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Three Effects of Undervaluing Stock Options

July 31, 2014



Over the last few years, Teknos has worked with thousands of companies preparing valuations to comply with IRC 409A and ASC 718.  During that time, we’ve been brought in to help fix a number of situations in which the company had issued stock options at a value that later was determined to be too low.  Based on our experience, here are some of the worst effects of such undervaluation.1

1. Cheap Stock Charge

Some of the bad effects are not about tax, they’re about accounting.2  Often the problem is a cheap stock charge.  We see these most frequently at two stages in a company’s life:  during the first financial audit; and during the IPO preparation process.

A cheap stock charge is an additional expense that an audit firm (or the SEC) forces a company to include on its income statement.  The audit firm (or the SEC) decides that the common stock was undervalued at some point in the past and, as a result, stock options were issued with a strike price that was too low.  To correct this, the company is required to restate its financial results by taking a non-cash charge against earnings to account for the “extra compensation” that was, in effect, “paid” to employees.

We often are asked, “It’s a non-cash charge, how bad can that be?”  The answer is:  bad.  Why?  Because the IRS has stated that a cheap stock charge is one of three “red flag” issues for which it looks when examining a company’s stock option pricing.3  So, you may acquiesce to your auditor (or the SEC) and accept a cheap stock charge to put the issue behind you.  But you may not be done with the problem if that causes the IRS to start looking at your case.  (More on this below.)

2. Cancel and Reissue

Sometimes, a company decides that it does not want to accept a cheap stock charge.  Even apart from being a red flag issue for the IRS, it does not look good to restate financial results – especially during preparation for an IPO.

Instead, a company may decide to cancel the old options that were priced too low and reissue new options at the correct value – hence, cancel and reissue.4

There are a number of problems with this.  The first difficulty is that any change in compensation arrangements can be terribly disruptive to employees.  They thought that they had a deal from when they were hired two years ago:  let’s say 100,000 options to buy the company’s stock at $0.05 per share.  Now you’re telling them that the deal is changed – perhaps at a time when you want them to be delivering a new product or new customers because your next financing will be raised soon.

The second difficulty is even worse.  That is because you cannot backdate stock options.  (Remember, the scandal surrounding backdating in the mid-2000s?)  To use a simple example, we’ll continue with the employees who thought that they had options to buy stock at $0.05 per share.  Let’s say that the correct value two years ago was not $0.05 per share but $0.10 per share.  Given that the current value is $2.00 per share, no one is going to be too upset about the small adjustment from $0.05 to $0.10 per share.  Right?

Wrong.  Because of the rule against backdating stock options, those grants of 100,000 shares at $0.05 per share cannot be reissued at a strike price of $0.10 per share.  Instead they must be reissued with a strike price that matches today’s value – that is, $2.00 per share.5  Suddenly, those employees aren’t just thinking about something besides their work – now they’re genuinely unhappy.

3. IRS Penalties

In the worst of all worlds, a company will not only have trouble with its audit firm (or the SEC) and disgruntled employees, it may have to deal with the IRS too.

As mentioned earlier, a cheap stock charge is one of the red flag issues that will bring IRS attention.6  And, if the IRS opens an investigation because of a cheap stock issue, this may not be a fight that you can win.

Generally, IRC 409A is advantageous to companies and option recipients (e.g., employees) because just having a valuation report that is less than 12 months old can move option grants into a regulatory safe harbor and shift the burden of proof to the IRS during a dispute.

Most observers have concluded that this is a good defensive posture and generally the IRS will not make an effort to overcome it.  However, a cheap stock charge could undo the entire defense.

First, revealing the cheap stock charge (e.g., in audited financials included in an IPO filing or as part of the disclosure of an acquisition) may draw the attention of the IRS.  Second, the dispute between the company and the audit firm will create a record that will, in essence, make the case for the IRS.  All of the objections to the low value (e.g., $0.05 per share from our example, above) and all of the reasons for the high value (e.g., $0.10 per share in that same example) may be well documented in company and audit firm files.  The IRS will only need to subpoena those records to get everything it needs for its prosecution.7

If the IRS prevails, it has shown in a previous case that it will impose the full amount of the penalty allowed by IRC 409A – a 20% surtax (to which California can add another 5% surtax).8  Remember, the penalty is applied to the employees, so those employees are not just distracted – now they’re paying taxes as high as 75% on their option income.9

Summary

We have seen a lot of well-intentioned efforts by management and the board of directors to get the lowest stock option strike price that is possible.  We understand the motivation – everyone wants to recruit and retain the most talented employees.  And, within the tax regulation and accounting standards, we’ll work to help achieve that objective.  But, just remember, pushing the strike price too low can have the opposite effect, causing problems for the company and ultimately for the employees too.

