K&L Gates : Newsstand : Valuation of Stock for Options and SARs: Recent Guidance under Section 409A of the IRC

Valuation of Stock for Options and SARs: Recent Guidance under Section 409A of the IRC
Preston Gates & Ellis Corporate Securities/Mergers and Acquisitions Alert

by Michael C. Ormsby, Robert D. Starin, David J. Perry . May 26, 2006

Section 409A of the Internal Revenue Code imposes burdensome tax consequences (including acceleration of income recognition and the application of a 20% penalty) on recipients of certain types of deferred compensation. The Section 409A rules generally do not apply to nonqualified stock options or stock appreciation rights (SARs) if, among other things, the exercise price is not less than the fair market value of the underlying stock on the date of grant. (Incentive stock options and grants of restricted stock are also not subject to the provisions of Section 409A). Thus, non-publicly traded companies must make an appropriate valuation of their stock for options and SARs issued to employees and other service providers in order to avoid the adverse impacts of Section 409A. What follows is a summary of existing Internal Revenue Service guidance with respect to valuing non-publicly traded stock for purposes of avoiding Section 409A problems, along with some practical tips and suggestions.

Summary
Current IRS guidance permits companies to use "any reasonable valuation method" to value their stock for purposes of avoiding the application of Section 409A to stock options and SARs. However, the IRS has issued proposed regulations under Section 409A which sets forth "safe harbors" for reasonable valuation methods; non-publicly traded companies may find it advisable to attempt to satisfy one of these safe harbors, as it will be difficult for the IRS to challenge the consistent use of one of these methods and because it is likely that final regulations will include some form of these safe harbors.

Notice 2006-4
Proposed Regulations under Section 409A include detailed guidance on determining the fair market value of non-publicly traded stock. On December 23, 2005, the IRS issued Notice 2006-4 which provides additional interim guidance addressing valuation of stock in respect of stock options and SARs and draws a distinction between those issued prior to January 1, 2005, and those issued on or after January 1, 2005. Generally, Notice 2006-4 permits companies, until final Section 409A regulations are issued, to use either the valuation rules set forth in previous IRS guidance or the more detailed valuation methodologies included in the Proposed Regulations.

A. Stock Rights Granted Prior to January 1, 2005
Notice 2006-4 provides that, until further guidance is issued, stock rights granted prior to January 1, 2005 are considered as having an exercise price not below the fair market value of the underlying stock at the date of grant if the valuation method used complies with the requirements for valuing incentive stock options under Treasury Regulation § 1.422-2(e)(2). Accordingly, where there is a "good faith attempt" to determine the fair market value of the underlying stock on the date of grant and the exercise price is set at or above such value, no adverse consequences should arise under Section 409A. Whether or not the valuation method was made in good faith is based on the relevant facts and circumstances at the time the stock option was granted.

B. Stock Rights Granted on or after January 1, 2005
With respect to stock rights issued on or after January 1, 2005, Notice 2006-4 clarifies that previous guidance under Section 409A (Notice 2005-1) for determining the fair market value of the underlying stock remains applicable until final Section 409 regulations take effect. Under the existing guidance, "any reasonable valuation method" may be used for purposes of determining the fair market value of the underlying stock on the date of grant. The Proposed Regulations also provide that any reasonable valuation method may be used; however, the Proposed Regulations provide greater detail as to the factors that will be considered in determining whether a valuation is reasonable.

A valuation method that does not meet the more detailed requirements of the Proposed Regulations may be reasonable for purposes of Notice 2005-1. Notice 2006-4 clarifies that the more general valuation method is acceptable until the effective date of the final Section 409A regulations. In light of past IRS practice, it is unlikely that final Section 409A regulations will have a retroactive effective date.

Valuation of Stock Rights under the Proposed Regulations
As noted above, the Proposed Regulations provide much greater detail than Notice 2005-1 for the factors that will be considered in determining whether a valuation methodology is reasonable.

