Any stock option, stock appreciation right (SAR), or similar stock rights program subject to Section 409A faces stringent regulations that will make the program’s administration cumbersome. More importantly, violation of Section 409A’s technical rules will subject participants to substantial tax liabilities and penalties. Hence, designing a stock rights program that avoids the grasp of Section 409A should be everyone’s principal objective. The escape route requires that the exercise price of an option or an SAR be not less than the fair market value of the company’s stock at the time of grant.
In proposed regulations and a follow-up notice, the IRS has provided some interim guidance concerning what nonpublic companies must do to demonstrate that the exercise price of a stock grant is not less than the fair market value of the stock at the date of grant.
For a stock option or stock appreciation right issued before January 1, 2005, IRS Notice 2006-4 states that the IRS will apply valuation principles similar to those applicable to incentive stock options. Accordingly, where there was a “good-faith” attempt to set the exercise price to a stock right granted before January 1, 2005, at a price not less than the fair market value of the stock subject to the stock right at the time of grant, then such exercise price will be treated as being not less than fair market value for purposes of determining whether the stock right is excluded from the requirements applicable to deferred compensation under Section 409A.
For stock rights granted on or after January 1, 2005, and before the effective date of final IRS regulations under Section 409A (currently anticipated to be January 1, 2007), a different and somewhat more stringent standard will apply. Any valuation method may be used, but only as long as it is “reasonable.” In particular, where a company can demonstrate that the exercise price of a stock right granted on or after January 1, 2005, is intended to be not less than fair market value at the date of grant, and that the value of such stock was determined using reasonable valuation methods, then that valuation will meet the requirements of Section 409A regardless of whether that determination satisfies the valuation requirements in either proposed or final regulations.
The IRS has also proposed regulations that would set the requirements for the valuation of stock that is not readily tradable on an established securities market. The proposed regulations would require a valuation method to be both reasonable and take into consideration all available information material to the value of the corporation. The valuation must be not more than twelve months old and, when applied to a particular grant, must reflect all information available after the date of valuation that may materially affect the value of the business through the date of grant. The IRS has indicated that the factors to be considered under a reasonable valuation method include, as applicable:
- 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 trades or businesses substantially similar to those engaged in by the corporation whose stock is to be valued, the value of which can be readily determined through objective means (such as through trading prices on an established securities market or an amount paid in an arm’s-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.
The proposed regulations offer a “safe harbor” for illiquid stock of a “start-up corporation” that has not conducted business for more than ten years. To utilize the safe harbor, the start-up corporation must have a valuation report, in writing, that reasonably and in good faith takes into account the relevant factors described above. However, the IRS will not treat such a start-up valuation as made reasonably and in good faith “unless the valuation is performed by a person or persons with significant knowledge and experience or training in performing similar valuations.” Moreover, this safe harbor is not available if the stock is subject to a put or call right (other than certain rights of first refusal or “lapse restrictions” such as a buy-backs upon termination of employment for nominal value), or if the company expects in the following twelve months to undergo a change in control or undertake an initial public offering. Given these requirements that limit the utility of the safe harbor, it is important to remember that start-up corporations can still utilize the general rules for valuation described above.
An additional safe harbor is available for certain formula valuation methods. However, to qualify for this safe harbor, the formula valuation for that class of stock (or substantially similar class of stock) must be used consistently by the company, not only for compensatory purposes, such as employee stock rights grants, but also for all noncompensatory purposes requiring the valuation of such stock. These noncompensatory purposes would include regulatory filings, loan covenants, issuances to and repurchases of stock from investors and other nonemployees, and other third-party arrangements.
The generality and complexity of the proposed regulations have already met with criticism, and the IRS has solicited comments for changes as well as additional transitional relief. However, pending additional guidance, private companies should consider a number of alternatives when issuing stock options or stock appreciation rights:
- First, at a minimum, companies should consider preparing a written internal memorandum setting forth the reasons for reaching a particular valuation for any stock rights grants made on or after January 1, 2005. The reasons should include the factors set forth in the proposed regulations, to the extent applicable, such as asset value, the capitalized present value of projected future cash flows, comparisons to comparable public companies, and appropriate discounts for lack of marketability.
- Second, particularly in cases of established companies that have not had recent outside investments, companies should consider engaging an independent appraiser to determine a baseline valuation.
- Finally, companies where business factors change during a year in a way that may materially affect value, thereby rendering a once-annual valuation “stale,” should consider restricting granting options or stock appreciation rights to one or a few limited periods during the year when the company has reviewed and refreshed its valuation.
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