Tax

Several U.S. treaty partner jurisdictions have recently become aggressive in extending their taxation rights to cross-border acquisition transactions and the movement of assets, such as intellectual property. As a result, multinational companies should consider seeking advance unilateral or bilateral advance pricing agreements (also referred to as “APAs”) to resolve potential disagreements with foreign tax authorities and avoid lengthy and expansive audits and litigation proceedings.

What are “APAs”?

Commonly, following an acquisition of a foreign company by a U.S.-based multinational company, certain IP assets of the foreign target may need to be integrated with such company’s other operating assets to better align the ownership of IP assets with such company group’s operating structure, functions, other assets, and risks. Such an alignment of assets could involve the license, sale, or transfer of IP to the U.S. parent company or to another member of the multinational company group located in a jurisdiction different than that of the target. A cross-border transfer of assets could result in income recognition based on the value of the assets being transferred.

An APA is an agreement between a multinational company and a taxing authority or authorities regarding the transfer pricing methodology, valuation, and pricing of assets and certain transactions. A bilateral or multilateral APA (which involves the multinational company and two or several tax authorities, respectively) provides a non-adversarial alternative to resolving potential cross-border transfer pricing disputes, among many other benefits. Furthermore, the IRS is expected to be more likely to support valuation methodologies and adjustments that are based on acceptable international tax principles and valuation methodologies. The IRS’s support of a company’s valuation methodology in an APA process could be helpful in a dispute or litigation with a treaty partner jurisdiction in support of a company’s position. As a result, a bilateral or multilateral APA process provides an opportunity to set the stage and level the playing field with the treaty partner country(ies). A bilateral or multilateral APA may be a viable alternative to consider for both treaty partners (including Canada, Germany, India, Israel, Japan, Korea, Switzerland, and others) and other jurisdictions.

As a primary benefit, a bilateral or multilateral APA could eliminate the need for uncertain tax position reporting and provide for penalty protection. It would also help parties avoid repetitive tax and transfer pricing audits; limit tax authorities’ ability to change transfer prices retroactively; allow parties to manage transfer pricing real-time (rather than responding to audits years later); and mitigate the risk, cost, and burden of an audit or potentially harmful tax litigation in the U.S. and in the treaty partner jurisdiction. Other benefits may include the suspension of current tax audits or assessments relating to the transactions covered by the bilateral or multilateral APA negotiations until the APA process has been concluded, which could take several years.

For instance, recently at least one tax jurisdiction has gone so far as to argue on several occasions that the value of a target company’s IP could be higher than the entire purchase price paid to acquire such target company. The argument has been that, surely the buyer has taken into account the tax cost associated with moving the IP following the acquisition and, thus, discounted the purchase price paid for the target company and all of its assets, including its IP. Such a result, in the absence of an APA, can have a significant effect on deal structure, outcome, and consideration if not addressed in advance.

While the taxing authorities and the multinational company are not obligated to reach an agreement, they are generally required to try to reach a mutual agreement pursuant to the applicable income tax treaty, including relevant provisions for the relief from double taxation and mutual agreement procedure.

In a welcome development in the U.S., the IRS released additional guidelines on the IRS’s Advance Pricing and Mutual Agreement Program (APMA), a program that looks to identify multinational companies and matters early in the process that are more likely to successfully reach an APA resolution based on the facts at issue. Multinational companies can contact APMA for a pre-submission review and receive a preliminary opinion on whether to proceed with the APA process within just a few weeks of submitting a pre-filing memo and providing additionally requested information.

APMA considers a number of factors, including: the significance of the transaction; the probability that transfer pricing compliance will be significantly enhanced by engaging with the treaty partner; the scope, materiality, and complexity of the company group-covered transactions in the U.S.; whether there is an actual or potential transfer pricing dispute that would be most efficiently resolved through a bilateral or multilateral APA based on the APMA’s experience; country-specific strategy considerations; and the input of the treaty jurisdiction regarding the APA.

In addition to transactions involving IP assets, a bilateral or multilateral APA can cover the provision of services by a non-U.S. entity, the provision of services by a U.S. entity, sale of tangible property into and from the U.S., use of intangible property by a U.S. entity and by a non-U.S. entity, and other transactions. In the majority of “APAs”, the covered transactions involve numerous business functions and risks.

One of the most common legal missteps among emerging companies involves the classification of the people doing the work. In the earliest days of a startup, founders often bring on talented individuals as “consultants” or “independent contractors,” compensating them primarily or exclusively with equity. This arrangement feels natural when cash is scarce and everyone is pitching in to build something from the ground up. But what begins as a practical solution can quickly become a significant legal liability if the company does not revisit these classifications as it matures and secures funding.

This article provides a high-level overview of the risks associated with worker misclassification, the key legal frameworks that govern these determinations, and the steps founders should take to clean up classification issues before they become costly problems.

The Common Pattern: Early “Consultants” Who Are Really Employees

It is extremely common for pre-revenue startups to engage early team members as independent contractors or consultants. The logic is straightforward: The company cannot yet afford salaries, payroll taxes, or benefits, so it issues equity in exchange for labor. On paper, the individual signs a consulting agreement, invoices the company (or doesn’t), and is treated as a 1099 worker for tax purposes.

The problem is that many of these individuals are, as a matter of law, employees regardless of what the agreement says. Classification is not a matter of mutual agreement between the parties. It is determined by the nature of the working relationship under applicable federal and state law. If the engagement looks and feels like employment, then government agencies and courts are likely to treat it as such.

When these individuals are never reclassified, the company accumulates exposure over time. That exposure includes unpaid wages, overtime, employment taxes, penalties, and potential liability under both federal and state law. These issues often surface at the worst possible moment: during due diligence for a funding round, an acquisition, or in response to a complaint filed by a disgruntled former worker.

Why Reclassification Should Be a Priority After Funding

Securing any meaningful financing event should serve as a trigger for the company to revisit every worker classification. There are several reasons for this.

First, the original justification for the consulting arrangement, namely the inability to pay cash compensation, has likely changed. Once the company has capital, it has the resources to bring workers onto payroll and provide the protections required by law. Continuing to classify a worker as an independent contractor when the company now has the means to pay wages and withhold taxes weakens any argument that the arrangement was legitimate.

