Proposed 409A Regulations: Stock Option Pricing for Emerging Growth Companies

Emerging growth companies need to pay particular attention to the treatment of the pricing of stock options in new IRS proposed regulations under Section 409A of the Internal Revenue Code. 

Section 409A established rules for deferred compensation arrangements.  It is the result of perceived abuse of deferred compensation arrangements which were in the public spotlight in the wake of recent corporate scandals and it affects a broad array of compensation arrangements.  Although the proposed regulations are not effective until January 1, 2007, taxpayers must currently comply in “good faith,” and such compliance makes it more likely that the option will be treated as granted at fair market value.  Failure to grant an option with an exercise price equal to or greater than fair market value will result in potentially significant adverse tax consequences to both the optionee and the company.  These regulations are separate and independent from accounting considerations of issuing options below fair market value.  Such “cheap stock” accounting assessments are performed by the SEC and usually result in one-time non-cash earnings charges on financial statements, rather than the cash tax liability to both employees and companies that can result from a Section 409A violation.

This memorandum summarizes the proposed regulations and discusses the impact on private companies as they grant options.

Adverse Tax Consequences for Options Granted at Less than Fair Market Value

Section 409A provides that an option granted with an exercise price less than fair market value as of the grant date is a deferred compensation arrangement.  Under Section 409A, deferred compensation arrangements that do not comply with the Section 409A requirements are subject to the following adverse tax consequences:

For Optionees:  
1)  Taxation at the time of vesting rather than the date of exercise or later; and
2)  a 20 percent penalty tax in addition to income taxes.

For Companies: 
Withholding payments for applicable income and employment taxes at the time of option vesting, and potentially additional amounts if the value of the stock issuable upon exercise of the option increases over time.

Determination of Fair Market Value

Section 409A generally applies to any option granted with an exercise price less than fair market value.  Section 409A fundamentally changes the burden of proof in establishing whether an option has been granted at a price less than fair market value.  If a company uses one of the “safe harbor” methods described below to determine that the option was granted with an exercise price equal to fair market value, then the IRS will respect the valuation unless the company was “grossly unreasonable” in relying upon the valuation method.

However, if a company’s options are found to have been granted at a price less than fair market value (as a result of an IRS audit, for example), and the company has not followed a “safe harbor” method set forth in the proposed regulations, the company will have the burden of proving that its valuation method was reasonable.  Furthermore, if the company’s valuation method makes no reference to the general valuation factors set forth in Section 409A, it will likely fail to satisfy its burden and the adverse tax consequences of Section 409A will likely apply.

Options Subject to Section 409A

The proposed regulations exempt incentive stock options (ISOs), which by definition must be granted with an exercise price no less than the fair market value determined in a reasonable manner in good faith by a company’s board of directors.  That said, while this exemption may serve as a defense for the exercise prices of previously granted ISOs, on a going forward basis, we believe that the determination of fair market value for purposes of ISOs’ and Section 409A’s valuation requirements are likely to converge.

Section 409A generally applies as follows:

• Options granted with an exercise price less than fair market value prior to October 4, 2004 that vested by December 31, 2004 are exempt under Section 409A. 

• Options granted at a price less than fair market value after October 3, 2004 that vested by December 31, 2004 are subject to Section 409A unless they were granted pursuant to the company’s regular pattern and practice.

• Options granted at a price less than fair market value prior to December 31, 2004 and not vested by December 31, 2004 (or modified after October 3, 2004 while in the money) are subject to Section 409A.

• Options granted at a price less than fair market value after December 31, 2004 are subject to Section 409A.

• Non-qualified stock options (NSOs) granted on a class of stock other than the class of common with the greatest aggregate value are subject to Section 409A, even if granted at or above fair market value.

Safe Harbor Valuation Methods

The proposed regulations provide guidance regarding acceptable methods for determining the fair market value of private company common stock.  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’s common stock.  Moreover, regardless of the method a company uses, while valuations may be considered current for up to 12 months, they must be updated if new information material to the company’s value (such as a significant business or financial milestone, patent activity, or litigation) has occurred.

If a company follows any of the three methods described in the proposed regulations, the options it grants will be presumed to have been granted at fair market value.  The IRS will then have the burden of proving that the company’s application of these methods was “grossly unreasonable.”  The three methods described in the regulations are as follows: 

• Qualified Independent Appraiser.  The valuation is determined by a qualified independent appraiser as of a date no more than 12 months before the transaction date.

