Private companies that consider going public may not be aware of the overlap between Section 409A of the Internal Revenue Code and cheap stock accounting issues. If a company makes grants of equity awards prior to going public at share prices that are much lower than the initial public offering price, this could lead to accounting charges for the company. But, perhaps more significantly, this could also highlight tax compliance issues under Section 409A.

Accounting Background: Cheap Stock

The proper determination of the fair market value of a company’s common stock becomes very important from an accounting perspective when a private company considers going public. Under the accounting rules, the fair value of an equity award on the date of grant must generally be recognized as a compensation charge on the company’s financials for purposes of generally accepted accounting principles (GAAP). At the time of an initial public offering (IPO), the Securities and Exchange Commission will review the compensation charges taken for options granted for a period of approximately 12–18 months prior to the IPO. The SEC will apply hindsight in determining the pre-IPO value of the stock, and assume that the value of the stock had increased on a straightline basis from its value 12–18 months earlier through the date of the IPO. If the SEC concludes that a company has undervalued its common stock when granting stock options, the company will likely be required to recognize additional compensation expense for issuing “cheap stock.” Should the SEC decide to audit the valuation method used by the company, this could delay the timing of the IPO and could slow down the registration process.

Section 409A Background

Section 409A of the Internal Revenue Code imposes restrictions on deferred compensation arrangements. The law was originally intended to stop abuses in the administration of traditional deferred compensation plans. However, as adopted, the law applies broadly to a wide range of compensation arrangements, from traditional deferred compensation plans to any arrangement deferring the receipt of compensation beyond a short term, subject to limited exceptions. Options granted with an exercise price less than the fair market value of the underlying stock on the date of grant are considered deferred compensation for this purpose, and generally would not comply with the Section 409A restrictions. Penalties for noncompliance include the imposition of income taxes on the optionee when the option vests (even if it is not exercised), including an additional Federal tax equal to 20% of the spread between the exercise price and the fair market value of the underlying stock when the option vests, plus interest, and for California residents, an additional state tax of 20% of the spread, plus interest, for an aggregate marginal rate of over 80%.

Private Company Stock Option Valuations

The Internal Revenue Service has issued guidance for determining the fair market value of private company stock subject to options for purposes of Section 409A. Under the final Section 409A regulations, the fair market value for private company stock may be determined based on the reasonable application of any reasonable valuation method. The regulations provide a list of factors that the Internal Revenue Service would take into account in determining whether a valuation method is reasonable, including the value of the company’s tangible and intangible assets, the present value of future cash-flows, the market value of stock of similar entities engaged in substantially similar businesses, recent arm’s length transactions involving the sale or transfer of the stock to be valued, and other relevant factors including control premiums or discounts for lack of marketability, provided that all available information material to the value of the company is taken into account. The valuation must be as of a date within the last 12 months, and be updated for any subsequent developments that may materially affect the value of the company.

The final regulations under Section 409A also provide that the following valuation methods will be presumed reasonable if consistently applied:

  1. Valuations based on an independent appraisal meeting certain requirements will be presumed reasonable for a period of up to one year. This has emerged as a best practice for private companies.
  2. Valuations based on a non-lapse formula (that is, a formula price that would continue to apply to any transferee or subsequent stockholder) which applies generally to transactions in the company’s stock may qualify as reasonable. However, as a practical matter, this alternative is typically not applicable to pre-IPO companies.
  3. For start-up companies (less than 10 years in business) with illiquid stock, a valuation may be presumed reasonable if made by someone with significant knowledge and experience or training in performing similar valuations, and evidenced by a written report taking into account the factors discussed above. However, this presumption is not available if a public offering is reasonably anticipated within 180 days or a change in control is reasonably anticipated within 90 days.

Reliance on one of these valuation methods shifts the burden of proof to the Internal Revenue Service to demonstrate that the valuation is grossly unreasonable.

Impact of “Cheap Stock” Charges under Section 409A

If the SEC requires the company to restate its financials to increase the compensation charges taken with respect to its stock option grants, the Internal Revenue Service may be more likely to question whether the options were also granted at a discount for tax purposes – even though cheap stock charges may be based on perfect “20-20” hindsight. This creates a risk of additional taxes to the optionees under Section 409A.

Recommendations

Pre-IPO companies seeking to avoid Section 409A issues should consider the following alternatives:

  • Stop making option grants: Do not make stock option grants during the 12- to 18-month period prior to the initial public offering. More public companies, particularly those with relatively high valuations, have begun granting full value awards such as restricted stock units (or RSUs). These awards are generally not subject to Section 409A (provided that shares are issued as soon as the award becomes vested). However, stock options generally offer more value to an employee if the stock is expected to appreciate significantly, and thus this may not be a desirable alternative for most pre-IPO companies.
  • Obtain independent valuations: Get an independent valuation and limit option grants to the dates on which the valuation is issued (or updated). Many pre-IPO companies grant options only at quarterly Board meetings and have the independent appraiser update the last annual valuation on a quarterly basis. Companies are also well advised to work with valuation firms with a strong reputation and whose valuations will be respected by the auditors preparing the company’s financial statements.
  • Provide ample disclosure: Limit the SEC’s (and potentially the Internal Revenue Service’s) inquiries by providing fulsome disclosure in the registration statement which supports the company’s valuations and explains any changes in equity value leading up to the initial public offering.