February 17, 2009

This Memorandum highlights the critical need of all companies with stock based compensation plans (“Stock Rights”), such as a stock option plan, to implement a valuation methodology to ensure an accurate value of the company’s stock at the time the Stock Right is granted. Section 409A of the Internal Revenue Code of 1986, as amended, (the “Code”) and the Treasury Regulations (“Regulations”) issued thereunder, impose certain restrictions on certain types of nonqualified deferred compensation arrangements. Failure to abide by these restrictions often results in harsh and unplanned tax consequences to the employee including current taxation on deferred amounts, a twenty percent (20%) excise tax and interest charges on amounts past due. The list of Stock Rights programs potentially impacted include, without limitation: nonstatutory stock options, certain separation arrangements, and stock appreciation rights (“SARs”).  
 
A lynchpin of the new Regulations under Section 409A is found in the requirement that companies properly value the stock which underlies the Stock Right at the date of grant. The adverse tax consequences described above typically occur with so called “discounted” stock options, or options that have an exercise or “strike price” set below the fair market value of the company’s stock on the date the Stock Right was granted.  
 
The permissible valuation methods under Regulations differ depending on a company’s status, private or public. In the case of public companies, i.e. those traded on an established securities market, fair market value may be determined based upon the last sale before, or the first sale after, the grant; the closing price on the trading day before or the trading day of the grant; the arithmetic mean of the high and low prices on the trading day before or the trading day of the grant, or any other objectively reasonable method using actual transactions in such stock reported by the market.
 
For private companies, the value of a company’s stock must be established by utilizing the “reasonable application of any reasonable valuation method.” Thankfully, the Regulations further provide a list of valuation methods that are presumptively reasonable and that can be rebutted by the IRS only upon a showing that the method, or its application, was “grossly unreasonable” given the circumstances of the company. These methods are briefly summarized below.  
 
Independent Appraisal Method
Under this method a company may rely on the report of a qualified, independent appraiser who uses traditional appraisal methodologies, such as those used in valuing company stock for the purposes of Section 401(a)(28)(C) of the Code (relating to employee stock ownership plans). In order for such report to qualify as a reasonable valuation method, it must have been completed no more than twelve (12) months prior to the date to which the valuation will be applied, i.e. the date of the grant of the Stock Right.
 
Formulaic Method
This method allows for the use of a formula utilized in a shareholder buy-sell agreement (or similar binding agreement) that would constitute a non-lapse restriction for the purposes of Section 83 of the Code. Such formula must be used in the same manner for purposes of any stock transfer to the issuer or to any person owning more than ten percent (10%) of the combined voting power of all classes of stock of the company. Use of such formula is not required in the event of the sale of all or substantially all of the company’s outstanding stock.  
 
Method for Illiquid Start-up Companies
Start-up companies pose unique and difficult challenges in the world of valuation. The Regulations define illiquid start-up companies as those companies which (i) have been in business less than ten (10) years, (ii) have stock that is not traded on any established securities market, and (iii) are not anticipating a change in control event in the next ninety (90) days or a public offering within the next 180 days. In such instances, the Regulations allow value to be established by a reasonable, good faith valuation evidenced by a written report based on the facts and circumstances of the company. To utilize this method, the individual making this determination must be qualified in terms of knowledge, experience, education and training. Generally a person is considered qualified if a reasonable individual, seeking to sell or purchase the stock of the company would reasonably rely on the findings of the appraiser. The appraiser should have at least five years of relevant experience in business valuation or related fields. Unlike the Independent Appraisal Method, there is no requirement that the individual submitting the valuation report be independent. The factors to be considered in the valuation analysis include, without limitation: the value of tangible and intangible assets of the corporation; the present value of anticipated future cash-flows of the corporation; the market value of stock or equity interests in similar companies engaged in trades or businesses substantially similar to those engaged in by the company, the value of which can be readily determined through nondiscretionary, objective means (such as through trading prices on an established securities market or an amount paid in an arm's length private transaction); recent arm's length transactions involving the sale or transfer of such stock or equity interests; and other relevant factors such as control premiums or discounts for lack of marketability.
 
Alternative Methods
Notably, the Regulations permit the use of alternative methods for separate actions for which a valuation is relevant. For example, one method may be implemented to establish the stock price of an option, while a different valuation method may be employed to determine the value at the date of a repurchase of stock. However, once value is established under a particular method for a specific action, such value may not be retroactively altered through the use of an alternate method.
 
The suitability of these methods will vary depending on the facts and circumstances of each company. Regardless of the method chosen however, the overarching point remains that it is fundamentally important that all companies with stock based compensation programs implement a valuation system to correctly determine the value of the entities stock prior to making any grants of Stock Rights. While there can be no assurances that a proper valuation will, on its own, be sufficient to avoid penalties under Section 409A regarding grants of Stock Rights, it is certain that an improper valuation significantly increases this risk.  
 
CIRCULAR 230 DISCLOSURE
THE DISCUSSION OF TAX CONSIDERATIONS WAS NOT INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED BY ANY TAXPAYER, FOR THE PURPOSE OF AVOIDING TAX PENALTIES THAT MAY BE IMPOSED BY THE INTERNAL REVENUE SERVICE.  ANY TAX ADVICE CONTAINED HEREIN WAS WRITTEN TO SUPPORT THE PROMOTION OR MARKETING OF THE TRANSACTIONS OR MATTERS ADDRESSED BY THE WRITTEN ADVICE. EACH PARTY SHOULD SEEK ADVICE BASED ON THE PARTY’S PARTICULAR CIRCUMSTANCES FROM AN INDEPENDENT TAX ADVISOR.