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Section 409A a Lurking Beast for Private Companies

New regulations will affect private companies issuing employee stock options

Don Wenk

 
 

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:

  • independent appraisal presumption,

  • illiquid start-up presumption, and

  • 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.