Second, investors and their counsel will scrutinize the company’s employment practices during due diligence. Misclassification issues are a well-known red flag. Unresolved classification problems can delay or even derail a financing, reduce the company’s valuation, or result in specific indemnification obligations imposed on the founders.

Third, as the company grows, the risks multiply. More workers mean more potential claimants. Longer periods of misclassification mean larger back-pay and tax liabilities. And the shift from a small, informal team to a structured organization makes it increasingly difficult to argue that any given worker was genuinely operating as an independent business.

The bottom line is that reclassification is not merely a housekeeping exercise. It is a critical step in putting the company on sound legal footing for its next phase of growth.

Federal Law: The Key Frameworks

At the federal level, worker classification is governed by several overlapping tests, depending on the statute at issue.

The Fair Labor Standards Act

‍The FLSA uses an “economic reality” test to determine whether a worker is an employee or an independent contractor. The inquiry focuses on whether the worker is economically dependent on the company or is in business for themselves. Factors include the degree of control the company exercises over the work, the worker’s opportunity for profit or loss, the worker’s investment in equipment or materials, the permanence of the relationship, the degree of skill required, and the extent to which the work is an integral part of the company’s business. The Department of Labor has historically taken a broad view of employment under this test, and the consequences of misclassification include liability for unpaid minimum wages and overtime, liquidated damages, and attorneys’ fees.

The Internal Revenue Code

‍The IRS applies a common-law test that examines the degree of control and independence in the relationship. The IRS groups relevant factors into three categories: behavioral control (whether the company directs how the work is done), financial control (whether the company controls the business aspects of the worker’s role, such as how the worker is paid and whether expenses are reimbursed), and the type of relationship (including written contracts, benefits, and the permanence of the engagement). Misclassification under the tax code can result in liability for unpaid employment taxes, penalties, and interest. In some cases, officers of the company may face personal liability under the trust fund recovery penalty.

Exempt vs. Non-Exempt Classification

‍Once a worker is properly classified as an employee, the company must also determine whether the employee is exempt or non-exempt under the FLSA. Exempt employees are not entitled to overtime pay, but they must meet specific salary and duties tests. The most commonly applicable exemptions for startups are the executive, administrative, professional, and computer employee exemptions. Each requires that the employee be paid on a salary basis at or above a specified threshold and that the employee’s primary duties satisfy specific criteria. Founders should not assume that simply paying a salary or giving someone a managerial title is sufficient. The analysis turns on the actual duties performed, not the job title.

State Law: Where the Rules Get Stricter

Many states impose classification standards that are more restrictive than federal law, and compliance with federal standards alone does not guarantee compliance at the state level.

California’s ABC Test

‍California applies a particularly stringent standard under its ABC test, codified by Assembly Bill 5. Under this test, a worker is presumed to be an employee unless the hiring entity demonstrates that the worker (A) is free from the company’s control and direction in performing the work, (B) performs work that is outside the usual course of the company’s business, and (C) is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed. Prong B is often the most difficult to satisfy for startups, because early workers are typically performing tasks that are central to the company’s core business. California law also provides for significant penalties for misclassification, including penalties under the Private Attorneys General Act, which allows employees to bring representative actions on behalf of the state.

Other Notable State Frameworks

‍Several other states have adopted or are moving toward ABC-style tests, including Massachusetts, New Jersey, and Illinois. New York applies a similar multi-factor test and has aggressive enforcement mechanisms. States vary considerably in their approaches, and companies with remote workers in multiple states must ensure compliance in each jurisdiction where a worker is located, not merely where the company is headquartered. Founders should be particularly attentive to any state in which the company has workers, as the applicable test is generally determined by the worker’s location.

Cleaning Up Past Misclassification

For companies that have already been operating with misclassified workers, there are several steps to consider when undertaking a remediation effort.

The first step is to conduct an honest internal audit. Identify every individual who has been engaged as a contractor or consultant and evaluate each engagement under the applicable federal and state tests. Determine which individuals are likely misclassified and assess the duration and scope of the exposure.

The second step is to consult with experienced employment counsel. Remediation strategies vary depending on the jurisdiction, the number of affected workers, the duration of misclassification, and the company’s financial position. In some cases, the IRS Voluntary Classification Settlement Program may be available, which allows companies to prospectively reclassify workers with limited look-back liability in exchange for a modest payment. Similar programs or settlement frameworks may exist at the state level.

The third step is to transition misclassified workers to employee status going forward. This includes placing them on payroll, withholding applicable taxes, providing required benefits, and ensuring compliance with wage and hour laws, including proper exempt or non-exempt classification.

The fourth step is to address the equity arrangements already in place. Early equity grants made to individuals who should have been classified as employees may have been structured as contractor grants, which have different tax treatment than employee equity awards. Companies should work with both employment counsel and tax advisors to evaluate whether corrective filings or revised equity documentation are necessary, particularly with respect to Section 409A of the Internal Revenue Code, which governs deferred compensation and imposes significant penalties for noncompliance.

Finally, companies should implement classification policies and procedures that will prevent these issues from recurring as the company continues to hire. A brief intake process for every new engagement, whether employee or contractor, can go a long way toward ensuring that the correct classification is applied from the outset.

For private companies backed by venture capital investors, acquisition is frequently the most likely path to liquidity. Founders are often laser-focused on product development, market expansion, and fundraising, without devoting the same early-stage discipline to ensuring the company is well-positioned for a future exit via a merger or acquisition.

M&A preparedness is not a late-stage exercise, but an operational strategy to position your company as an attractive, high-value target to potential acquirors.

Corporate Governance

Some of the most common obstacles to efficient M&A processes stem from issues related to corporate governance. Complex capitalization tables, unclear chain of equity ownership, and unresolved governance issues can create transaction delay and, depending on the structure of the transaction, loss of leverage.

Companies should consider focusing on three key areas of corporate governance to be prepared for future M&A processes: capitalization table discipline, stockholder rights, and board and stockholder alignment.

Capitalization Table Discipline

Maintain clear documentation of all equity issuances with proper board and stockholder approvals; confirm board minutes are complete, approved by the board, and signed; verify that 83(b) elections have been timely filed with respect to restricted stock grants to founders and early employees; and ensure 409A valuations are updated following major events that may impact valuation (such as a financing) and, absent such events, at least annually.

