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Stock Option Pricing by Private Companies: The New Valuation Environment Under 409A

By Peter Barnes-Brown and Diana Espanola

March 2008

Introduction

It has been almost one year since final regulations under Section 409A1 of the Internal Revenue Code were issued by the Internal Revenue Service (the "IRS"" or "Service") and in such time we have observed the development of what we believe are likely to become best practices related to option pricing. To appreciate the significance of Section 409A, it is important to understand the tax treatment of nonqualified stock options both before and after the adoption of Section 409A. Prior to the enactment of Section 409A, an optionee who was granted a nonqualified stock option was taxable on the "spread" between the exercise price and the underlying stock's fair market value at the time the optionee exercised the option.

Section 409A changed the income tax treatment of nonqualified stock options. Now, an optionee who is granted a nonqualified stock option may be subject to immediate income taxation in the year the nonqualified stock option vests (and in subsequent years prior to exercise to the extent the underlying stock's value has increased) and a 20% tax penalty plus interest. A company that grants a nonqualified stock option may also have adverse tax consequences if it fails to properly withhold taxes. Fortunately, nonqualified stock options granted with an exercise price which is not less than fair market value of the underlying stock on the date of grant3 are exempt from Section 409A.

In the new Section 409A environment, establishing a supportable fair market value is now critically important. This memorandum provides a general overview of the current practices and what we believe are likely to become the best practices for determining the fair market value of the common stock of privately held companies.

Summary

The initial Section 409A guidance issued by the IRS in 2005 abruptly ended the longstanding practice, previously accepted by the IRS and the Securities and Exchange Commission (the "SEC"), of permitting the fair market value of the common stock of a privately held company to be set by loosely estimating an appropriate discount from the price of recently issued preferred stock on the basis of the company's stage of development. Final regulations, issued by the IRS on April 17, 2007, generally adopt the initial guidance and contain detailed guidelines for determining the fair market value of the common stock of a privately held company, including a few presumptively reasonable valuation methods or "Safe Harbors." These rules have reshaped private company valuation practices.

This memorandum first describes pre-Section 409A common stock valuation practices — the time-honored appropriate discount method. Next, it describes the valuation rules that are established by the Section 409A guidance issued by the IRS, including the Safe Harbors. It then describes the reactions of privately held companies of varying sizes and stages of maturity we have observed — what managements, their boards and their advisors are actually doing on the ground. Finally, it describes where we think best practices are headed.

Note that this memorandum is not intended to cover all of the issues under Section 409A. The sole focus of this memorandum is valuation of the common stock of privately held company for purposes of setting option exercise prices, so that such options are exempt from Section 409A. There are a number of significant issues relating to the effect of Section 409A on option terms and on nonqualified deferred compensation more generally that are beyond the scope of this memorandum.4

How Exercise Prices for Common Stock Options Were Set Before Section 409A

Until the issuance of IRS guidance with respect to Section 409A, the time-honored practice of privately held companies in setting the exercise price of incentive stock options ("ISOs") for their common stock5 was simple, easy and substantially free of worries that the IRS would have much to say about it.6 For start-ups, the option exercise price could be comfortably set at the price the founders paid for their common stock, and often the objective was to get the upside equity opportunity into the hands of the key early employees as cheaply as possible. After subsequent investments, the exercise price was pegged at the price of any common stock that was sold to investors or at a discount from the price of the latest round of preferred stock sold to investors. The discount in recent years has typically ranged from 90 percent7 for a company that has just completed an A Round8 to as little as 25 or 30 percent for a late stage private company that has just completed a mezzanine or bridge round in anticipation of an imminent IPO or sale. For the sake of illustration, a company with a capable and complete management team, released products, revenue, and a closed C Round might have used a discount of 50 percent. It was all very unscientific. Rarely did a company buy an independent valuation for option pricing purposes, and, while the company's auditors were consulted — and their opinions carried weight, although not necessarily without some arm wrestling — the conversation between them, management, and the board was typically quite brief.

The New Valuation Rules Under Section 409A

The IRS guidance pertaining to Section 409A establishes a dramatically different environment in which private companies and their boards must operate in setting the exercise price of their options, now including both ISOs and NQOs9.

The General Rule. Section 409A guidance sets forth the rule (which we will call the "General Rule") that the fair market value of the stock as of a valuation date is the "value determined by the reasonable application of a reasonable valuation method" based on all the facts and circumstances. A valuation method is "reasonably applied" if it takes into account all available information material to the value of the corporation and is applied consistently. A valuation method is a "reasonable valuation method" if it considers factors including, as applicable:

The General Rule provides that use of a valuation is not reasonable if (i) it fails to reflect information available after the date of calculation that may materially affect value or (ii) the value was calculated more than 12 months earlier than the date on which it is being used.

The"Safe Harbor" Valuation Methods. A valuation method will be considered presumptively reasonable if it comes within one of the three valuation methods specifically described in Section 409A guidance10. These Safe Harbors include:

The Shifting Standard Over Time -Transition Rules. In an apparent attempt to alleviate some of the angst expressed by private companies and their advisors regarding their compliance (or non-compliance) with the valuation requirements of Section 409A, the IRS issued guidance which adopts differing valuation standards depending upon whether options were granted before January 1, 2005, on or after January 1, 2005 but before April 17, 2007, or on or after April 17, 2007.

