Private companies need to pay particular attention to proper pricing of stock options because of regulations issued under Section 409A of the Internal Revenue Code.
Congress passed the American Jobs Creation Act in 2004. Among other things, this law tightened up the taxation of deferred compensation. One of the types of deferred compensation covered by the new law is employee stock options. The law provides that if a stock option is issued to an employee, and that stock option has an exercise price that is lower than the fair market value of the stock on the date of issuance, then the employee is subject to certain adverse tax consequences, spelled out below. It is very important, then, that a company issuing employee stock options make sure that the exercise price of the options is at or above the fair market value of the stock at the time of issue.
On April 10, 2007, the Treasury Department and the IRS issued regulations on the treatment of nonqualified deferred compensation plans under § 409A. Among other things, the regulations provided guidance on determining the fair market value of stock for the purpose of establishing the exercise price for employee stock options issued on the stock.
We will summarize below the portion of the regulations that applies to such stock option exercise price valuations. A copy of the regulations can be found here.
Options as Deferred Compensation
Section 409A provides that an option granted with an exercise price less than fair market value as of the date of the grant is a deferred compensation arrangement. The recipient of such an option is subject to the following adverse tax consequences: (a) taxation at the time of vesting, and (b) a 20% tax penalty in addition to income taxes. There has been great uncertainty, prior to the issuance of these regulations, as to how private companies should value their stock when issuing options in order to avoid these significant adverse tax consequences. Now we have some help.
The valuation guidance provided by the new regulations includes the following general principles:
“the fair market value of the stock as of a valuation date means a value determined by the reasonable application of a reasonable valuation method…Factors to be considered…include… the value of the tangible and intangible assets of the corporation, the present value of anticipated future cash flows of the corporation, the market value of stock or equity interests in similar corporations and entities engaged in trades or businesses substantially similar to those engaged in by the [subject] corporation,…recent arm’s length transactions involving the sale or transfer of such stock or equity interests, and other relevant factors such as control premiums or discounts for lack of marketability and whether the valuation method is used for other purposes[.]” §1.409A-1(b)(5)(iv)(B)(1)
The regulation goes on to say that the valuation method will not be considered reasonable if it does not take into consideration all available information material to the value of the corporation. Similarly, an earlier valuation will not be considered reasonable as of a later date if it fails to reflect information available after the earlier date that may materially affect the value of the corporation (for example the resolution of material litigation or the issuance of a patent). The valuation will also not be considered reasonable if it is more than 12 months old.
Valuation Safe Harbor
The regulations describe circumstances under which a valuation will be accorded a “presumption of reasonableness” by the IRS. The use of any of the following methods is presumed to result in a reasonable valuation:
- A valuation that is not more than 12 months old and is prepared by an independent appraiser.
- A valuation based on a formula which is used consistently by the company and by all of its 10% plus shareholders for all restricted stock transactions (except for a sale of control).
- For start-up companies (non-public and in business less than 10 years), a written valuation report prepared by a person that the corporation reasonably determines is “qualified” to perform the valuation, based on the person’s significant knowledge, experience, education or training. Generally, a person will be qualified to perform such a valuation if a reasonable individual, upon being apprised of such knowledge, experience, education, and training, would reasonably rely on the advice of such person with respect to valuation in deciding whether to accept an offer to purchase or sell the stock being valued. For this purpose, significant experience generally means at least five years of relevant experience in business valuation or appraisal, financial accounting, investment banking, private equity, secured lending, or other comparable experience in the line of business or industry in which the company operates. The written report must take into account the factors listed under General Principles above. The presumption of reasonableness will not apply to the valuation if the company or the option holder may reasonably anticipate, as of the time the valuation is applied, that the company will undergo a change of control event within 90 days, or make a public offering within 180 days.
The Commissioner may rebut the presumption of reasonableness upon a showing that either the valuation method or the application of the method was “grossly unreasonable”.
Section 409A has changed the landscape in which private companies issue stock options. There is no one pricing or valuation answer applicable to all issuers. Hempstead & Co. has extensive experience in helping companies with their §409A stock valuations. We would be happy to help you.