409A Valuation: A must consideration before implementing deferred compensation plan including issuing stock options
May 22, 2014 Leave a comment
By BALJEET SINGH
There are many ways in which management is given a portion of the appreciation in value of the organization in which they work. The various forms include stock options, stock appreciation rights, and similar instruments. One of the more common forms is common stock options under an equity incentive plan.
Section 409A of the Internal Revenue Code applies to the compensation that workers earn in one year, but that is paid in a future year. This is referred to as nonqualified deferred compensation and is different from deferred compensation in the form of elective deferrals to qualified plans such as a 401(k) plan or to a 403(b) or 457(b) plan. Under Section 409A, a stock option having an exercise price less than the fair market value of the common stock determined as of the option grant date constitutes a deferred compensation arrangement. This typically will result in adverse tax consequences for the option recipient and a tax withholding responsibility for the company. The tax consequences include taxation at the time of option vesting rather than the date of exercise or sale of the common stock, a 20% additional federal tax on the optionee in addition to regular income and employment taxes, potential state taxes and a potential interest charges. The company is required to withhold applicable income and employment taxes at the time of option vesting, and possibly additional amounts as the underlying stock value increases over time. In simple words, to avoid adverse tax consequences referred to above, it is indeed very significant to value the stock options correctly at the fair market value complying with 409A valuation rules.
The valuation task for public companies is quite straight forward. The regulations generally require that the valuation of such stock be based upon the contemporaneous prices established in the securities market, subject to the certain modifications. Also, consideration is given to each stock option agreement’s particular restrictions and features.
The valuation could be complicated for private companies. The fair market value of private company stock must be determined, based on the private company’s own facts and circumstances, by the application of a reasonable valuation method. A method will not be considered reasonable if it does not take into consideration all available information material to the valuation of the private company. The factors to be considered under a reasonable valuation method include, as applicable, the value of the tangible and intangible assets of the corporation; the present value of anticipated future cash flows of the corporation; the market value of stock or equity interests in similar corporations and entities engaged in trades or businesses substantially similar to those engaged in by the subject corporation; recent arm’s length transactions involving the sale or transfer of such stock or equity interests, and other relevant factors such as control premiums or discounts for lack of marketability and whether the valuation method is used for other purposes.
The regulations provide safe harbor protection for valuation of stocks of private companies and describe circumstances under which a valuation is considered reasonable as outlined below:
- A valuation that is not more than 12 months old and is prepared by an independent appraiser.
- A valuation based on a formula which is used consistently by the company and by all of its 10% plus shareholders for all restricted stock transactions (except for a sale of control).
- For start-up companies (non-public and in business less than 10 years), a written valuation report prepared by a person that the corporation reasonably determines is “qualified” to perform the valuation, based on the person’s significant knowledge, experience, education or training.
The presumption of reasonableness will not apply to the valuation if the company or the option holder may reasonably anticipate, as of the time the valuation is applied, that the company will undergo a change of control event within 90 days, or make a public offering within 180 days.
The fair market value calculated previously is not considered reasonable if it does not reflect the information available after the initial date of the valuation that materially affects the value of a private company; or the value was calculated as of a date that is more than 12 months earlier than the date for which the valuation is being used. It is significant that material events which could trigger the need for a re-valuation are kept in mind. Some of these events could be:
- Changes in the economy at large, or industry
- New product launch or completion of product development milestones
- Material changes to company capital structure like financing events, or recapitalization
- New major customers
- Resolving material litigation
- Receiving material patent
Though the valuation could be performed internally as far as it meets the requirements of the regulations, the one performed by outside appraiser is more reliable due to the complexity of valuation techniques and their application. Further, an appraisal performed by an outside appraiser is regarded more independent than one done internally. Employers thinking about implementing an equity compensation plan should obtain defensible appraisal considering the adverse tax consequences the employee and company can have.
Write to Baljeet Singh at email@example.com