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January 2007 Section 409A a Lurking Beast for Private
Companies
New regulations will
affect private companies issuing employee stock options
While stock option backdating scandals for public
companies have littered the business pages for months now, many privately held
companies are likely grappling with their own stock option headaches. Those
headaches come courtesy of Internal Revenue Code 409A. Section 409A, which was included in the American
Jobs Creation Act of 2004, codifies standards for nonqualified deferred
compensation. With limited exclusions, any plan that defers taxable compensation
for employees is covered, including stock appreciation rights and stock options.
Employee stock options generally fall into two categories: qualified or
statutory options, and non-qualified options (also called NSOs). The impact of
409A will be felt primarily on holders and issuers of NSOs. NSOs generally are taxable at the date of their
exercise, not at the date of their granting or vesting. Section 409A preserves
this treatment, but only if it can be shown that the stock option is granted
with an exercise price at or above the fair market value of the underlying stock
on the date of grant. A stock option granted with a per share exercise price
that is less than the fair market value per share of a company’s underlying
stock on the date of grant is treated as deferred compensation under the Act.
With certain limited exceptions, this determination
will result in tax at the time of vesting (as opposed to at exercise), an
additional 20% tax on the optionee, and other potential penalties. Given these
penalties, it will become vital that private companies, which do not have an
active marketplace dictating the fair market value of the their shares, take
action to ensure that the estimated fair market value of the company as of an
option grant date is reasonable and defensible.
Proposed regulations Proposed regulations issued under Section 409A on
September 29, 2005, set forth reasonable valuation method presumptions for
valuing stock not “readily tradable on an established securities market.” These
presumptions will influence the way in which private company stock valuations
are conducted, in order to best assure that companies are not inadvertently
granting discounted stock awards. Although the proposed regulations are not
expected to become final until January 2008, and may change in the meantime, the
presumptions they establish should be relied upon currently. They offer private
companies with an opportunity to establish common stock valuations that will be
presumed reasonable should the IRS decide to challenge them. The proposed regulations approved certain methods
for determining the fair market value of a company’s stock for purposes of
granting stock options. The new regulations do not mandate a valuation of the
underlying stock by an independent appraiser. However, in the absence of an
outside appraisal, the burden will fall on the company, if challenged, to prove
that its stock valuation method was reasonable. If, however, a company chooses to adopt one of the
“presumptive” stock valuation methods set forth in the proposed regulations, the
burden rests on the IRS to prove that the option’s exercise price was below fair
market value and that the company’s application of the presumptive method was
“grossly unreasonable.” Reasonable valuation methods There are three valuation methods that will be
presumed reasonable under the regulations, if the methods are consistently used
to value underlying stock for all of a company’s equity-based compensation
arrangements. Again, as long as the application of these valuation methods is
not grossly unreasonable, the valuation resulting will be considered to be fair
market value. The three “presumptive valuation methods” are the:
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independent appraisal presumption,
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illiquid start-up presumption, and
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binding formula presumption.
Under the independent appraisal presumption,
a valuation performed by a qualified independent appraiser using traditional
appraisal methodologies will be presumed to be reasonable if it values the stock
as of a date that is no more than 12 months before the related stock option
grant date. This presumption would not apply if events subsequent to the
appraisal date have a material effect on the value of the stock. The illiquid start-up presumption is a
special presumption available only to a privately owned company that is less
than 10 years old. Under this presumption, a valuation will be considered
reasonable if it is evidenced by a written report and is performed by a person
with “significant knowledge and experience or training in performing similar
valuations.” In addition, the valuation must take into account certain
“valuation factors” specified in the proposed regulations. Finally, the
valuation cannot be more than 12 months old, nor can there have been a
significant event (financing, IPO, etc.) since the performance of the valuation,
nor can there be a reasonable anticipation of an IPO, sale or change of control
of the company within 12 months following the equity grant to which the
valuation applies. Finally, under the binding formula presumption,
a valuation will be presumed reasonable if it is based on a formula that is used
in a shareholder buy-sell agreement or similar binding agreement. The formula
must also be used for all non-compensatory purposes requiring the valuation of
the company’s stock. Conclusion In summary, the arrival of IRC 409A will raise to
new levels the accountability of company management regarding employee deferred
or non-cash compensation. We believe that the boards of companies that use
these forms of employee compensation will have to work in close conjunction with
the company’s accountants, attorneys and valuation advisors to determine fair
market values at various intervals and to document the methodologies utilized to
determine these values. The days of management using rules of thumb and
“best guesses” to set employee stock option exercise prices are over, and the
continued use of these short-cuts will result only in many more headaches for
management. ■ |
