Private Company Stock Options: Determining Fair Market Value in ...

Private Company Stock Options:
Determining Fair Market Value in
Light of Section 409A of the
Internal Revenue Code
Mark Bettencourt
Ken Gordon
Marian Tse
Scott Webster
March 2, 2006
©2006. Goodwin Procter LLP

Agenda
• Discussion of the Law
• Valuations – Quasi Safe Harbors
• Case Studies
• Other Considerations Relating to Option
Grants
• Best Practices
2

The Law
• American Jobs Creation Act of 2004
created Section 409A of the Internal
Revenue Code
• IRS Guidance
– Notice 2005-1 on December 20, 2004
– Proposed Regulations on September 29, 2005
– Notice 2006-4 on December 28, 2005
– Final Regulations expected this summer to be
effective January 1, 2007
3

The Law
• Broadly applies to all types of nonqualified
deferred compensation
arrangements (e.g., discounted options,
supplemental retirement plans, restricted
stock units, phantom stock, certain
severance payments)
• Covers arrangements with employees,
directors, consultants and other service
providers
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The Law
• 409A penalizes:
– Discounted options
– Options with a deferral feature
– Options to acquire preferred stock
5

The Law
• Covers options granted after
December 31, 2004 or modified after
October 3, 2004
• Covers options granted before
January 1, 2005 to the extent vesting
occurs after December 31, 2004
6

The Law
• Penalty for non-compliance includes
taxation at vesting, plus a 20%
additional tax
• For discounted options, spread is taxed
(plus the additional 20% tax) at vesting
and any incremental value is taxed
annually thereafter until exercised
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The Law
• For example, option granted at $2 when
FMV is $3
• At vesting, FMV is $7
• Under Section 409A, the spread of $5 is
taxed at ordinary income rates (a tax of
$2 at 40% rate) on the vesting date
• Plus an additional 20% tax on the
spread of $5 (or $1)
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Valuation Methods
• To qualify for the exemption from 409A,
the exercise price per share must not be
lower than the FMV of the underlying
stock at grant
• Options granted before January 1, 2005
are exempt from 409A if FMV was
determined in good faith
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Valuation Methods
• For options granted after December 31,
2004, FMV can be determined using any
reasonable valuation method under Notice
2005-1 or using the reasonable application
of a reasonable valuation method under
the proposed regulations
• FMV means a value determined by the
reasonable application of a reasonable
method that takes into account all relevant
circumstances
10

Valuation Methods
• Factors to consider:
1. The value of tangible and intangible assets;
2. The present value of future cash flows;
3. The fair market value of stock of companies
engaged in substantially similar trades or
businesses that can be determined by objective
means;
4. Control premiums or discounts for lack of
marketability; and
5. Whether the valuation method is used for other
purposes that have a material economic effect on
the company, its stockholders or creditors.
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Valuation Methods
• A valuation method is not considered
reasonable if it:
– is more than 12 months old;
– does not take into account all available
information material to the determination of value
as of the valuation date; or
– fails to take into account subsequent events such
as the resolution of material litigation or the
issuance of a patent.
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Valuation “Quasi” Safe
Harbor
• The proposed regulations provide a
“quasi” safe harbor in the consistent use
of one of the following methods:
– Independent appraiser
– Written report for illiquid stock of start-up
corporation
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Valuation “Quasi” Safe Harbor
• Valuation determined by an independent
appraiser
– Cannot be more than 12 months old
– Must satisfy certain tax requirements
14

