1.50.

Mukesh Bajaj, a financial economist quoted by the newswire, said securities law mandates that employee-allocated stock should be priced at its “fair value.” But there are no explicit rules on calculating that fair value, which may give companies what Bajaj said is a “loophole to enrich their executives.”

“There’s a tremendous incentive to value the stock at the lowest possible figure,” Robert Willens, a New York-based tax analyst, told the WSJ. “It’s a tried-and-true strategy, and the IRS, surprisingly, is not very vigilant about it.”

Beyond the boon that comes as public offerings drive up share prices, insiders who hold options get taxed at the capital gains rate, which is in turn lower than the income tax rate.

There are laws in place that help the IRS levy tax penalties on firms that use extremely low valuations and may seek to skirt tax liabilities – but some companies have been able to skirt what are known as 409A rules by hiring outside and independent valuation firms. Some of those firms promise to calculate low valuations. And only a few firms have been targeted by the IRS for breaking 409A mandates.