Stockholder Rights

Ensure all stockholders have signed the relevant stockholder agreements and that the company’s management team understands the protective provisions embedded within such agreements; similarly, ensure that the company’s management team is familiar with relevant provisions of any investor side-letters (think drag-along mechanics, rights of first refusal, and co-sale rights).

Board and Stockholder Alignment

Understand what approvals are required to approve a sale or merger of the company and whether any investor has blocking rights.

Contracting Discipline

Material contracts, such as key vendor and customer agreements, collaboration agreements, and licensing arrangements, are some of the first diligence requests in an M&A process. These contracts often contain assignment or change-of-control provisions that can require third-party consent, accelerate payment obligations, or trigger termination rights or other contractual rights that could significantly impact the trajectory of a deal. Accordingly, it is important for companies to maintain clear records of all material contracts, ensuring that all contracts are fully executed and include all attachments, exhibits, amendments, and restatements. Companies should track whether any material contracts have upcoming renewals or expiration dates. Additionally, tracking key provisions in such material contracts that may be triggered by an M&A (such as third-party consent requirements) will help streamline the M&A diligence and consent process.

Intellectual property is another value-driver for life sciences companies and technology companies, making it vital for companies to have documentation that clearly delineates intellectual property ownership. Companies should verify that all employees and contractors have signed Proprietary Information and Inventions Assignment Agreements (PIIAAs), review consulting agreements to confirm that intellectual property created by consultants/contractors has been validly assigned to the company, and obtain confirmatory assignments from founders and early contributors, if needed, and at the appropriate time. For companies with affiliated entities, confirm that the company’s core intellectual property assets sit within the target entity and not within any affiliated entities.

Being proactive can save time and expense during the M&A diligence process.

Regulatory Compliance

Depending on industry and geography, regulatory risk can become a gating diligence issue. Companies should identify areas of risk and preemptively resolve any outstanding compliance risks (e.g., data integrity, marketing, industry-specific licensing, etc.). In particular, life sciences companies should consider pursuing regulatory planning with the assistance of healthcare and/or FDA counsel (as needed) to ensure, among other things, that regulatory filings, communications, and approvals are complete and accessible.

Deal Team Preparation

Once the company has decided to start a sale process, identify at the outset who will be part of the core deal team, which will typically consist of a select number of employees and outside advisors. Members of executive management and other key internal personnel with specialized knowledge about the company’s corporate governance, labor and employment practices, employee benefits structure, assets (IP, real estate, etc.), litigation exposure, and regulatory compliance are typically included within the core deal team. Further, at the appropriate time, companies should engage outside advisors, such as outside legal counsel, financial/tax advisors, and investment bankers, all of whom can help quarterback the transaction and efficiently drive the deal process.

After the deal team is in place, consider implementing deal confidentiality procedures to maintain the integrity of the sale process:

• assign code names to the project and company participants;
• limit working group size and access; and
• consider antitrust issues and the use of “clean team” agreements and data rooms.

Data Room Readiness

Prepared companies treat diligence readiness as an ongoing process and not an exercise triggered by a letter of intent or term sheet. First, select a virtual data room that provides strong security and activity tracking. Second, build the company’s data room with organizational discipline, using logical folder structures (corporate, IP, finance, regulatory, benefits, etc.) and uploading documents in a searchable, digital format with consistent document naming conventions. Lastly, in connection with building the data room, flag with the guidance of deal counsel any confidentiality concerns and access restrictions that need to be put in place. For example, are there any documents that need to be redacted or anonymized? Does the transaction present antitrust sensitivity requiring documents to be shared through a “clean room”?

In all, a well-maintained and categorically organized data room significantly accelerates a sale process and signals sophistication to potential acquirors.

The most successful exits rarely begin when a banker is engaged. Ideally, they begin years earlier with strategic and operational foresight. Companies that understand the value of M&A preparedness can preserve negotiation leverage and act more decisively when M&A opportunities arise. After all, engineering an exit is more than closing a deal — it is positioning the company so that the right deal finds you.

Whether a company is gearing up for an acquisition, a growth equity financing, or an IPO, a due diligence review will be an inevitable part of that transaction, and that review will test not only the current business but also the integrity of a company’s historical records. Readiness for that review is critical, as once a diligence process begins, gaps in corporate approvals, equity records, contract management, intellectual property ownership, and regulatory compliance can quickly become leverage for purchase price adjustments, closing conditions, and/or special indemnities. At best, diligence gaps can consume management attention at a time when a company has little bandwidth to spare. At worst, they can detract from a company’s credibility and can have a meaningful impact on deal speed and certainty. Most issues are fixable, but the available solutions often narrow after a deal is already on the table. This article provides an overview of actionable steps leadership at mid- to late-stage private companies can take to make transaction readiness an ongoing discipline rather than a pre-signing scramble.

Set Up and Maintain a Virtual Data Room

Rather than waiting until a letter of intent is signed, companies should stand up and maintain a virtual data room (VDR) early, using records they already keep locally, and treat it as a living repository of critical corporate documents. Management teams that prepare to address anticipated diligence focus areas and maintain organized virtual records early are better positioned when a process launches than teams that start flat-footed. Companies can get a head start by asking outside counsel for a standard due diligence request list, which serves as an organizational and gap-identification tool, as well as an organized table of contents for their VDR. This ensures that documents are comprehensive and indexed by categories prospective investors and acquirers will expect.

The VDR should contain current, fully executed, and dated documents together with all amendments, statements of work, and side letters. Superseded and terminated agreements should be archived, not deleted or mixed with operative versions. One small but time-saving step in setting up a VDR is using a consistent and intuitive naming convention as documents are uploaded, which will help not only management but also third-party reviewers quickly navigate the VDR’s contents. Once a diligence process begins, access should be staged and subject to tiered permissions, with additional controls for competitively sensitive information, compensation data, and litigation files; privileged materials should be withheld or handled through a process designed to preserve privilege. Particularly when a potential buyer is a competitor, or when the underlying material is subject to confidentiality restrictions that do not permit sharing with a potential acquirer or investor, counsel should advise prior to upload and contemplate redactions, clean-team arrangements, and restrictions on downloading or printing. When in doubt, leave it out; it is easier to pause early and evaluate permissions and other protections than to pull back a document after it has been shared.

A word of caution: prospective investors now run AI review tools that can scan an entire data room in minutes, and while that process can generate false positives, it can also magnify every internal inconsistency across the VDR, including in the cap table, contracts, and other materials. As a best practice, keeping the VDR updated quarterly helps identify issues early and positions the company and management to earn credibility from the moment that transaction diligence begins.