Choices for Companies' Valuation Practices

Companies may decide to take one of three courses of action:

The Search for Practical Solutions and Best Practices

While patterns we are seeing among private companies are falling along a continuum without sharp demarcations from start-up stage, to post-start-up to pre-expectation of liquidity event, to post-expectation of liquidity event, these are useful classifications for discussion of how managements, boards and advisors are reacting to the Section 409A valuation environment.

Start-Up Stage Companies. At the earliest stage from a company's founding to the time when it begins to have significant assets and operations, many of the well known valuation factors set forth in the IRS guidance may be difficult or impossible to apply. A company typically issues stock to founding shareholders, not options. Until a company begins to grant options to multiple employees, Section 409A will be of less concern. Even after significant option grants commence, we are seeing companies balance the potentially significant dollar and other costs of achieving definitive protection from noncompliance with Section 409A against the often stringent financial circumstances of start-up stage companies. In general, however, we expect that most start-up stage companies will not obtain independent appraisals but will instead rely on the Start-Up Method.

Our Recommendations:

Intermediate-Stage Private Companies. Once a company is beyond the start-up stage but does not yet reasonably anticipate a liquidity event, its board of directors will have to apply its judgment in consultation with company's legal counsel and accountants to determine whether it should obtain a valuation of its stock by an independent appraiser. There will be no bright line test for when a company has reached this stage, but in many cases we expect the company to have reached this stage when the company takes its first significant investment from outside investors. An 'angel' round could be significant enough to trigger this concern. Boards that gain truly independent outside directors as a result of the investment transaction will be more likely to conclude that outside appraisal is advisable. Indeed, venture capital investors are increasingly requiring the companies they invest in to obtain an outside appraisal.

Our Recommendations:

Later Stage Private Companies. Companies that anticipate — or reasonably should anticipate — going public within 180 days or being acquired within 90 days, or that have a line of business that has continued for at least 10 years, cannot rely on the Start-Up Method and, while such companies may rely upon the General Rule, many will, we believe, rely predominantly on the Independent Appraisal Method. An independent appraisal may be relied upon by the company for 12 months unless it has experienced significant changes that would affect its valuation (for example, completing a financing at a higher valuation, accomplishment of a significant milestone such as completion of development of a key product or issuance of a key patent, or closing a significant contract).

Our Recommendations:

What Else We Expect to See

Initially, the cost of valuations by professional appraisal firms ranged from around $10,000 to $50,000 or more, depending on the age, revenue, complexity, number of locations, intellectual property and other factors that control the extent of the investigation required to determine a company's value. However, we are seeing a significant market response, with a number of established and new appraisal firms competing specifically for Section 409A valuation business on the basis of price, with initial fees as low as $5,000 and falling. We have also heard of other valuation firms offering a 'package deal' where subsequent quarterly valuations are priced at a discount when done as an update to an annual valuation. We also expect that companies will adhere to a more systematic schedule in their option grants, clustering grants to a greater extent close to the date of a valuation report or update.

Please feel free to contact any member of our Tax or Corporate and Securities practice groups for assistance and advice in considering your company's choices of valuation practices under Section 409A. While we are not competent to perform business valuations, we have counseled a number of clients in these matters.

To ensure compliance with U.S. Treasury Regulations governing tax practice, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.


Footnotes:

1. The tax law regulating nonqualified deferred compensation plans, including nonqualified stock options, which became effective on January 1, 2005.

2. The tax law regulating nonqualified deferred compensation plans, including nonqualified stock options, which became effective on January 1, 2005.

3. To be exempt from Section 409A, a nonqualified stock option must also not contain an additional right, other than the right to receive cash or stock on the date of exercise, which would allow compensation to be deferred beyond the date of exercise.

4. These issues are addressed in more detail in other MBBP Tax Alerts.

5. Not nonqualified options ("NQOs"), because until Section 409A there was no requirement that NQOs be priced at fair market value.

6. The SEC was not a concern unless the company was likely to file for its IPO in less than a year or so, giving rise to cheap stock accounting concerns that could require a restatement of the company's financial statements. This has not changed as a result of Section 409A, although there have been changes recently in the valuation methodologies that the SEC sanctions, which seems to point to a substantial convergence in valuation methodologies for all purposes.

7. A ninety percent discount meant that the exercise price of the common options was set at ten percent of the price at which the preferred was issued.

8. At least an A Round with convertible preferred stock with all of the classic venture capital bells and whistles. If the preferences were more limited, some accountants and business lawyers at times raised questions about the propriety of the discount, but clients' boards often prevailed in these discussions.

9. While ISOs are technically exempt under Section 409A, one of the criteria for ISOs is that they must be granted with an exercise price not less than the fair market value of the stock on the date of grant. If the exercise price of an ISO is later determined to have been below fair market value, it will not qualify for favorable ISO treatment and will treated be as a NQO.

10. The presumptively reasonable valuation methods have been referred to by many commentators as "safe harbors".


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