409a Valuation Risks in Deferred Compensation Plans

By avm

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Once a simple concept – reward employees for participating in the growth of a company’s value via stock options – incentive compensation has now become a very complicated area of tax regulation and accounting. At least since the creation of “qualifying stock options” in 1981, the IRS has required that options be priced at or above the fair market value (FMV) of the underlying stock. But until recently, the IRS did not provide much guidance about how FMV was to be calculated, nor was it very active in enforcing the regulation. Today, since January 2009, companies that grant deferred compensation must comply with IRC Section 409a of the Internal Revenue Code. This includes options, warrants and other incentives, such as:

         • Stock Options 
         • Incentive Stock Options (ISOs)
         • Non-qualified Stock Options (NSOs)
         • Restricted Stock
         • Restricted Stock Units
         • Stock Appreciation Rights (SARs)
         • Phantom Stock
         • Employee Stock Purchase Plans

Under IRC 409a, private companies are required to show that their common stock options are issued at strike prices at or above fair market value to avoid a taxable event, and must conduct a formal valuation opinion at least once every twelve months to avoid tax penalties.

Analysis
In most private company situations, the main concern is not to issue qualified deferred compensation instruments ‘in the money’; i.e. below FMV. If this occurs, employee issued options with a strike price less than the FMV of the underlying stock will be subject to income tax on deferred compensation at the time issued, and the company (issuer) is subject to complicated accounting rules and tax consequences.

This requires us to look at the company and the employee and shareholder situations separately. Financial Accounting Standards Board (FASB) ASC 718, (formerly, FASB Statement 123R), generally requires that all equity awards granted to employees be accounted for at Fair Value (FV). Yet, we want to evaluate the individual share or derivative at the lower FMV – the difference between Fair Market Value (FMV) and Fair Value (FV) being any discounts applied to the stock for lack of control or marketability. So essentially, the company accounts for the stock at FV, but the employee accounts for the stock at the discounted FMV.

Consequences of Failure to Comply
If the company is not in compliance with IRC 409a, penalties are imposed directly on the employees and include immediate tax on vesting, a 20% penalty and interest. These tax penalties, when combined with state penalties and taxes, can reach 60% to 90% of gains. While employers are not directly subject to penalties for IRC 409a violations, they may decide, or have agreed, to pay any 409A tax penalties incurred by their employees, and may face tax reporting and withholding penalties.

IRS Compliance Initiative Project
At the May 2014 meeting, an IRS official announced that the IRS has created a compliance initiative project (CIP) for Section 409A of the IRC. As part of the CIP, the IRS will review the deferred compensation plans of selected employers to evaluate their compliance with Section 409A requirements. “A compliance initiative project has been created for Section 409A,” said Thomas D. Scholz, IRS senior technician reviewer, Office of Division Counsel/Associate Chief Counsel, Tax Exempt and Government Entities. The audits will be conducted by the IRS’s Small Business/Self-Employed (SB/SE) Division.

The IRS said the project will be conducted through standard “information document requests” (IDRs) and will focus on three broad issues: initial deferral elections, subsequent deferral elections and payouts under Section 409A (including compliance with the six-month delay for specified employees). To limit the burden on the audited companies, the IRS said the scope of the audit will focus on the top 10 highest paid employees at the audited companies, and will be limited to the deferral elections and distributions for the years under examination. This program is seen by many as a first step in a process that will allow the IRS to develop audit techniques and areas of inquiry before the program is expanded to more employers. Targeted IRS examinations for compliance with IRC Section 409A have been anticipated for years. We are likely seeing the first phase of an ongoing 409A enforcement initiative.

Once a company or an executive is under an IRS audit on these issues, the IRS correction programs are no longer available. Although the tax consequences apply to the employee or other service provider, companies will want to make sure that their deferred compensation arrangements comply because of potential related exposure, e.g., employee claims against the employer, employer withholding and reporting noncompliance, and the allocation of related risks/costs associated with plans.

Unintended Consequences of Poor Analysis
Other than the specter of the IRS finding fault and liability for improper valuation, other risks present themselves when the company’s management does not foresee the impact of issuing incentives. These risks include employee anger, dilution of existing shareholders, conflict of interest between management and other stakeholders, and the under-subscription of capital – all of which can result in expense to the company.