Maintain a Corporate Record Book and Organizational Documents

M&A buyers and growth equity investors will expect clean and current corporate governance records. This means prospective investors will review: current versions of the certificate of incorporation (including all amendments) and bylaws; board and stockholder minutes; and fully executed, dated written consents. An improperly compiled consent with a missing signature page or date can cost the company meaningful time and resources to track down or, worse, require corrective action to cure. Every material corporate action should tie out to a corresponding board and/or stockholder approval, including equity issuances, option grants, director and officer elections, and subsidiary formations.

Companies should also at least annually confirm good standing in their state of incorporation and in every jurisdiction in which they are qualified to do business. Outside counsel can obtain verbal good standing confirmations from third-party service providers, often for a nominal or no cost to the company. Good standing lapses can trigger fees, taxes, and penalties and, in many states, can bar the company from bringing suit in local courts until the lapse is cured, although a lapse does not typically invalidate contracts executed while the company was not in good standing. For an additional layer of caution, companies can consider ordering lien and litigation searches from third-party service providers in the same set of jurisdictions.

Ensure Vigilant Capitalization Table Hygiene

The company should expect buyers or investors to request a current copy of the capitalization table and, in the case of an equity financing, a pro forma cap table reflecting the completed round. Most cap table hygiene issues exist well before a contemplated transaction and surface in the diligence process. Common hiccups include unsigned option grants, undocumented stock issuances, unrecorded convertible note draws, and inconsistencies between vesting schedules and employment terms. Cap table accuracy is key: a company’s representations about its capitalization are often treated as fundamental representations, giving buyers or investors the ability to claim breach even for minor discrepancies. Moreover, a messy cap table can be perceived as poor ownership discipline by the company or its management.

With assistance from outside counsel, the company should reconcile the cap table against the stock ledger and equity grant documentation, ensuring that every stock and option issuance is supported by board resolutions, grant agreements, evidence of payment of the exercise or purchase price, and, if applicable, an approved, unexpired equity incentive plan. Each option grant should also be supported by a current 409A valuation that supports the board’s determination of the fair market value of the underlying shares.

Importantly, companies should develop a clear understanding of how antidilution provisions operate and how change-of-control acceleration clauses (single-trigger and double-trigger) may affect the equity/distribution waterfall in a transaction. Modeling these scenarios in advance allows management to communicate the deal economics clearly to all stockholders and avoids last-minute surprises that can derail negotiations.

Understand Key Provisions in Material Contracts

Counsel for buyers and investors will expect the opportunity to review each contract that is material to the business. These typically include: contracts with key customers and suppliers above certain revenue or expense thresholds; license agreements; leases; employment and severance agreements with key personnel; and other contracts that are important to the business. These contracts often contain change-of-control consent triggers, rights of first refusal, out-licensing restrictions, most favored nation provisions, exclusivity, non-solicit, non-compete, and other restrictive covenants. In certain circumstances, a counterparty may have a notice, consent, or termination right in connection with a transaction. Accordingly, with the help of outside counsel, a company should be generally aware of which key agreements contain those provisions and should have a plan for obtaining consents or providing timely notice in advance of entering into a transaction process. Seeking consent late in the process can give leverage to the counterparty, which can increase overall costs and decrease deal certainty.

Confirm Intellectual Property Ownership and Assignment of IP

Depending on the company’s core business, clean IP title is often a significant driver of the diligence process. One consideration that comes up time and again is whether every founder, employee, and contractor who contributed to the company’s IP portfolio has executed an invention assignment agreement that assigns all intellectual property rights to the company. It isn’t uncommon for advisors and early contributors in early-stage companies, often compensated in equity, to miss the assignment paperwork altogether, or to execute, but not date, the assignment. Any gaps in assignment should be addressed ahead of the buyer or investor diligence process, which can be done with the help of outside IP counsel. Companies should also routinely conduct an audit of open-source software usage to confirm compliance with applicable license terms.

Maintain Compliance with Industry-Specific Regulatory Requirements

Companies operating in regulated industries, such as healthcare, financial services, energy, and government contracting, should confirm that all material licenses, permits, and registrations are current and in good standing. Identifying regulatory approvals or notices that would be required in connection with a change-of-control or assignment of a license can avoid an additional layer of investor diligence caused when gaps are identified later in the deal negotiation process. Regulatory non-compliance discovered during diligence can significantly delay closing or reduce deal certainty.

Incentive stock options (ISOs) have long been a favored form of equity compensation for companies, particularly startups, to attract, incentivize, and retain employees. When properly structured, ISOs offer two key federal tax benefits: (i) ISOs are not taxed as income when granted by the company or exercised by the employee, and (ii) subject to applicable holding periods, any gain on stock acquired from the exercise of an ISO is taxed at a more favorable capital gains rate (however, the spread at exercise may be subject to the alternative minimum tax (AMT)).

But the regulatory framework that gives ISOs potentially advantageous tax treatment comes at the price of their flexibility once granted. What companies may view as a “minor” change to the terms of an ISO may be treated as a “modification” under the tax regulations, which can have significant, unanticipated consequences and, in some cases, cause the ISO to lose its preferential tax treatment altogether, and in the worst-case scenario, become subject to Section 409A and the 20% additional tax thereunder. In such instances, the option no longer qualifies as an ISO and is thereafter treated as a nonqualified stock option (NSO) for tax purposes, meaning that it is taxable upon exercise and any resulting stock is not eligible for favorable capital gains treatment.

Loss of ISO treatment may be frustrating to both companies and their employees, and therefore, it is important to understand the implications of an option amendment before implementation.

Summary of ISO Requirements

In order for an option to qualify as an ISO under Internal Revenue Code § 422, it must satisfy all statutory requirements, including the following, on the date of its original grant:

• Option must be granted to an employee of the company (or its parent or subsidiary)
• Option must be granted under the company’s written equity plan
• Exercise price must be at least equal to the fair market value of the underlying shares (and for employees who are >10% stockholders of the company, the exercise price must be at least 110% of fair market value)
• The term of the option is no longer than 10 years (or no longer than five years for >10% stockholders)
• No more than US$100,000 of shares (based on the fair market value as of the date of grant) may first become exercisable in any calendar year

To the extent an option fails to meet the statutory requirements, or is in excess of the US$100,000 annual limitation, it is treated as an NSO for tax purposes.

