If you are an executive or a director of a private company, then you probably have heard about IRC 409A. And you probably also know that failing to meet the requirements of IRC 409A can subject both your company and the employees who receive stock options to substantial tax penalties.
What many people do not know is that this tax rule is not the only regulation to which stock options are subject. The other regulatory framework – financial accounting under GAAP – also sets some tough requirements and can impose a high cost on your company for non-compliance.
For more than a decade, there has been a push by both sets of regulators – tax and financial accounting – to tighten the rules for stock option valuation and accounting. This has driven stock option prices higher.
Why Stock Options?
For the last several decades, emerging growth companies have competed with larger companies for employees by offering equity compensation. It is a tradeoff that is well known: longer hours for lower pay at a less financially stable company in return for an equity stake that may provide a substantial financial upside in the future.
For many years, emerging growth companies issued stock options at bargain prices to provide this equity upside. Since at least the creation of “qualifying stock options” in 1981, the IRS has required that options be priced at or above the fair market value of the underlying stock. But, until recently, the IRS did not provide much guidance about how fair market value was to be calculated nor was it very active in enforcing the regulation (at least among private companies issuing stock options).
The tax advisors of emerging growth companies were aware of the IRS requirement and one reason that preferred stock emerged as the financing vehicle of choice for venture capital investments was that it separated the security used for funding (preferred stock) from the security used for compensation (common stock). This allowed a company to argue with some plausibility that the fair market value of common stock was substantially less than the price obtained for preferred stock in an investment transaction.
Why Have Stock Option Prices Increased?
Over time, a “rule of thumb” developed that the fair market value of common stock was approximately 10% of the price of the last round of preferred stock, a convention that was followed by the boards of most venture capital backed companies for the last several decades – despite the fact that it had no foundation in any valuation practice nor was it accepted by any authority.
More recently, there has been pressure from both the tax and GAAP accounting authorities to move away from the 10% “rule of thumb” to valuations based on accepted methodologies. The SEC cracked down on “cheap stock” during the IPO boom of the late 1990s. The FASB published accounting standards directing that stock options be expensed and the AICPA followed with a practice aid laying out acceptable methodologies for valuing the underlying common stock.
But the big change came when the IRS published a new section of the Tax Code, IRC 409A which took effect in 2009. Using a “carrot and stick” approach, IRC 409A offered a company which issues stock options the “carrot” of a safe harbor, if the company obtains an independent appraisal to determine the fair market value of the common stock, and threatened the “stick” of a penalty surtax (which, when combined with certain state taxes, could reach 60% to 90% of gains), if the stock options were not priced at or above fair market value.
Concern about potential IRS penalty taxes and pressure from audit firms means that most venture-backed companies now obtain outside valuations of their common stock before issuing stock options. And, in most cases, a properly prepared independent appraisal is going to indicate a stock value higher than the old 10% “rule of thumb.” Deviation from this will only cause problems down the road during an audit or – worse – during a sale of the company, when it will be much more expensive or even too late to fix the problem.
How to Stay in Compliance?
Given all of these rules and the inherent complexity of trying to balance the different standards of the tax and accounting regulatory systems, what should a private company do to stay in compliance – while still using stock options to recruit and retain employees? We think that there are a few straightforward principles to follow.
Obtain an Independent Appraisal
Both the IRS and and audit firms strongly prefer a report prepared by an outside expert, so bite the bullet and hire an independent appraiser.
Ensure that the Appraisal Follows a Recognized Standard
The IRS has said that it will concentrate its enforcement activities on reports which do not conform to an accepted standard. Obtain a commitment in writing from the appraisal firm that the valuation report will follow the guidelines of the AICPA Practice Aid and will adhere to the standards of USPAP.
Ask if the Appraiser is Accredited
The IRS also has said that it will look harder at reports prepared by “valuation specialists” who lack credentials. Ask if your appraiser has “a designation from a recognized professional appraiser organization.”
Check if the Appraisal Firm is Known by the Auditors
Especially if you use a Big Four audit firm, ask your audit partner if his or her internal valuation team knows of the appraisal firm. The review process will go more smoothly (and result in lower audit fees) if the appraiser understands the audit requirements and if the appraisal firm and auditor have worked together before.
Provide a Complete and Balanced View
When meeting with the appraiser to explain your company, provide a thorough and balanced understanding of the forces which work for – and against – your company. Remember, if your company is wildly successful, someone examining an appraisal a few years later will be judging it with 20:20 hindsight and you will want a full description of the risks and challenges your faced at the time to help defend what may seem like a low value.
Understand the Role of a “Prior Sale”
If your company has recently completed a financing, then the value implied by that financing must be used in a back-solve to determine the value of common stock for pricing stock options. Since the publication of FAS 157 (now ASC 820) there has been no flexibility about this. You may be able to find a “valuation specialist” who is willing to ignore the value implied by a “prior sale.” But a later examination by the IRS or an auditor is going to reveal it – and lead to cheap stock charges or worse.
Notify the Appraisal Firm about Changes
Finally, keep the appraisal firm up to date about changes in your company. If there is a material change – a new financing, litigation, or results which are substantially better or worse than plan – it may be necessary to obtain a new valuation report. In any event, you will need a new valuation report no later than 12 months after the last valuation report.
We have prepared a white paper, How Changes In Regulation Have Driven Stock Option Prices, which discusses this subject in more detail.
Teknos Associates provides valuation and advisory services for emerging growth companies and their venture capital backers. Clients rely on our financial expertise, knowledge of technology markets, and high standards to deliver relevant and timely valuation reports and fairness opinions.
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.