I’m sure that at least one securities litigation lawyer got a fever just from reading the title of this post. And that’s a good thing — you should all learn from it.

Here’s the scenario: you intended to grant some options to a valued employee, but that was a few months ago, or maybe even a year ago. You didn’t even have an option plan, or really know what one was, when you came up with the proposal. You shared it with your employee, who has continued to work hard based on your promise.

But now you’ve got a new lawyer, one who knows a thing or three about startup companies, and your streamlined option plan is ready to go. What do you do?

Well, the first thing you learn is that you have to grant the options at the fair market value of the shares at the time of the grant. (I’m going to talk about shares here, but the same principles apply to LLC units.) If you give someone something that has little value, it has little value, which means that the IRS won’t really tax it. NB: I’m simplifying here: taxation of options, from 83(b) filings to Black-Scholes valuation, can be complicated. This is the high-level POV for a CEO or board member who doesn’t really understand this from experience. IAALJNY (I am a lawyer, just not yours.)

For example, if a bottle of wine is $23, me selling you the right to buy it for $23 is not worth an awful lot. However, if I give you the right to buy that wine for $20, the IRS, just like you, knows a good thing when it sees one. Using these numbers in the option context, the IRS takes that excess of the FMV over the strike price (recognizing that the employee HASN’T even exercised the option!) and finds $3 of taxable income.

Here are some numbers from a real company. The company intended to grant the employee an option to purchase 30,000 units. Based on the value of the company at the time of that initial intention (which even showed up on a cap table to show the employee and everyone else what the deal was), the strike price at that time was $0.25 per share. Later, the company decided the employee was really doing well and so decided to grant options on an additional 70,000 units. The strike price at that time was $0.41 per share.

So, there was no plan at the time the first grant was discussed and agreed. From a pure corporate law perspective, it’s easy to just say “no plan, no board approval, no grant. Do not pass go; do not collect $200.” But that sucks as a leadership technique. Breaking promises to your troops is a fast track to being the only one on the team.

What are your options? First, let’s look at the most obvious approach

1. Grant 30,000 units at $0.25, dated the intended grant date, and 70,000 units at $0.41, dated currently.
   What happens?
   Well, as long as everyone reports everything properly, your employee now has ($0.41-$0.25) * 30,000 = $4800 of taxable income from an option grant that he hasn’t even exercised. That means somewhere around $1600-$2400 in taxes that your employee will have to take out of her vacation fund to pay. No one is happy when that happens, except the IRS.

(As an aside, here’s where all the option backdating people got into trouble: they never reported any of this, which means they gave employees those lower-priced grants but didn’t report them properly, resulting in tax evasion, loss of deductions for compensation to employees, and a whole lot of other miscellaneous problems.)

In general, no one thinks this approach is a good one, and even fewer people think that counseling employees to evade taxes is a winning HR strategy.

What’s next?

First off, do the math, just like I did above. Figure out how much the employee has “lost” from the delay in grant dates and the change in the value of the company. In this case, it’s under $5000. That’s awfully slim pickings when it comes to a federal crime. That’s step 1 so that everyone realizes it’s easier to fix any problem than to be sneaky. Really.

Next, think about how many additional shares it might take for the employee to make up the $4800 “loss.” Here, where the company’s valuation was about $4m, you could imagine the value doubling by the time of a liquidity event. (There are lots of scenarios, of course: you’re just trying to get a handle on the magnitude of the problem and hence the solution.) Here, $4800/ ($0.82-$0.41) = 4800/.41 = about 11700. That means that if you increase the grant at the current FMV by 11700 shares, then the employee will be basically even assuming the company doubles in value between now and the exit.

So, here’s what the paperwork might look like:
a. grant of 30,000 shares at $0.41 with a grant date of today and a vesting start date of whenever you agreed on the original grant.
b. grant of 70,000 shares at $0.41 with a grant date of today and a vesting start date of today.
c. grant of 11,700 shares at $0.41 with a grant date of today and a vesting start date of whenever you agreed on the original grant.

This way, the company bears the cost to the employee of any delay, no additional taxes are paid on phantom income, and you get to frame that additional grant any way you like — bonus grant for good work or you refusing to shaft the employee. Either way, this approach is the primary legal method for resolving this common issue.

Q&A: could you pay the taxes on the phantom income for your employee? Sure, but that tax payment is also taxed, and when you pay the taxes on that, that payment is also taxed. You’re going to spend a lot of money on the gross-up. It’s a bad idea in most cases unless you’ve already created this problem for the employee and you can’t unring the bell.

Bonus advice: keep this phantom income issue in mind when you start trying to negotiate equity packages. Another company and executive had settled on a sizable grant of stock, 250,000 units, at a $0.01 price. The FMV of the stock at that point was closer to $0.50 per share, meaning they were facing $125,000 in phantom income and $50k+ in cash taxes out of pocket. Both the company’s original lawyer and the executive’s lawyer missed this. Conveniently, they never really papered the deal and were renegotiating other employment and bonus terms. Some timely advice made everyone much happier once they realized what they would have been facing.