Modifications of ISOs

Under applicable tax rules, a “modification” of an outstanding option is generally treated like a newly granted option as of the modification date. “Modification” is broadly defined to include any change that provides additional benefit to the optionholder, regardless of whether the optionholder actually benefits from such changes.

When an option is “modified,” it must re-satisfy all ISO requirements based on and as of the modification date to continue to be treated as an ISO. To the extent that ISO requirements are not met as of the modification date, the option is thereafter an NSO for tax purposes. In most cases, ISO status that is lost due to a modification cannot be restored.

Common Modifications and Their Impact

Companies may contemplate any number of changes to their outstanding options. Most often, companies propose amendments to (i) grant early exercise rights, (ii) accelerate vesting, (iii) extend exercise periods, or (iv) change exercise price.

Grants of Early Exercise Rights

To make option awards more competitive or attractive for its employees, a company may consider granting early exercise rights, which allow employees to exercise outstanding but unvested options, subject to a right of repurchase. Early exercise allows employees to own shares earlier and accordingly start their capital gains holding periods earlier.

While early exercise rights that are added to an option after its original grant date would seem to be a modification because they appear to provide an additional benefit to the optionholder, the ISO regulations specifically provide that this is not a modification of an ISO and can be added without jeopardizing the ISO status.

Acceleration of Vesting

In connection with acquisitions, layoffs, changes in control, or other special scenarios, companies may consider adding single-trigger or double-trigger acceleration terms to outstanding options to allow employees to vest in unvested options upon the occurrence of such events.

As a general matter, accelerating vesting does not itself constitute a modification for ISO purposes. However, acceleration might cause more shares to “first become exercisable” in a single calendar year, potentially causing all or a portion of the option to exceed the US$100,000 ISO limit for that year. Any excess over the limit is treated as an NSO.

Extensions of Exercise Periods

Most employee options are originally granted with a three-month post-termination exercise period (with certain extended periods provided for death or disability and shorter periods for a termination for cause). When an employee departs, a company may consider extending the exercise periods of the employee’s options to allow them additional time to decide whether to exercise them for shares.

Two separate ISO issues arise with respect to extensions: (i) extending the post‑termination exercise window is generally treated as a modification, causing re‑testing of ISO status as of the extension date, and (ii) regardless of any extension, an exercise that occurs more than three months after employment ends (excluding disability or death) cannot receive ISO tax treatment. In other words, if the ISO is in-the-money when the exercise period is extended, it will become an NSO, and even if the option remains an ISO, if it remains outstanding and exercisable after the three-month post‑employment period, it becomes an NSO at the end of such three-month post-employment period.

Adding Exercise Method (such as Promissory Note)

Adding an additional method of exercising an option, such as allowing exercise with a full-recourse promissory note, is typically expected to be treated as a modification, even though this may have been permissible to include when the ISO was granted. If the ISO is in-the-money or otherwise cannot requalify as an ISO at the date of this modification, it would be expected to become an NSO.

Changes to Exercise Price

If the price of a company’s stock decreases over time, a company may consider repricing any underwater options to restore their retentive purpose. Options are “underwater” if the exercise price per share is greater than the current fair market value of the share, meaning that an employee would inherently lose value by exercising their option. To fix this, a company may want to amend underwater options to reduce their exercise price to the current fair market value.

A reduction in exercise price is among the clearest examples of a modification and results in a deemed new grant of the option. Because ISOs must have an exercise price at least equal to the fair market value on the grant date, a repricing to lower that value will generally cause the option to fail the ISO test; however, repriced ISOs generally should be able to re-satisfy all ISO requirements based on and as of the modification date and typically will continue to be treated as an ISO (although if there are changes that make requalification not possible, such as no longer being an employee, the ISO will lose its ISO status in the repricing). Note that repricing can effectively double count prior ISOs, as the repriced grant is treated as a new ISO, such that the award could exceed the US$100,000 limitation when including the prior ISOs as new awards.

Consider the AMT

As a final thought, if the ISO holder would otherwise be subject to the AMT, the loss of ISO status may be less detrimental than for someone not subject to AMT. Losing ISO status would subject the holder to ordinary income tax rates, which may not be dramatically different than the AMT rates (26% or 28%, based on 2026 rates). Additionally, the vast majority of ISOs are not exercised and held for the required ISO holding periods and become NSOs in any event. Accordingly, the loss of ISO status is less impactful than it would otherwise be, although the tax benefits of an ISO when utilized to get long-term capital gain are measurably better where possible.

Many private companies are having to grapple with the realities of lower valuations. When a new Section 409A valuation values the company’s common stock at a lower price than any past Section 409A valuations relied on to grant prior stock options, the company may want to consider repricing the stock options held by its service providers. Where an existing stock option has an exercise price higher than the company’s current valuation, the result is an “underwater option.”

While repricing can restore some of the incentive and retention value of employee equity, it raises a host of valuation, perception, legal, tax, and accounting considerations that a company must manage.

Is a repricing necessary?

If the decreased valuation is a temporary situation that is expected to shift and change in a short period of time, or the long-term value is expected to be significantly greater than the current price, a repricing may not be necessary. This is particularly true if the value that is added to the option as a result of the repricing is not significant from a long-term perspective (i.e., the adjustment in price is relatively small). For example, if an employee held 1,000 company stock options that were currently priced at $2 per share, but that could be repriced to $1 per share, it may feel like making this change would be a significant repricing. However, if, a few years later, the company were to have a liquidity event where the shares were sold at $100 a share, this repricing only added an additional $1,000 to the total sale amount of $99,000, which is an increase of only 1 percent. Contrast that to a situation where the shares are ultimately sold at $3 a share. Repricing the options to $1 a share would still only add $1,000 to the total sale amount, but that would effectively double the holder’s total sale proceeds from $1,000 to $2,000.

While companies may not be able to predict the ultimate sale price, it is useful for a company to look at what a healthy potential exit will look like and how significant this repricing would be in that context, to ensure there is material value being added as a result of the repricing.

