Proposed Code Section 409A
Regulations Prompt Reconsideration of Stock Valuationsfor Equity Compensation Programs
Source: Morrison & Foerster, January 2006
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The recent adoption of Section 409A of the Internal Revenue Code (“Code”) has prompted significant concerns about valuation practices relating to stock options and other forms of equity compensation. This Morrison & Forester Legal Update link gives an overview of Code Section 409A and its impact on stock option valuation and provides guidance on how to address its valuation requirements going forward.
Some key valuation issues are noted here.
Establishing Reasonable Valuations Under Code Section 409AExperienced Appraiser
Safe Harbor Valuation Methods
Establishing Reasonable Valuations Under Code Section 409A
The proposed regulations require the employer to use a “reasonable valuation method” to determine the value of stock underlying compensatory option grants. The reasonableness of any proposed valuation method will be based on the relevant facts and circumstances as of a specified valuation date. The IRS will consider the following factors to test the reasonableness of a proposed valuation method:
- The value of the company’s tangible and intangible assets;
- The present value of the company’s future cash flows;
- The market value of stock or equity interests in substantially similar businesses that can be determined readily by objective means;
- The effects of any control premiums and/or marketability discounts;
- Whether the proposed valuation method is used for other material purposes by the company, its stockholders, or creditors; and
- Other relevant factors.
Experienced Appraiser
The most interesting sections of the proposed regulations, from the Rubicon Valuation point of view, is within the three Safe Harbor Valuation Methods.
The first Safe Harbor Method recommends an independent valuation by a qualified ESOP appraiser.
The third Safe Harbor Method is for start-up companies and recommends a valuation by an appraiser with experience in the valuation of start-up corporations.
Rubicon Valuation has a history of performing qualified appraisals for ESOPs and young high-technology firms.
Safe Harbor Valuation Methods
The proposed regulations describe three alternative valuation methods that will be presumed to result in a reasonable valuation if they are used consistently. These methods include:- Independent Valuation. A valuation by an independent appraiser qualified to value employer securities held by tax-qualified employee stock ownership plans that is conducted no more than 12 months prior to the relevant transaction date (e.g., the grant date for an NSO) assuming there are no subsequent material developments that would affect the accuracy of the valuation.
- Formula-Based Valuation. A formula-based valuation that is acceptable under Code Section 83, provided that the valuation is performed in a uniform manner for all compensatory and noncompensatory purposes (e.g., regulatory filings, loan covenants, stock repurchases, and other third-party arrangements) and that is used consistently. We do not expect that this valuation method will be widely used, primarily because of its uniformity requirement.
- Start-Up Company Valuation. For the “illiquid stock of a start-up corporation,” a valuation made reasonably and in good faith by a person(s) with significant knowledge and experience or training in making similar valuations (including an insider) and evidenced by a written report that takes into account the relevant factors described above. We expect that many early-stage private companies will attempt to rely on this method assuming they can secure a valuation performed by a person with the requisite knowledge and experience.
Note: As proposed, the Code Section 409A regulations (PDF available) will be effective for taxable years beginning on or after January 1, 2007.
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