Deferred compensation in the form of stock options is an appealing way for private and early-stage companies to attract top-tier talent without draining their precious cash reserves. However, companies that award stock options are required to comply with the U.S. Internal Revenue Code’s (“IRC” or “Code”) Section 409A (“IRC 409A”), which is covered in greater detail in our article, “Know 409A Rules to Avoid Employee Tax Penalties” Given that failing to comply with the required tax rules carries stiff penalties, management teams planning on awarding stock options to employees need to be familiar with the regulations as well as the situations that necessitate a valuation appraisal.
Basic Requirements for Stock Options and Stock Appreciation Rights
As discussed in our other article covering IRC 409A mentioned above, failure to comply with the tax rules concerning deferred compensation arrangements can result in the IRS levying penalties on a company’s employees, which can become nightmarishly expensive. Thus, for companies seeking to avoid tax penalties on stock options and stock appreciation rights (“SARs”) awarded to employees, IRC 409A establishes five basic requirements with which the stock options and SARs awarded must comply:
- Incentive stock options (“ISOs”) and stock options issued under Employee Stock Purchase Plans (“ESPPs”) covered by Section 423 of the Code are exempt if they continue to meet applicable qualification requirements.
- Non-qualified stock options and SARs may not have an exercise price that falls below the fair market value of the underlying common shares as of the grant date.
- The underlying common stock must be that of either 1) the company receiving the services of the employee or 2) of a parent company that owns 50.0 percent or greater of the company receiving services.
- Only stock that qualifies as “common stock” may underlie a stock option or SAR granted to an employee.
- A stock option or SAR may not provide for a deferral feature or be exchanged for another form of deferred compensation.
For the second requirement, the IRS requires companies to prove that stock options awarded to employees have been granted with an exercise price that is at least equal to the fair market value of the underlying stock on the grant date. To assist companies in their compliance with IRC 409A, the IRS provides for three “safe-harbor” methods on which companies may rely, which are discussed in the following section.
Safe-Harbor Rules
If one of the three safe harbor methods are employed, the IRS must accept the valuation unless it can prove that the valuation performed was “grossly unreasonable.” The safe harbor methods are described below:
- New Company / Illiquid Startup Method: A company may perform an internal valuation if a) it has conducted business for 10 years or less, b) is not reasonably expected to undergo a change in control within 90 days or a public offering within 180 days, and c) the company’s stock is not subject to put or call rights. The internal valuation may be presumed to be reasonable if it meets certain requirements including the qualifications of the preparer, narrative documentation, consideration of all material facts affecting the value of the company, and the application of appropriate premiums and discounts.
- Qualified Independent Appraiser Method: A private company may retain a qualified independent appraiser to perform its 409A valuation. The valuation analysis must be no more than 12 months prior to the grant date, assuming no material company events have occurred in the time elapsed between the date of the valuation and the date of the grant that would be likely to affect the value of the company. Examples of material events include new rounds of financing, an acquisition offer by another company, certain instances of secondary sales of common stock, acquisition or development of valuable intellectual property, significant changes to a company’s financial outlook, among others.
- Binding Formula Method: Private companies may also be able to employ a formulaic method to satisfy the requirements of IRC 409A. The valuation must be based on (a) a non-lapse restriction such as a buy-sell agreement, which requires the transferee to sell such common stock only at a formula price based on book value, a reasonable multiple of earnings, or a reasonable combination thereof, and (b) that method is then consistently used for both compensatory and non-compensatory purposes in all transactions in which the issuer is either the purchaser or seller of the common stock, such that the formula acts as a substitute for the value of the underlying stock.
Each of the three safe harbor methods listed above have various pros and cons with respect to cost, subjectivity, and the burden each method places on a company’s management team, which we have summarized in the table below:
Conclusion
Although the IRS provides three safe harbor methods to comply with the regulations, maneuvering complex valuation issues by yourself can be like steering a large ship on a dark night – without knowledge of the waters, you might be putting your boat and crew at risk. If you find yourself getting battered on the rocks, allow VIO to navigate you safely ashore with a free valuation consultation.