A. General Rule under the Proposed Regulations
With respect to private companies, fair market value may be determined by "the reasonable application of a reasonable valuation method." Whether a valuation method is reasonable is based on all of the facts and circumstances. The Proposed Regulations provide that the following factors, as applicable, are to be considered:

The value of tangible and intangible assets of the corporation.
The present value of future cash flows of the corporation.
The market value of stock or equity interests in similar corporations and other entities engaged in similar trades or businesses.
Control premiums or discounts for lack of marketability.
Whether the valuation method is used for other purposes that have a material economic effect.
A valuation method is not reasonable if it does not consider all available information material to value. The company’s consistent use of a valuation method for other purposes, such as the sales price for non-compensatory investments by third parties, is a factor supporting the reasonableness of a method.

B. Safe Harbors under the Proposed Regulations
The Proposed Regulations also provide that a valuation is presumed to be reasonable when any of the following methods are consistently used:

Independent Appraisal. The fair market value of the underlying stock is determined through an independent appraisal that meets the employee stock ownership plan valuation requirements of Internal Revenue Code Section 401(a)(28)(C) and is no more than twelve months old.
Illiquid Start-Up Companies. In determining the value of the stock of an illiquid start-up company, the valuation method will be presumed reasonable if the method is evidenced by a written report that takes into account the factors noted above and it is performed by a person with significant knowledge and experience or training in performing similar valuations. This safe harbor is available for companies that (i) have not conducted a trade or business for ten or more years, (ii) do not have any class of equity traded on an established securities market, and (iii) do not anticipate any change in control or initial public offering within twelve months.
Formulaic Determination of Value. The fair market value of the underlying stock is determined pursuant to a formula under Treasury Regulation § 1.83-5, provided that the valuation is used for all noncompensatory purposes regarding the valuation of such stock (for example, in a shareholders’ buy-sell agreement). Treasury Regulation §1.83-5 requires generally that the price of the underlying stock be determined using a formula (e.g., a formula price based on book value, a reasonable multiple of earnings, or a reasonable combination thereof).
Practical Tips and Suggestions

Here are some practical suggestions or tips that non-publicly traded companies should consider when valuing their stock in connection with option and SAR grants:

Avoid relying on old "rules of thumb," such as valuing common stock at 10% of the value of preferred stock.
Consult with your auditors for their thoughts on valuing stock for options because, in light of FAS 123, which requires fair value expensing of options for non-public companies for fiscal years beginning after December 15, 2005, your auditors are far more likely to closely scrutinize the methodology used to set your stock price.
If an outside valuation firm is not used in determining the value of stock, the CFO or other appropriate company personnel, with a background in valuation work, should undertake a careful review of the company’s value and the value of its common stock, using traditional valuation techniques such as a liquidation analysis, market comparables and a discounted cash flow analysis. The results of that valuation work should be presented to the board of directors well in advance of the meeting when decisions on setting the strike price of options will be made. Minutes of the meeting deciding on the strike price should reflect careful consideration of the valuation work. Thought should be given to having the audit or compensation committee review the valuation work prior to a full board decision, particularly if there are individuals on that committee well versed in valuation techniques. This valuation work should be updated annually and after significant events that could effect value take place (such as an acquisition or a sale of a new round of equity).
Make sure that the data used in valuing your stock is consistent with projections, budgets and other materials provided to the board of directors, shareholders, and prospective investors. Generally, it is important to use over time a consistent approach to valuations of stock.
If an IPO is a reasonable possibility in the near future, then use of a outside valuation firm, on a periodic basis (for example, quarterly), is highly recommended. Note that this has not always been persuasive with the SEC. In the past, companies going public routinely have been required by the SEC to take a compensation charge against earnings associated with option awards prior to the IPO filing. It is possible that, going forward, such a situation will cause the company and the option recipients to incur the adverse consequences of Section 409A. As a result, in light of the SEC scrutiny during the registration process on stock option pricing, heightened diligence in setting strike prices is required for companies that may go public.
Small companies may consider granting restricted stock in lieu of options or SARs, since the 409A rules do not apply to restricted stock. It remains necessary to determine the value of shares granted as restricted stock at the time of vesting or at the time an 83(b) election is made; however it appears that the IRS would have more difficulty in challenging a valuation determined under existing law applicable to restricted stock grants.
If a company has issued in the past options at a strike price which was then less than fair market value, the company should consider replacing this option with one which has a strike price equal to present fair market value prior to the end of 2006 in order to avoid any Section 409 problems with such options.