Negative Aspects of a Repricing

At first blush, most people would expect employees would be happy to have their options repriced as it gives them additional potential equity value; however, repricing options can introduce worry about the long-term value and prospects of the equity and, as a result, impact employee morale. Repricing can, and often does, have a positive impact on employees, but employees may also interpret it to mean the equity they hold is decreasing in value and that they are less likely to get the hoped-for. This can be particularly true where there are multiple repricings over a period. Repricing can also impact employees’ trust in management, especially if the message coming from management is about how well the company has been doing during that same period. If the future value of the shares is perceived to be weak, it creates jitters among the service providers and can negatively impact retention and hiring. The impact is exacerbated if the company is in an industry where most companies are doing well, as opposed to general market downturns impacting all similar companies. Finally, a company repricing can be a signal to investors that the company does not perceive as much long-term value in the shares and can actually lead to low-ball investment proposals, creating a self-fulfilling prophecy. Companies need to carefully weigh both the long-term and short-term impact of a repricing and its perceptions by service providers and investors.

Repricing Terms & Participation

If the company has decided that a repricing is necessary to properly incentivize its employees, the next consideration is what terms the company should offer in connection with the repricing. While a private company may be tempted to use the repricing as a chance to add vesting or other terms favorable for the company, anything other than a simple repricing (e.g., changing only the price) adds considerable cost and complexity for the repricing and could trigger the tender offer rules as discussed in more detail below.

Generally, only current service providers can participate in a repricing. This is because the repricing is effectively treated as a cancellation of the prior grant and a grant of a new award at the new price. All new awards need to be granted pursuant to a valid securities law exemption; thus, the repricing is generally limited to service providers that satisfy compliance under Rule 701 (discussed more below). If a significant number of former service providers are impacted by underwater stock options, the company should consult with counsel to determine the best path forward.

Tax Considerations

Any time a company wants to do a repricing, it needs to consider Section 409A compliance and Incentive Stock Option (“ISO”) tax issues.

Section 409A Tax Compliance

Section 409A governs deferred compensation, including stock options, and imposes severe tax penalties on options granted with an exercise price below fair market value. Section 409A penalties include an immediate income inclusion plus a 20% extra tax for the option holder. Any option repricing must therefore be done in compliance with Section 409A. In practice, this means the new exercise price cannot be less than the then-current fair market value of the underlying stock as of the repricing date. To ensure this, companies generally obtain an updated Section 409A valuation before repricing options. The board will use this valuation to set the repriced exercise price at or above fair market value, preserving the options’ exemption from 409A. Furthermore, a single repricing is usually not a risk under Section 409A, but successive repricings may be. While market volatility may tempt companies to repeatedly adjust option prices, serial repricings can be seen as the company not having a fixed price for options (e.g., the repeated repricings are seen as chasing a price to the bottom), which could be a Section 409A violation. Each modification should be carefully considered and tied to a material change in value (not minor fluctuations), and any subsequent repricings should be analyzed for their impact under Section 409A.

ISOs

Repricing an ISO is deemed a grant of a new ISO. This means that the regular limit on ISOs ($100,000 per year in which the option first becomes exercisable) must be recalculated, and some holders of repriced options may end up with fewer ISOs and more non-qualified stock options (“NSOs”) as a result of these recalculations. Also, since the repricing of ISOs is deemed a grant of new ISOs, the ISO holding periods (specifically, the prong requiring the ISO be held for two years from date of grant) will restart from the repricing date. Whether these changes are sufficiently material to require the consent of the option holder or a company tender offer should be analyzed by the company in consultation with its counsel under the terms of the plan (such as plan limitations on ISO grants and changes to existing grants) and applicable securities law.

Securities Law Considerations

A repricing raises securities law issues under Rule 701 and could trigger tender offer issues.

Rule 701

Rule 701 of the Securities Act of 1933 is the primary federal exemption that allows private companies to offer stock options and other equity compensation to employees without registering shares with the Securities and Exchange Commission. Repriced options count toward Rule 701 limits and disclosure thresholds. Importantly, as noted above, a repriced stock option is generally treated as issuance of a new security which must qualify for an exemption at the time of repricing. Therefore, the company must ensure that the repriced options, taken together with other equity compensation issued in the same 12-month period, do not exceed Rule 701’s size limits (the greater of $1 million, 15% of assets, or 15% of outstanding securities). Moreover, if the value of the repriced options, taken together with other equity compensation issued in the same 12-month period at the time of repricing, exceeds $10 million, the company must provide the required disclosures under Rule 701 (financial statements, risk factors) to all participants. Companies should keep in mind that, because Rule 701, by its terms, covers offers to current employees, directors, consultants, and advisors, it is generally not available as an exemption for repricing options to former service providers.

Tender Offer

An issuer tender offer under Rule 13e-4 and Regulation 14E of the Securities Exchange Act of 1934 (the “Exchange Act”) encompasses an offer by the company to security holders to exchange securities, which offer is open for a limited time and involves decisions by the holders. Importantly, a “simple” unilateral repricing that changes only the exercise price to the new Section 409A valuation while leaving the other terms the same is generally not thought to rise to the level of a tender offer. However, an option repricing where the option holder’s consent or action is needed may require compliance with tender offer rules, which are triggered because the option holder is making an investment decision over whether to accept the proposed terms of the repriced options. To comply with tender offer rules, the company then must observe a host of requirements under the Exchange Act. Also note, if the option is an ISO, keeping an exchange offer open more than 30 days might affect ISO status, so companies with ISOs will sometimes limit the offer window to 29 days to be safe.

Corporate Governance Considerations

A repricing will also raise a number of corporate governance issues, including approval requirements and fiduciary duties.

Board Approval

In almost all cases, repricing will require approval by the company’s board of directors (or a committee with delegated authority). The board should formally approve the repricing terms (who is eligible, new exercise price, timing, etc.) via a resolution. This is both a governance requirement and a key part of the board fulfilling its fiduciary duty (documenting that it considered the repricing and found it in the company’s interest to retain talent). The board should also be mindful of any conflicts of interest that may arise, particularly if grants to the directors are implicated.

Stockholder Approval

For private companies, stockholder approval of a repricing is typically not required unless the company is contractually obligated pursuant to agreements with investors. It is crucial to review the stock option plan documents, the company’s charter or organizational documents, and any investor agreements (such as an Investor Rights Agreement) before proceeding. Credit agreements or other contracts might also restrict modifications of equity incentives.

