March 2015 | Issue 78
We’ve seen this happen all too often. Harry Jones* goes to work for Virus Systems, an early-stage biotech firm. His compensation package includes 100,000 shares of Virus common stock. Virus’ accountant needs a valuation for the stock as of the date of grant so that he can record Harry’s compensation expense. With not much thought, Harry and the accountant settle on a value of 10 cents a share, valuing the whole grant at $10,000.
Three years go by. Virus is looking very promising. People talk about Virus having an IPO. When no one is looking, Harry loves to do back-of-envelope calculations to determine the value of his stock. He pinches himself when he sees what the value of his Virus stock might be.
The roof caves in
Then the world comes to an end. Virus has a bad FDA clinical trial of its one and only drug. The company’s prospects evaporate, and the value of the Virus stock goes to zero.
To make matters worse, the IRS has decided to audit Harry’s tax return from three years ago, the year in which he received the Virus stock grant. The IRS says that Harry undervalued Virus’ stock on his tax return.
“It was worth a lot more than 10 cents a share on the day that you received it,” said the Agent.
‘Yes, but it’s worth nothing today.” said Harry.
“That doesn’t matter”, said the Agent “What matters is the value of the stock on the day you received it. Virus did a private financing with a venture capital investor during the same month in which you received your stock grant. The price paid by the VC was $10 a share. At that price, your grant was worth $1 million. That’s what we’re going to use to measure the value of the grant. The federal income tax on $1 million is $396,000.”
If it’s only phantom, why does it hurt so much?
Harry was a victim of phantom taxable income. He had received a tax bill but not the cash income to pay it. After Harry picked himself up off the floor, his accountant suggested that he consult with a business appraiser to get another opinion on the question of the value of his Virus stock.
The appraiser spent some time analyzing the situation. He made the following observations about the difference between the attributes of the stock received by the VC and the stock received by Harry.
- The VC investor received preferred stock with dilution protection. Harry received common stock.
- The VC investor was given two seats on the Virus board. Harry had none.
- The VC investor had enough shares to exercise control of the company if he wished to do so. Harry did not.
- The VC investor could bring about a sale of the company, if he wished to do so. Harry could not.
- The VC investor could cause the company to pay a dividend. Harry could not.
The appraiser pointed out that because the stock bought by the VC had some important privileges that Harry’s stock lacked, an investor would certainly ascribe a higher value to the stock that the VC bought than he would to the stock Harry received. This difference in value between the two kinds of stock is reflected by applying a valuation discount to the value of the VC stock in order to determine the value of Harry’s stock.
Bring in the discounts
There are a number of methods available to the appraiser to determine, and convincingly support, valuation discounts. They are, in general, derived from an examination of transactions in the capital markets that are marked by discounts that are similar to the discounts he is trying to determine. For example, if he were to look at the difference between the stock price of a closed end investment company, and the value of its underlying holdings, he would be looking at an indicator of how much of a discount the market extracts for not having control of the underlying assets.
Similarly, if he compares the market price of an IPO with the prices of private transactions that have occurred in the same stock at around the time of the IPO, he can gain an idea of how much more valuable tradable (IPO) stock is than untradable (restricted) stock.
There are also approaches to determining an appropriate discount which involve determining the expected volatility of the price of the stock in question. This can be done by examining the volatility of the stock price of other public companies that might be considered comparable. Since the volatility of a company’s stock is a measure of the risk of loss faced by an investor who can’t sell his holding at will, examining volatility is an approach to determining the discount for lack of marketability.
A skilled appraiser will consider all of the relevant markers that can be found in the marketplace in determining the appropriate discount(s) to apply. In Harry’s case, the IRS Agent listened to the appraiser’s arguments, and the parties reached an agreement that was reasonably satisfactory to both of them.
One last point
One additional bit of too-late advice for Harry; he should have had his stock appraised by a qualified business appraiser at the time that he received it. The appraiser would have presumably arrived at a reasonable value and Harry would have had first mover advantage in the valuation negotiations. The discussions with the IRS might also have begun at a reasonable price, rather than at the no-discount point, as was the case here.