| The IRS recently threw down the gauntlet and | | | | two birds with one stone if you will. First, |
| placed pressure on private companies to get | | | | let's examine the code and regulations |
| their valuations right at no matter what | | | | driving this change. |
| stage of development they are. The Service | | | | |
| has backed up this gesture by exposing | | | | Say Hello to the Culprits: IRC Section 409A |
| private companies to substantial tax | | | | requires private companies which award stock |
| liabilities and penalties if they do not. | | | | options that have exercise prices below fair |
| | | | market value to withhold income taxes on |
| Since the enactment of Section 409(A), | | | | these grants. Significant penalties on |
| non-public companies have struggled with how | | | | non-complying option grants have placed |
| they should establish that the exercise price | | | | private or closely held companies under |
| of a stock option or a stock appreciation | | | | increased pressure to be able to support and |
| right (SAR) was determined reasonably to be | | | | defend the fair market value determinations. |
| fair market value. Up to this point, most | | | | |
| private companies did not worry about valuing | | | | FASB 123, Accounting for Stock-Based |
| their stock very often, if at all. Private | | | | Compensation, provides alternative methods of |
| company valuations were needed usually for an | | | | transition for a voluntary change to the fair |
| imminent transaction, for an ESOP, or for | | | | value method of accounting for stock-based |
| estate and gift tax purposes. One could also | | | | employee compensation. FASB 15X (Working |
| throw in serious IPO candidates who obtain a | | | | Draft - issued October 21, 2005), Fair Value |
| valuation to avoid a "cheap stock" issue with | | | | Measurements, established a framework for |
| the SEC. | | | | measuring fair value under a wide variety of |
| | | | accounting pronouncements that require fair |
| Many private companies do not qualify for any | | | | value measurements. |
| of these scenarios; therefore they have not | | | | |
| needed valuations in the past. As a result, | | | | In developing FASB 15X, the Financial |
| companies and management that issue stock | | | | Accounting Standards Board considered the |
| options could be somewhat unenthusiastic | | | | need for increased consistency and |
| about this development. However, although a | | | | comparability in estimates of fair value and |
| valuation in this situation can appear fairly | | | | enhanced disclosures about the estimates. |
| cumbersome and superfluous, it's not all bad | | | | |
| - just ask auditors. | | | | In most cases, when company management |
| | | | determines value and option pricing using an |
| Auditors have expressed a desire for this to | | | | informal, internally generated valuation, the |
| be done for years. They are cognizant of this | | | | tax burden will be on the company to prove to |
| development because valuing stock options is | | | | the IRS that the fair market value of the |
| a financial reporting issue under FAS 123 and | | | | equity is reasonable. In light of the recent |
| they want to know how a private company | | | | regulatory changes announced over the past |
| established the strike price of its options. | | | | year, many private companies are proactively |
| There is some liability risk attributed to | | | | adopting one of the "presumptive" stock |
| auditors when they sign off on this standard, | | | | valuation methods set forth in the proposed |
| and a professional valuation provides them | | | | regulations. |
| with a level of reasonableness and | | | | |
| reassurance that they desire. Considering | | | | Procuring a qualified independent appraisal |
| this, there is a potential for tax and | | | | will cause the burden of proof to shift to |
| financial reporting synergy here. | | | | the IRS and may only be rebutted by the IRS |
| | | | if the application of the method is found to |
| With a good valuation report on hand, both | | | | be grossly unreasonable. |
| issues could be satisfied simultaneously - | | | | |