Employee Outrage
With internal formulas, boards of directors have set option prices under-priced by as much as 60% to Fair Market Value. In one example, the IRS challenged the value and the executive employee ended up with penalties of $61,000 on a $75,000 unrealized ‘paper’ gain. This meant that the employee had to pay out $61,000 in cash for the option grant. Although underpricing generally means that value is present, if the share price falls below the strike price in the future, the executive gets nothing. In any case he is out $61,000 until the exit event.

Dilution
Without guidance, we have seen companies inadvertently issue incentive compensation in a manner that dilutes the common stock. This occurs when options are issued with strike prices less than Fair Value. A classic example is when a company issues options with a strike price based upon the discounted FMV instead of FV – which it can do and be in compliance with the IRC 409a. This issuance dilutes the common stock because the capital received upon exercise is less than the pro-rata Fair Value of the firm – Fair Value being its full value. So the newly exercised options buy in at a discount compared to the existing shareholders and it has a dilutive effect.

In light of the downstream effects, it is essential to understand the interactive effects of all value related programs – options, convertible preferred stock, warrants, and convertible notes when issuing new financial instruments. Plus, under ASC 505, a stock or cash distribution that does not affect all shareholders proportionally is treated as a share issuance. In these situations, companies must identify the factors in play and be intentional in how they are implemented. The potential dilution resulting from new issues and cash distributions, if not carefully planned, can result in the elimination of any value flowing through to the common shareholders, making the common stock options worthless.

Conflict of Interest
As you may see from the previous issue, improper pricing of options can cause conflict in an organization once the impacts are realized by the stakeholders. Normally, a primary beneficiary of incentive options is the company’s CEO. Should an error be found in equity compensation treatment, it can invariably lead to a shareholder dispute with management. One complaint takes the form of an accusation against the CEO for intentionally valuing options low in order to benefit at the expense of other shareholders. This opens the company to distraction, conflict, shareholder disputes, potential litigation and friction with angels or VC investors who hold preferred positions.

Under-Subscription of Capital
Setting low strike prices has the effect, not only of diluting the remaining shareholders, but also of depriving the company of cash flow and capital. One of the benefits of using options to the private equity firm is that when an option is exercised, the company receives capital in the form of the option buy-in at the strike price. With low strike prices, the company receives proportionally less capital when the options are exercised. Since the continued renewal of company capital is the basis for maintaining growth, this planning consideration should also not be overlooked.

Risk Reduction

Valuation Methods: IRS Safe Harbor Provisions
The IRS provides three “safe harbor” methods to reduce or eliminate the liability that companies and their management assume for making financial projections and forecasts made in good faith when issuing incentive instruments. These are:

Binding Formula Internal Valuation
This valuation method is based on consistent application of a single formula and used for all transactions, i.e. both for the grant of stock and options, purchases or sales of stock to third parties, conversion of loans into stock, etc. The common way to implement this method is for the company accountants to use a multiple of a material criterion, such as Sales, EBITDA or Net Income.

Illiquid Start-up Internal Valuation
This methodology applies to private companies that are less than 10 years old, are not anticipating sale, IPO or change of control within the next 12 months and the stock is not subject to a put or a call right. This valuation will be considered reasonable by IRS, if it is in written form, performed within 12 months of an option grant and performed by a person with significant knowledge and experience or training in performing similar valuations. If the company accounting professional is completing this valuation, they must have specific training in this practice.

Independent Valuation
A valuation performed by a qualified independent appraiser, such as American ValueMetrics, using traditional appraisal methodologies will be presumed reasonable if it values the stock as of a date that is no more than 12 months before the applicable stock option grant date. This method provides safe harbor no matter the age of the company, and is the sole option for IRS risk mitigation, outside of the binding formula, after ten years in business.

Valuation Method Selection Risks
To put the burden of proof for disputing stock valuation on the IRS, a private company must use one of the above three “safe harbor” methods to issue options. If the valuation is performed outside these limitations by the taxpayer or his employees, the burden of proof falls on the taxpayer to substantiate that a disputed valuation is proper.

