409A Valuation Issues Q&A

On October 4, 2005, the IRS issued proposed regulations for Section 409A of Code. The proposed regulations are intended to further explain how Section 409A applies to various compensatory arrangements, including stock options granted by private companies.

Does Section 409A apply to private company stock options?

Incentive Stock Options are exempt from Section 409A.  Nonqualified Stock Options are exempt from Section 409A if the following requirements are met:

• the option is granted with an exercise price per share equal to or greater than the grant date fair market value per share of the common stock subject to the option and at no point through the exercise date of the option is the exercise price below the grant date fair market value;
• the number of shares subject to the option must be fixed on the grant date of the option; and
• the option may not include any additional feature for the deferral of compensation (other than deferral of recognition of income until the award is exercised or vested). (Note, standard option grants generally do not include any additional deferral features.)

Are incentive stock options subject to Section 409A?

Although Section 409A exempts incentive stock options, this exemption does not apply if an amendment disqualifies the incentive stock option.  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 incentive stock options.

Are any nonqualified stock options grandfathered from Section 409A?

Yes. Stock options are grandfathered from Section 409A if the option was vested before January 1, 2005. The exemption will end if the stock option is materially modified after October 3, 2004.

Are Limited Liability Company units subject to Section 409A?

Yes. Grants of partnership interest, options and appreciation rights in partnership interests are treated in the same manner as grants of corporate stock, stock options or SAR’s. (IRS Notice 2005-1)

As a private company, how do we determine the fair market value of our common stock for purposes of these rules?

The proposed regulations state 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.

The value must be determined taking into consideration all available information material to the value of the corporation, and must be calculated as of a date that is within 12 months of the date for which the valuation is being used.

Are there any valuation methods that will be presumed to be reasonable?

Yes. While the foregoing “facts and circumstances” standard raises uncertainty, the proposed regulations provide three specific methods that the IRS will presume to be reasonable if consistently applied: (1) an appraisal by an independent appraiser as of a date that is within 12 months of the date for which the value is being determined; (2) a valuation of illiquid stock of a start up company by experienced personnel and (3) a valuation based upon certain types of formulas.

What is the “start up” valuation method?

To qualify as “illiquid stock” of a “start-up” company under the proposed regulations, the following requirements must be met:

• the valuation must be made reasonably and in good faith and be evidenced by a written report that takes into account the relevant valuation factors described above;
• the company (and its predecessors) cannot have been in the active conduct of a business for ten years or more;
• the company cannot be public (i.e., it cannot have any securities that are readily traded on an established securities market);
• there must not be any permanent put or call on the stock or any permanent requirement that the company or any other person purchase the stock (a right of first refusal or a repurchase right for unvested restricted stock awards is permitted); and
• at the time of the valuation, it cannot reasonably be anticipated that the company will undergo a change in control or an initial public offering within 12 months after the valuation.

The person(s) performing the valuation of a “start-up” company must have significant knowledge and experience or training in performing similar valuations. They may be employees or directors of the company. In many instances, it would appear that a board of directors or a committee of the board of directors of the start up company may do the valuation, where the board or committee is composed of experienced venture capitalists or private equity investors that have significant experience in valuing start up companies.

What is the “formula-based” valuation method?

A formula-based valuation also will be presumed to be a reasonable valuation method if certain requirements are met. Examples of the formula-based valuation method would be valuing the stock based on a multiple of sales or earnings, or book value. However, for a formula-based valuation to qualify under the proposed regulations, it must be consistently applied to all valuations of the stock. For example, the formula value would have to be used for issuances to and repurchases by the company from third parties and non-employees as well as for regulatory filings and loan covenants. This appears to be a very restrictive method and we do not anticipate many companies will be willing and able to qualify for this method.

How long will a valuation be valid?

All valuations under any of these methods are valid until the earlier of (i) 12 months from the valuation date or (ii) a material change in the value of the company. Any method used must be applied consistently for all valuations.

How do these rules apply to stock options granted before January 1, 2005?

In the proposed regulations, Section 409A applies to all stock options that were not vested prior to January 1, 2005. No distinction is made based on the grant date of the option. However, on December 23, 2005, the IRS issued Notice 2006-4 which provides interim guidance with respect to the application of the new rules for non-qualified deferred compensation under Section 409A to stock options granted by private companies.  The guidance provides transitional relief for private company stock options and the determination of fair market value and is welcome news to private companies.