Fiduciary Duties and Legal Risk

A company’s decision to reprice options should also be evaluated through the lens of fiduciary duties and fairness to all stockholders. While repricing is aimed at benefiting employees (and, by extension, the company, through improved retention), it does effectively transfer potential economic value from existing stockholders to the option holders. Directors must justify the repricing as a reasonable, informed, and fair decision. To withstand scrutiny, the company’s board should document the business purpose, such as, for instance, maintaining team morale and productivity during a downturn. Additionally, to the extent any holders benefiting from repriced stock options are directors, officers, or controlling stockholders of the company, the company should be mindful of the safe harbor requirements under Section 144 of the Delaware General Corporation Law and obtain the appropriate approvals.

Qualified Small Business Stock (QSBS) has become an increasingly central focus for founders and investors, as awareness of its potential tax benefits continues to grow. If stock qualifies as QSBS, a holder may be eligible to exclude up to 100% of federal capital gains on disposition subject to a cap equal to the greater of (a) $10 million, or $15 million for post-2025 issuances, and (b) 10 times the taxpayer’s initial basis in the shares. Further, with careful structuring and planning, founders and investors can maximize the QSBS exclusion.

In practice, founders, investors, and senior executives often seek confirmation, typically in the form of a company-level analysis or determination letter, that the corporation’s stock satisfies the applicable requirements at issuance. As QSBS planning has become more sophisticated, both the importance of this analysis and the consequences of getting it wrong have increased materially.

Background

Before 2010, the Internal Revenue Code Section 1202 generally provided individual taxpayers with what was, in most cases, a very small tax rate reduction for gains recognized from sales of QSBS that had been held for more than five years.

That all changed significantly following the 2008 financial crisis. In the wake of the crisis, Congress passed the Small Business Jobs Act of 2010 to encourage individual taxpayers to make additional equity investments in startup corporations during the remainder of calendar year 2010. The Small Business Jobs Act of 2010 included an amendment to Section 1202 that, for the first time, provided for a complete U.S. federal income tax exemption (with no application of the alternative minimum tax) for specific gains recognized by non-corporate investors on the sale of QSBS held for more than five years but only if the stock was purchased at original issue in the limited window after September 27, 2010 and before January 1, 2011.

Although initially intended as a tax incentive for stock issued during a limited period, the 0% rate for gains on QSBS became so popular that Congress began expanding it. Congress repeatedly extended the applicable window for issuance of the 0%-eligible QSBS in successive one-to-two-year tranches. In 2015, the Protecting Americans from Tax Hikes Act of 2015 made the 0% rate for specific gains from sales of QSBS a permanent tax benefit. The tax benefits of QSBS have significantly increased in both value and accessibility. In 2025, the One Big Beautiful Bill Act (“OBBBA”), which applies to issuances after July 4, 2025, raised the “cap” on tax-free gains and introduced more flexible holding periods for new investments. The following table highlights key differences between the pre-OBBBA rules and the new rules:

Several requirements must be satisfied before those benefits can be realized and, even if those requirements are met, there are important limitations on the amount of gain that can qualify for the 0% rate. These requirements and limitations are further discussed below.

General Requirements

The general requirements for qualifying for the 0% federal tax rate on gains from the sale of QSBS include the following:

1. Original Issue. The taxpayer must still be a non-corporate entity (individual, trust, or estate) and acquire the stock directly from a U.S. domestic C corporation.
2. Tiered Holding Periods. For stock issued after July 4, 2025, a taxpayer can now receive a partial exclusion earlier: 50% after three years, 75% after four years, and the full 100% after five years. Pre-OBBBA stock still requires a strict five-year hold to receive any benefit.
3. Gross Assets Test. For stock issued after July 4, 2025, the corporation’s aggregate gross assets cannot exceed $75 million (up from $50 million) at the time of issuance. Importantly, the amount of a corporation’s assets at any given time is generally measured by the corporation’s adjusted tax basis in those assets, except when any property is “contributed” to the corporation. In that case, for this purpose the property must be taken into account based on its fair market value at the time of the contribution.
4. Active Business Test. During substantially all of the taxpayer’s holding period of the stock, at least 80% of the issuing corporation’s assets must be used by the corporation in the active conduct of one or more qualified trades or businesses. This includes assets used in furtherance of a prospective active business, i.e., startup activities, research and experimentation, and in-house research. It also includes working capital, investments expected to finance research and experimentation or increased working capital within two years, and computer software rights that produce active business royalties. However, after the corporation has existed for two years, no more than half of its assets can be working capital or investments held for future research or working capital. Although many types of trade or business should qualify for this purpose, the following are specifically excluded: any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services. Also specifically excluded is any trade or business for which the principal asset is the reputation or skill of any of its employees.
5. No Significant Redemptions. The issuer of the stock must not have engaged in specific levels of buybacks (redemptions) of its own stock during specified periods before or after the date of issuance of the stock to the taxpayer.

Exclusion, Limitations, and the Rise of Structured Planning

A non-corporate taxpayer who recognizes gain from the sale of stock meeting the above requirements can thus generally qualify for a 0% federal income tax rate. However, the amount of gain eligible for this 0% rate is subject to a cap. Section 1202(b)(1) states that the aggregate amount of gain for any taxpayer regarding an investment in any single issuer that may qualify for these benefits is generally limited to the greater of (a) $15 million (Post-OBBBA), or (b) 10 times the taxpayer’s adjusted tax basis in the stock. For a taxpayer who invests cash in the QSBS, the basis would generally be equal to the cash purchase price. However, there is a special rule for when a taxpayer instead purchases the QSBS for in‑kind property (that is, other than cash). In those cases, the taxpayer’s basis in the QSBS, solely for purposes of these Section 1202 rules, is deemed to be an amount not less than the fair market value of the property transferred for that QSBS as of the date of such transfer (often referred to as the basis-is-not-less-than-value rule). The general purpose of the basis-is-not-less-than-value rule is to ensure that inherent built-in gain for any property contributed to a corporation in exchange for QSBS does not qualify for the Section 1202 benefits. Only the gains from the sale of QSBS that are attributable to appreciation in value of the QSBS occurring after the date of issuance are potentially eligible for the Section 1202 benefits.

These new rules now theoretically allow for exclusions of up to $750 million for certain large-scale investments and certain other circumstances. As a result, taxpayers increasingly employ planning strategies, such as “stacking” QSBS across multiple taxpayers (e.g., trusts), and “packing” assets into QSBS-eligible entities. These strategies can be effective but require careful implementation and are subject to scrutiny. In May 2026, the Treasury Department signaled that it will be issuing guidance addressing what it sees as abuse of the QSBS “stacking” strategy.

