"Center Point provides a thorough, timely, and reasonably priced 409A valuation report."
Stock Options (409A & 123R)
IRS Section 409A
Congress passed the American Jobs Creation Act in 2004. Included in the Act is Internal Revenue Code Section 409A targeting nonqualified deferred compensation arrangements. The code section became effective as of January 1, 2008. One of the types of deferred compensation covered by the new law is employee stock options. Although 409A exempts incentive stock options (ISOs), this exemption does not apply if an amendment disqualifies the ISO. Additionally, if it is determined that the fair market value of the option price is greater than the strike price at the date of grant, the option will not be exempted from 409A. Therefore, the steps necessary for valuing a nonqualified stock option are also applicable to ISOs.
The law provides that if a stock option is issued to an employee at an exercise price that is lower than the fair market value of the stock on the date of issuance, then the employee is exposed to certain adverse tax consequences, including:
- Tax at the time options vest as opposed to when they are exercised
- 20% additional tax penalty on the option holder
- Possible interest and fines
Noncompliance with 409A can also lead to exposure for company board members and could adversely impact the marketability of the business to investors and/or acquirers.
Section 409A states that for the IRS to accept a valuation of private company common stock, it must be done by "the reasonable application of any reasonable valuation method." Factors that the IRS states should be considered in the valuation in order for the valuation method to be reasonable include:
- The value of tangible and intangible assets of the corporation;
- The present value of future cash-flows;
- The market value of stock or equity interests in similar corporations and other companies engaged in trades or businesses substantially similar to those engaged in by the corporation being valued, the value of which can be determined by objective means (such as through trading prices on an established market or an amount paid in an arms length private transaction); and
- Other relevant factors, such as control premiums or discounts for lack of marketability and whether the valuation method is used for other purposes that have a material economic effect on the service recipient, its stockholders or its creditors.
A valuation must be completed within 12 months of the stock option grant date or upon a material change in the value of the company.
The best way to avoid potential adverse consequences of 409A is to hire an independent appraiser. If an independent appraiser is used, the valuation will be presumed to be reasonable under 409A, and such presumption can only be challenged if the valuation is deemed grossly unreasonable. If a company does not use an independent appraiser, the company will bear the burden of proving that its valuation methodology and approach is reasonable.
SFAS 123R
A valuation report that provides the fair market value of the common stock to satisfy Section 409A can also provide the fair value of the common stock to satisfy financial reporting requirements. This "dual purpose" valuation will provide consistency between book and tax accounting treatment, and will ensure that the company does not have to obtain a second valuation to satisfy its auditors. Center Point adheres to the allocation methods proscribed in the AICPA Practice Aid, Valuation of Privately-Held-Company Equity Securities Issued as Compensation.
The valuation will generally not be accepted for financial reporting purposes if it does not comply with the new methodologies outlined in the Practice Aid. The 409A tax guidance is less specific. To our knowledge there is no proscribed valuation methodology or guidance comparable to that contained in the Practice Aid. Section 409A, however, mandates that the valuation be done using reasonable valuation methods and that the valuation professional has the proper experience and training.
The Practice Aid details three methods used to allocate equity value to common stock: the current value method, the option-pricing method (OPM), and the probability-weighted return method (PWERM). The Aid does not deal with the determination of equity value – the appraiser must use generally accepted valuation methods and their experience to determine a company’s overall equity value.
The current value method is only acceptable when liquidity is imminent or when the company is at a very early stage of development. If liquidity is not imminent, either the option-pricing method or the probability-weighted return method is recommended. There is no requirement that both methods be used. The OPM may be more suitable for earlier-stage companies when the timing and valuation surrounding a future liquidity event is less defined. The PWERM is more suitable for later stage companies that have the potential to be acquired or go public within a few years of the valuation.
Summary
Private companies at all stages of development are now obtaining independent valuations to support option grants for tax and financial reporting purposes, not just IPO candidates. Section 409A is aimed at taxation of stock options and falls under the IRS’s fair market value standard while FASB 123R is aimed at the financial reporting and expensing of stock options and falls under FASB’s fair value standard. In the end, if the appraiser has done their valuation properly, there should not be a significant difference in the value of a company’s common stock for either purpose. Therefore, Center Point offers a “dual purpose” appraisal that utilizes valuation methodologies and techniques that are acceptable for both purposes.
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