The best way to avoid any of these problems is to obtain timely valuation reports which are prepared by a “qualified appraiser” in conformance with “generally accepted valuation standards” and which meet the requirements of both the tax regulation (IRC 409A) and the accounting standards (ASC 718 and the AICPA Valuation Guide).


Teknos Associates provides valuations and fairness opinions for technology companies and their venture capital backers. Clients rely on our financial expertise, knowledge of technology markets, and high standards.

Special Note: From time to time, Teknos Associates has been retained by the Internal Revenue Service to perform valuation services.  However, nothing in this communication may be taken to represent the official position or policy of the IRS.  The opinions expressed herein are those only of Teknos Associates.

IRS Circular 230 Disclaimer:  Pursuant to regulations governing the practice of attorneys, certified public accountants, enrolled agents, enrolled actuaries, and appraisers before the Internal Revenue Service, unless otherwise expressly stated, any U.S. federal or state tax advice in this communication (including attachments) is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of (i) avoiding penalties that may be imposed under federal or state law or (ii) promoting, marketing, or recommending to another party any transaction or tax-related matter(s) addressed herein.


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[1] Technically, IRC 409A and ASC 718 deal with valuation of the common stock that underlies stock options.  But almost everyone refers to problems with these valuations as “undervalued stock options.”

[2] See our previous publication:  IRC 409A After Three Years:  It’s Not Just About Tax

[3] Most notably, the IRS discussed the red flag issues at the AICPA/ASA National Business Conference in November 2008 and mentioned the AICPA practice guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation.

[4] Some will remember that cancel and reissue required that the employee wait six months for the new option grant – with no promise about the new strike price.  This was because of a FASB issued interpretation (Interpretation No. 44) of APB 25.  Fortunately, this no longer applies and reissue now can be done promptly after cancellation.

[5] The problem of backdating most often comes up in connection with an employee who joined the company some time ago, but the company did not get around to setting the option strike price and granting the stock option – perhaps after an event which caused the value of the stock to rise (e.g., a new venture capital financing).  It is permissible to backdate vesting of the stock options (as far back as the employee’s starting date), but it is never permissible to backdate the strike price.

[6] The other two red flag issues are:  the valuation report was not prepared by a “qualified appraiser”; and the valuation report was not prepared in conformity with “generally accepted valuation standards.”  A “qualified appraiser” is someone who “has earned an appraisal designation from a recognized professional appraiser organization or has otherwise met minimum education and experience requirements set forth in regulations prescribed by the Secretary [of the Treasury].”  IRC §6695A(1)(E)(iii)(I), clarified by IRS Notice 2006-96, section 3.03(2).  The US Tax Court recently allowed the IRS to impose a 20% accuracy related penalty because a valuation was not performed by a “qualified appraiser.”  Estate of Helen P. Richmond, T.C. Memo. 2014-26, February 11, 2014.  And “an appraisal will be treated as having been conducted in accordance with generally accepted appraisal standards … if, for example, the appraisal is consistent with the substance and principles of the Uniform Standards of Professional Appraisal Practice (USPAP), as developed by the Appraisal Standards Board of The Appraisal Foundation.”  IRS Notice 2006-96, section 3.02(2).  The federal courts have given USPAP the same recognition.  In Kohler et al. v. Commissioner, T.C. Memo. 2006-152, July 25, 2006, the judge chose to disregard the report of an expert because it had not been “prepared in accordance with all USPAP standards” and did not contain “the customary USPAP certification.”  See:  Tax Court Upholds 20% IRS Penalty Because Appraiser Not Qualified

[7] Technically, at the beginning of the information gathering process, the IRS sends out IDRs (information data requests), not subpoenas.  But the effect is the same.  Some have asked whether communication between a company and its accounting firm are privileged, like communication between a company and its law firm.  There is no such privilege.  US v. Gurtner, 210 F,2d 795, 1954.

[8] See our previous publication:  Think That The IRS Doesn’t Care About IRC 409A?  Think Again.

[9] In California the tax calculation would be:  federal rate on ordinary income (39.6%) plus state rate on ordinary income (9.3%) plus federal surtax (20.0%) plus state surtax (5.0%) for a total of 74.9%, before interest and penalties.  Plus, the company likely would be penalized for not having made adequate withholdings against the incremental income.