Is It Possible to Issue Stock Options on a Company That Is Not Publicly Traded?

A company's stock does not need to trade on a stock exchange for the company to issue stock options. When a private company issues a stock option, it is called a private stock option. A company may offer stock options to its executives and early employees before the company has its initial public offering and makes shares available for sale to the general public.

Taxation

When a company grants stock options to its shareholders, the Internal Revenue Service considers the difference between the fair market value of the stock and the exercise price of the stock option taxable income. It is more difficult to value stock options when the company's stock does not trade on a stock exchange, because the price that the stock sells at on the exchange is the preferred method to determine the fair market value of the stock, according to the Securities and Exchange Commission.

Backdating

A company can backdate a private stock option. Normally, the company uses the current market price of the stock to set the initial value of the option, so the executive or other employee will only earn value if the stock price increases. When a company backdates a stock option, it allows the holder to sell the stock at a lower price that the share sold at in the past. The company has to immediately record a compensation expense for a backdated stock option, including a backdated private stock option.

Reporting

The Securities and Exchange Commission requires a publicly traded corporation to report a grant of stock options to investors. Since a private company's stock does not trade on an exchange, it doesn't have to report its grant of the private stock options to the public. The company does have to report the grant to the Internal Revenue Service for tax purposes. If the private company decides to go public and have an initial public offering, it then has to disclose any private stock options that it has granted.

Benefits

When the company's stock does not trade on any exchange, the strike price of the stock option is usually very low. The strike price sets the initial value of the stock option. The option holder will earn a profit on any stock sale at a price that is higher than the strike price, so an investor says that the option is trading in the money. A pre-IPO stock may only have a strike price of $1, so if the stock later sells for $100 a share at the IPO, the investor receives $99 per share in profit.

Valuation

One method of determining a strike price for a stock option when the stock does not trade on an exchange is to set the strike price equal to the stock price for the initial public offering. According to Yale University, the risk of using this method is that an executive who receives these stock options may set the initial public offering price per share too low so that the executive earns more money by exercising the stock option.

References

• Internal Revenue Service: Interim Guidance With Respect to the Application of Section 409A to Outstanding Stock Rights
• Internal Revenue Service: Industry Director Directive on Backdated Stock Options Directive #1
• Yale University: Executive Stock Options and IPO Underpricing
• Securities and Exchange Commission: Statement by SEC Staff