The practice of valuation through a binding formula is not widespread because the valuation can vary dramatically year-to-year and that management desires flexibility in their financial instruments to take advantage of different opportunities. The use of flexibly priced instruments results in multiple classes of stock or warrants, some of which, management may want to treat preferentially. For example, the use of two classes of stock, preferred stock as the financing vehicle for venture capital investments and common stock used for compensation, precludes the use of the binding formula method. From, the valuation aspect, this method will overstate or understate the equity value, as it does not take into consideration the many internal and external factors that determine Fair Value. The lack of a suitable valuation inhibits proper equity and debt financing decision-making and can lead to mistakes in this area.

If the illiquid start-up approach is used, satisfaction of the qualifications is vital. A change in circumstances, such as the sale of the company, could lead to problems with the IRS. Or the qualifications of the valuation person could be called into question if the IRS felt that an improper valuation was made. At the very least a private company should obtain a person with significant knowledge and experience or training in performing similar valuations to conduct an internal FMV valuation and write a valuation report.

The cleanest and most accurate solution to IRC 409a is to hire an independent qualified valuation expert to perform FMV analysis and write a valuation report. When performed by an independent, professional valuation analyst, the company has no risk to defend its valuation to the IRS. In a dispute, the burden of proof moves to the IRS to prove that a valuation is ‘grossly unreasonable’, an extremely high barrier for the IRS to overcome and an unlikely event. Of the three “safe harbor” methods, this is the most effective, least risk and best reflects the true enterprise value.

The IRS appears to be encouraging a shift in valuation practices from internal professionals to unaffiliated, third parties and is regulating toward that end. Discussions with corporate attorneys indicate that about two thirds of VC and angel backed startups use the independent appraisal method. Others either ignore the issue in their early stages or conduct the illiquid start-up valuation approach.

Benefits of Independent Valuation

Three important benefits are realized by using third party valuation. As we discussed, independent valuation immediately satisfies the safe harbor requirement for company valuation. Second, it places management and their accounting firms at arm’s-length from the valuation, insulating it from the accusation of self-dealing. And third, a firm such as American ValueMetrics will apply current market value and independent thought to the valuation, giving it broad appeal to all stakeholders.

Provided that the valuation includes expert analysis from experienced business people, the value will make sense from not only a financial perspective, but also for the strategic factors that make the company unique. In addition, the independent valuation cost is modest in comparison to the risk, as a typical valuation is in the $5000 range. The valuation may be used for twelve months, but may also be completed quarterly when options are issued quarterly.

Proper Stock Valuation Methodology

Determine Fair Value
Fair Value (FV) is a rational and unbiased estimate of the potential market price of a good, service, or asset. Book value alone cannot be used to determine FV. In some cases, it may be possible to use a recent arms-length round of funding to value a company, but a Uniform Standards of Professional Appraisal Practice (USPAP) compliant valuation is almost always the better course. A compliant business valuation addresses the value of the dependent fixed assets and intangible assets, known as the Market Value of Invested Capital (MVIC), plus the separable independent assets. If a recent round of financing is available this also is used as a component in the valuation analysis.

Set the Fair Value Price of the Stock Share
To determine the stock share price, an accounting of a company’s outstanding fully diluted shares is required, including:

         • Outstanding options 
         • Vested Options
         • Options “In the money” on the grant date
         • Restrictions placed on the options
         • Conversion rights of other financial instruments and forms of equity

This waterfall analysis will require assessing the preferred stock, convertible notes or debentures before determining the equity value of the common stock.

Invalid Option Pricing Model – Black-Merton-Scholes
After performing a waterfall analysis to find the current value of the shares, some analysts will argue that share prices for private companies have a tradable value above current value that can be determined using the Black-Sholes model. The goal of OPM is to simulate each class of invested capital as a combination of call options in order to capture the futuristic nature of a probable exit event.

However, the basic premise of a business valuation is that it captures today’s value for all future cash flows. If the valuation incorporates a discounted cash flow, or potential market exit value, then it certainly is adjusting for future changes in those cash flows and valuing those as of the current date. The OPM premise that some value from a future event is ‘missing’ is faulty. Although an elegant technique, there simply is no need for an expensive calculus-based analysis if a proper valuation is made, but there also is no known harm in doing so.