• The Early Stage Company Written Valuations.  The valuation of the stock of a private company that has conducted business for 10 years or less and is not reasonably expected to undergo a change in control or public offering within 12 months of the date the valuation is used will be presumed reasonable if:

  • The valuation was performed within the past 12 months by a person “with significant knowledge and experience or training in performing similar valuations.”

  • The valuation is evidenced by a written report.

  • The valuation considers the following relevant valuation factors:

    • The value of the company’s tangible and intangible assets;

    • The present value of future cash flows;

    • The market value of similar entities engaged in a substantially similar business; and

    • Other relevant factors, such as control premiums or discounts for lack of marketability.

  • The common stock is not subject to put or call rights or other obligations to purchase such stock (other than a right of first refusal or other “lapse restriction,” such as the right to purchase unvested stock at its original cost).

• Non-lapse Restriction Valuation.  This method will be available only to a relatively small number of emerging growth companies, as the valuation must be (a) based on a non-lapse restriction (“buy/sell agreement”), which requires the transferee to sell such common stock only at a formula price based on book value, a reasonable multiple of earnings, or a reasonable combination thereof; and (b) consistently used for both compensatory and non-compensatory purposes in all transactions in which the issuer is either the purchaser or seller of the common stock, such that the formula acts as a substitute for the value of the underlying stock.

Note that newly-formed private companies that have minimal assets, few employees and no financial history may find a meaningful valuation difficult.  Very early stage companies may wish to sell restricted stock, rather than granting options since stock grants or sales are generally exempt from Section 409A.

Practical Considerations

We expect that the approach companies choose to take will depend on the stage of the company.

• Pre-funding.  At the earliest stages, before a company has real assets, any valuation method may be difficult to apply.  At this stage, companies may wish to sell stock, rather than grant options, as restricted stock is generally outside the scope of Section 409A and an error in valuation should not raise the same concerns as with options

• Funding to Pre-Liquidity.  Most venture-backed companies may choose to follow one of the safe harbor methods.  Some companies may have the requisite expertise in house (either in the internal financial function or on the board) to satisfy the early stage written valuation approach.  Given the potential liability involved with such activities, companies will want to ensure that they provide appropriate indemnification and D&O coverage.
  
  Other companies may choose to get independent assistance, even if they do not request full-blown appraisals.  We expect a market to develop in outside valuations designed to satisfy the early stage company approach at a more attractive price point than is currently available in the formal appraisal context.

• Approaching Liquidity.  We expect companies preparing for an IPO to use independent appraisals, both due to Section 409A concerns and as a means of satisfying the SEC with respect to potential cheap stock issues.  Similarly, M&A buyers are subjecting grant practices to increased scrutiny and in at least some cases are requiring stricter indemnification for Section 409A issues, particularly because the IRS generally has a three year look back period in which to revisit tax issues and this three-year period exceeds the standard escrow periods of most acquisition agreements.  Accordingly, we expect that companies preparing for a sale will want to ensure that the valuation used in their grants is likely to be acceptable to a potentially risk-adverse buyer.

Transition Relief

As noted above, for certain options subject to Section 409A because the option exercise prices were below fair market value at date of grant, corrective action may be taken to avoid the adverse consequences of Section 409A.  Potential corrections include:

• Exercise the option prior to January 1, 2006.

• Prior to January 1, 2006, exchange the option either for stock or cash having a value equal to the “spread” (i.e., the difference between the fair market value and the exercise price).

• Before January 1, 2007, raise the exercise price of the option to the fair market value as of the option grant date.  The company may pay the optionee a cash or stock bonus to compensate for any lost economic benefit, though this must generally occur during 2005.

• Structure the option so that each tranche must be exercised if at all within 2-1/2 months of the tax year in which it vests.

Each of these corrective actions has certain implications to the company and optionee.  We advise you to consult with counsel before taking any such action.

Conclusion

The landscape in which private companies price stock options has changed dramatically as a result of the proposed regulations under Section 409A.  There is no one answer that will apply for every private company.  To determine how best to proceed, please call your DLA Piper contact or:

Richard W. Ashley III

David Boyle

Michael T. Frank

William H. Hoffman

Joseph A. (Tony) Hugg

Ian S. Kopelman

John E. Kratz, Jr.

Mark Muedeking

Linda Marotta Thomas

 

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