Setting the Exercise Price: HMRC versus Section 409A Valuations

Companies granting share options to employees in both the UK and the U.S. need to navigate different valuation requirements. Understanding how HMRC-agreed valuations and U.S. 409A valuations differ can help companies set appropriate exercise prices and manage tax risks on both sides of the Atlantic.
 

For EMI and CSOP options, a company may ask HMRC to agree to the actual market value (AMV) and unrestricted market value (UMV) of the shares before grant.
 

In the U.S., the exercise price of a standard option (ISO or NSO) granted to a U.S. taxpayer generally must be no less than FMV of the underlying shares on the grant date to preserve ISO status and avoid adverse tax consequences. U.S. private companies typically establish FMV through an independent appraisal of their common stock, known as a “409A valuation,” which is usually prepared by a qualified third-party valuation firm.
 

A current 409A valuation provides a safe harbor that shifts the burden to the IRS to prove the valuation is grossly unreasonable in an IRS audit. Unlike an HMRC valuation, however, a 409A valuation is not submitted to or reviewed by a governmental agency before it is used to price option grants.
 

Although the two analyses use similar financial information, an HMRC-agreed valuation and a 409A valuation are not automatically interchangeable. For a breakdown of the difference, see our chart here.
 

Bottom line. A valuation prepared for one regime will not necessarily satisfy the other. Companies granting equity on both sides of the Atlantic should obtain separate valuations or a single valuation that is explicitly prepared to meet both standards.  Companies may also consider setting the exercise price at the higher of the two figures to avoid adverse tax consequences in either jurisdiction and disparate employee treatment.
 

(For a checklist of steps to take before and after the flip, click here.)
 

This article is the third and final article in a series that walks through how stock options are treated in a Delaware flip and what a UK startup founder needs to know about granting stock options in the new U.S. TopCo, and how the U.S. approach differs from the UK framework.  For the first article, see Equity Isn’t Equal: How Stock Options Work Differently After a Delaware Flip, and for the second, see Building the Equity Incentive Framework in the U.S. Post Delaware Flip.