The effect of performing the Black-Sholes analysis is to change the strike price for the option arbitrarily to a speculative standard of value from the Fair Market Value standard, while costing the client for the additional services. The company can choose to set its strike price above Fair Value by any method it chooses with no downside repercussion with the IRS.

Invalid Technique

Fair Value of the common stock of a privately held company implies that equity interests be discounted for lack of marketability from public markets. This marketability discount is based on lack of liquidity, preferred stock conversion rights and dividends and sale/transfer restrictions in the company’s bylaws.

In academic circles, professionals using a public markets starting point to value private stock propose the direct application of restricted stock studies to determine the value of equity for privately held companies. However, these studies have limited applicability and the discount could be much different than justified.

Restricted Stock Studies deal with stocks of public companies that have been temporarily restricted from sale for one to two years in the public markets. As these securities continue to be sold in private transactions, they sell at an average of 30% less than the publicly traded stock. However, these discounts do not have the intrinsic liquidity problem faced by privately held companies which makes them far less marketable – and worth significantly less.

Conversely, an inexperienced valuator (i.e. the company controller) could double discount by mistakenly applying marketability discounts to private transaction data. This error will result in a penalty if found by the IRS.

A seasoned business valuation practitioner is expected to use comparable sales transactions from private markets to help set the investment rate of return and enterprise value. This intrinsically incorporates the private market discount and eliminates the need to determine the discount between public and private market types.

Determine the Minimum Strike Price
Though an additional minority discount for lack of control is applicable to closely held minority positions, and issuance of an option with a strike price equal to this discounted value would satisfy 409a, it can cause real problems with dilution of existing shareholders. A wiser practice is to set the strike price at or above the company Fair Value (undiscounted) rather than at the Fair Market Value of the minority interest. This is also the accounting directive of ASC 718.

This not only deters shareholder suits over unfair dilution, it should insure that the option program provides market rate capital infusions over the long run.

Conclusions
Working with an independent qualified firm that knows how to evaluate your business is a fundamental step to satisfying the IRS and company stakeholders. The key words to ensure safe harbor with independent valuation are independent, qualified and within 12 months. If these requirements are met, the burden is on the IRS to prove a valuation was “grossly unreasonable.”

Avoid financial determinations based solely on financial theory because formulas created for public markets do not apply to privately held companies’ illiquid scenarios. Privately held companies are not valued by an independent market and require special attention to financial, market and operational factors. Using a valuation expert for these matters will help the company avoid IRS penalties, identify its real value and provide insights into key business factors.

A company’s best option to reduce risk and satisfy all stakeholders is to employ independent valuation. The benefits accrue in more accurate values, less litigation and lower potential for internal conflict. Mistakes in this area 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.

ABOUT THE AUTHORS

James A. Lisi is a partner and certified valuation analyst (CVA) at American ValueMetrics Corporation providing cost efffecive, defensible business valuation reports in about two weeks.

Mr. Lisi has an MBA from UC Irvine and a BSIE from the University of Michigan and has been valuing businesses with American ValueMetrics since 2004. Rooted in executive and acquisition experience, Jim brings start-up, family business, private equity and Fortune 100 experience to his projects.

Gerald W. Barney is president and founder of American ValueMetrics Corporation, and the author of Street-Smart Guide to Valuing Business Investments. He began his career as a financial professional in 1971 as an NYSE, ASE, and NASD licensed securities broker with the regional firm Mitchum, Jones & Templeton dealing in mid-sized mergers and acquisitions and commercial real estate syndications. Since 1983 he has been active principally in providing financial services in business valuations, machinery and equipment appraisals, consulting, business brokerage and financing.

He is a member of the National Association of Certified Valuation Analysts (NACVA) and holds the designations Certified Valuation Analyst (CVA) and Master Analyst Financial Forensics (MAFF). He is a member of the National Equipment & Business Brokers Institute (NEBB) and holds the professional designations of CMEA (Certified Machinery & Equipment Appraiser). He is also a member of the International Society of Business Analysts and holds the designation as a CSBA (Certified Senior Business Analyst).

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