Valuation “Quasi” Safe Harbor
• Valuation of an “illiquid start-up
corporation”
– Corporation must be in business for less than 10
years, cannot have publicly-traded equity, and
stock must not be subject to any put or call right
– Must be made reasonably and in good faith by a
person or persons with significant knowledge and
experience or training in performing such
valuations
– Must be evidenced by a written report
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Valuation “Quasi” Safe Harbor
• Valuation of an “illiquid start-up
corporation” (cont’d.)
– Must take into account all relevant factors,
including those described above
– Presumption not available if the corporation
reasonably anticipates at the time of the
valuation that the corporation will undergo a
change-in-control event or an IPO in the next
12 months
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Case Study
• Emerging technology company with two
preferred rounds completed
• Company in existence for 5 years
• Board of directors includes CEO, two
VC fund representatives, and two
industry experts
• Historically options granted to new
employees on the date of hire and to all
employees twice each year
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Option Grant Profile
• Historical options
– Options granted before January 1, 2005
• good faith determination
– Options granted January 1, 2005 through
December 31, 2006
• reasonable application of a reasonable
valuation method
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Scenario 1
• IPO likely in 2006 or 2007
– Company should seriously consider obtaining
independent appraisal to manage Section 409A
and SEC “cheap stock” concerns
19

Scenario 2
• Sale event likely in 2006 or 2007
– Company should strongly consider obtaining
independent appraisal to manage Section 409A
concerns
20

Scenario 3
• Neither IPO nor sale event likely in 2006
or 2007
– Can use any reasonable method
– Consider use of written report quasi safe harbor
21

Modifications and Extensions
• Any modification of an “in-the-money”
option, other than an extension of term,
is treated as new grant
• If option term is extended, the option is
treated as having a deferral from the
date of grant
22

Modifications and Extensions
• Modification
– Any change in option that may provide optionee
with
• direct or indirect reduction in stock price
• an additional deferral feature
• an extended exercise period
23

Modifications and Extensions
• Examples of changes that are not
considered modifications:
– Shortening exercise period
– Accelerating vesting
– Adding right to tender shares towards exercise
price
– Adjustment to reflect stock split or stock dividend
– Substitutions and assumptions in corporate
transactions
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Modifications and Extensions
• Extensions
– Exercise period is extended
–Notan extension if exercise period is extended to
a date no later than the later of:
• the 15 th day of the third month at which, or
• December 31 of the calendar year in which,
the option would have otherwise expired
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Modifications and Extensions
• Rescission
– Modification can be rescinded if done before the
earlier of the end of calendar year or date of
option exercise
– Example:
• Option amended on March 1 to extend
exercise period by two years
• Rescind extension before year-end and before
option exercise
• Not a modification
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Remedial Measures
• Alternative 1
– Re-price discounted options to FMV on original
grant date before December 31, 2006
– Compensate optionee with cash bonuses
– Cash bonuses must be subject to vesting and
may be tied to option vesting schedule
– Cash bonus may not be paid before 2007
• Alternative 2
– Fix option exercise date
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Accounting Considerations
• AICPA Practice Aid
– Valuation of Privately-Held-Company Equity
Securities Issued as Compensation
– Includes three valuation methodologies:
• market-based
• income-based
• asset-based
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Accounting Considerations
• AICPA Practice Aid (cont’d.)
– Ranks preferred methods:
• Contemporaneous independent appraisal
• Retrospective independent appraisal
• Contemporaneous or retrospective “relatedparty”
valuation
– Pre-IPO companies should consider the AICPA
Practice Aid
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Best Practices
• Consider likelihood and timing of IPO or
sale event
• Adopt valuation method, either appraisal
or written report
• Apply valuation method consistently
• Reduce frequency of grants and vesting
dates
• Be careful of modifications
• Consider increased use of restricted stock
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GOODWIN PROCTER LLP
Boston
Exchange Place
Boston, Massachusetts 02109
(617) 570-1000
New York
599 Lexington Avenue
New York, New York 10022
(212) 813-8800
Washington, DC
901 New York Avenue, NW
Washington, DC 20001
(202) 346-4000
www.goodwinprocter.com
31

GOODWIN PROCTER LLP
Mark Bettencourt – mbettencourt@goodwinprocter.com
Ken Gordon – kgordon@goodwinprocter.com
Marian Tse – mtse@goodwinprocter.com
Scott Webster – swebster@goodwinprocter.com
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