The IRS has shown growing interest in QSBS claims, particularly in large exit transactions. Areas of focus include active business qualification, asset valuation (especially for contributed property), and related-party and restructuring transactions. QSBS remains one of the most compelling tax incentives available to founders and investors, but its benefits are not automatic. As the regime has matured, so have the expectations around compliance, documentation, and planning. For those who get it right, the rewards can be substantial. For those who do not, the cost of missed qualification can be equally significant.

State Conformity

While federal benefits are permanent, state treatment varies wildly. As of 2026, many states, including New Jersey and New York, now align with federal Section 1202 rules, while Alabama, California, Mississippi, and Pennsylvania continue to tax QSBS gains at full state rates. Residents in certain states, including Texas, can achieve a true 0% effective tax rate on QSBS gains by combining the federal exclusion with a lack of state income tax.

Rollover of Gain

A taxpayer other than a corporation (i.e., individuals, partnerships, S corporations, estates, and trusts) may elect to roll over capital gain from the sale of QSBS held for more than six months if QSBS is purchased by the taxpayer during the 60-day period beginning on the date of sale. Accordingly, gain is recognized only to the extent that the amount realized on the sale exceeds the cost of the replacement QSBS purchased during the 60-day period, as reduced by the portion of such cost, if any, previously taken into account. To the extent that capital gain is not recognized, that amount will be applied to reduce the basis of the replacement QSBS. The basis adjustment is applied to the replacement stock in the order in which the replacement stock is acquired.

Treatment for Pass-Through Entities

Gain on qualified stock held by a partnership, S corporation, regulated investment company, or common trust fund is excludable if the entity held it for the required holding period and if the partner, stockholder, or participant to whom the gain passes through held an interest in the entity when the entity acquired the stock and at all times thereafter. However, the partner, stockholder, or participant cannot exclude the gain to the extent that his or her share in the entity’s gain is greater than what it was when the entity acquired the qualified stock.

The Bottom Line

QSBS has evolved from a niche tax benefit into a central component of early-stage investment planning, particularly in light of recent expansions under the OBBBA regime. The increased exclusion caps, more flexible holding periods, and expanded asset thresholds have made QSBS more valuable, and more widely accessible, than ever before. At the same time, these enhancements have accelerated the use of structured planning strategies and heightened IRS scrutiny, raising the stakes for both companies and investors. In this environment, QSBS should be viewed not as a passive benefit but as a strategic framework that requires thoughtful implementation from formation through exit. With proper planning, documentation, and coordination, taxpayers can unlock substantial tax efficiencies; without such planning, the opportunity may be irretrievably lost.

Successful founders often find themselves stock rich and cash poor, with most of their net worth held in illiquid shares. The usual path to early liquidity is a secondary sale, in which a founder sells a portion of existing shares to investors in connection with a financing. FF preferred stock (also called founders preferred stock or Series FF) is a class of stock adopted at formation to make that future secondary sale cleaner and more streamlined. Despite the name, it generally functions as common stock: it carries no dividend or liquidation preference, and it is distinct from the super-voting share classes sometimes used to concentrate founder control.

How It Works

FF preferred stock has a single distinguishing feature: when sold to investors in connection with a future preferred stock financing, it converts into the series of preferred stock being sold in that round. The investor receives preferred stock rather than common stock, and the founder typically receives the preferred price for the shares. The precise mechanics vary by form. Some versions convert automatically upon the sale, some convert at the holder’s option if the buyer pays the same per share price as the new round, and some require board approval; typical forms also permit conversion into common stock at any time and convert automatically into common stock in a qualified IPO.

Three practical rules follow from the tax analysis. FF preferred stock is generally adopted at formation, when founder shares are first issued; adding the class later can carry tax consequences. It is often, but not always, issued fully vested, because shares subject to forfeiture or repurchase may raise additional tax issues; as a result, any vesting sits on the founder’s common shares. And it typically covers only a modest portion of a founder’s holdings, most often 10 to 25 percent, with the balance in common stock.

Why It Exists

The structure responds to two problems with selling common stock at a preferred stock price. The first is tax. A founder who sells common stock for more than its fair market value (which ordinarily sits well below the preferred price) risks having the excess treated as compensatory ordinary income rather than capital gain, and the risk increases if the company facilitates the sale by converting the founder’s common stock into preferred stock at closing. Since FF preferred stock converts by its terms when sold, no corporate action is required at the time of sale, which is generally viewed as more characteristically the type of transaction that should result in capital gain treatment. However, that treatment is not assured and depends on a variety of factors specific to the underlying transaction; the nature of the security sold is merely one such factor. The second is valuation. A founder sale of common stock at or near the preferred price can put upward pressure on the fair market value of the common stock and, with it, the strike price of future option grants. Alternatively, a sale of FF preferred stock that converts into preferred stock mitigates the repricing effect on the common stock. Note that market practice has evolved on this point: secondary sales of common stock at no or a small discount to the latest preferred round have become customary, and selling parties have found ways to work through the issues that FF preferred stock addresses in its absence. Nonetheless, founders often view the implementation of FF preferred stock as a “just in case” move to improve their chances of a successful secondary transaction in the future.

What to Weigh

FF preferred stock is not the norm. It adds drafting complexity and cost to the certificate of incorporation for a benefit that materializes only if investors are someday willing to buy founder shares, which as a practical matter requires a strong company, an oversubscribed round, and a supportive board. Some investors also read the class as a signal that the founders expect early liquidity, and, when the shares are issued fully vested, the company gives up repurchase rights over that portion of a departing founder’s equity. However, when a secondary sale does happen, the structure may have real advantages: the founder can sell at the preferred price rather than at a discount, the company avoids facilitating a sale of common stock above its appraised value, and an oversubscribed round can be accommodated with less dilution because investors buy existing shares. Additionally, the potential tax consequences of such conversion should be addressed on a case-by-case basis.

In almost all cases, one typical feature of FF preferred stock is that it can convert to common stock at the election of its holder at any time, so founders can always elect to eliminate FF preferred stock at a later time if they find its utility no longer of value. Thus, including FF preferred stock at incorporation gives founders flexibility down the road.