BY: GERALD BARNEY, MS, AVA, CFFA, CSBA, CMEA MELISA SILVERMAN, JD, AVA, SBA, CMEA

Transcription

1 EMPLOYEE STOCK INCENTIVE PROGRAMS AND IRC 409A COMPLIANCE BY: GERALD BARNEY, MS, AVA, CFFA, CSBA, CMEA MELISA SILVERMAN, JD, AVA, SBA, CMEA American ValueMetrics Corp Page 1 of 9

2 BACKGROUND The world was running along just fine until Congress passed the Jobs Creation Act of From it came IRC 409A which sets forth standards for Non-Qualified deferred compensation of employees. This has established a nearly incomprehensible set of tax regulations that affect employee stock options. Once a simple concept reward employees for building a great company by allowing them to participate in the growth of value via stock options has now become a very complicated area of tax regulation and accounting. The various tools that lie within this genre include: Stock options o Incentive Stock Options (ISOs) o Non-qualified Stock Options (NSOs) Restricted stock Restricted stock units Stock appreciation rights Phantom stock Employee stock purchase plans IRS COMPLICATIONS Underlying these various incentive plans is a complicated set of accounting rules which are far too lengthy to discuss here and not the purpose of this paper. The impact of IRC 409A falls mainly on issuers and holders of NSO options (by far the most common kind). The bottom line is that if options are issued with a strike price LESS than the Fair Market Value of the stock at the time issued, then the employees will be subject to income tax on deferred compensation, and the company (issuer) will be subject to very complicated accounting rules and tax consequences. American ValueMetrics Corp Page 2 of 9

3 The key to sanity in this situation lies with insuring that options are issued with a strike price that is equal to or more than the fair market value of the stock at the time it is issued. For public companies this is easy. For non-publicly traded companies it is complicated because fair market value implies discounts for lack of control and marketability for minority interests. It is also complicated by the fact that the valuation must address not only the value of hard assets, but intangible asset value as well. In most small companies the intangible asset value can comprise the lion s share of value, and yet is not normally shown on the company s balance sheet. That s what business valuations are for. IRC 409A requires that a business valuation be prepared upon issuance of the options. It gives three options (no pun intended) to the company for this valuation: 1. Independent Valuations by qualified appraisers 2. Illiquid Startup Presumption. This applies only to companies less than 10 years old, and requires a written report performed by a person with significant knowledge or training in performing similar business valuations. There cannot be any anticipation of an IPO. 3. Binding Formula Presumption. Based upon a formula used in a shareholder buysell or similar agreement, the formula must be used for all non-compensatory purposes requiring the valuation of the company stock. Option 1 is the safe haven. If the company has a qualified independent valuation report, the IRS will accept the valuation as reasonable proof. Options 2 and 3 may buy time however if challenged by the IRS the burden of proof will fall on the company to prove that its valuation was reasonable. And if proven unreasonable can unleash a real mares nest of problems for both the employer and employee. American ValueMetrics Corp Page 3 of 9

4 FIDUCIARY RESPONSIBILITY OF BOARD OF DIRECTORS The company should also be concerned that it is not making a gift of shareholders property by issuing options at a strike price below the fair market value of the stock at the time. This can generate grounds for shareholders disputes, especially when management is often the beneficiary of the options. The only way this can be defended is by obtaining an independent valuation from a qualified appraiser. PRACTICAL CONSIDERATIONS Companies usually offer option grants on a periodic basis quarterly, semi-annually or annually. In addition to restrictions normally placed on the options, there must be an ongoing calculation of which options are outstanding (employees may lose their options if terminated before vesting, etc.) and also which options are in the money on the grant date, because this will affect the fair market value per share of the stock. (The options imply dilution, and the diluted value per share is normally based by including outstanding options that are in the money as if they were issued shares.) As the company s fortunes rise and fall, so too does the diluted fair market value of the outstanding fully diluted shares. These normally have to be calculated periodically in conjunction with the option grants. THE VALUATION PROBLEM As mentioned previously, the valuation must address both tangible and intangible assets. The valuation must normally take place within 12 months of the issuance. The intangible assets can require a very complex analysis, because intangible asset value can take many forms. It can be discrete, as in the case of intellectual property, licenses, contracts, or even fully operational business systems such as a fully staffed and trained hospital. Discrete intangible assets can be transferred independently of the company as a whole. American ValueMetrics Corp Page 4 of 9

5 Or, it can be non-discrete which is normally termed goodwill. Goodwill cannot be transferred separately from the company (except in the case of personal or professional goodwill). Goodwill can be derived both from the results of positive cash flow, or from an entity that is not yet, but is likely capable of developing a positive cash flow in the future based upon development in progress. In either case, intangible asset value is a real value, but it normally does not show up on a company s balance sheet unless shown as purchased goodwill in an asset purchase price allocation. And even then it is shown at book value, not fair market value. THE EFFECTS OF PREFERRED STOCK In most startup situations, the founders take preferred stock. The terms attached to it can vary considerably from a simple preferred return, to voting control, various convertibility schemes, and/or redemption rights. The stock options issued by a company are normally for common stock, therefore the value of the preferred stock must normally be assessed first to then determine the equity value of the common shares, which will then be fundamentally the basis for option grants. This cannot be done from a simple book value analysis any more than it can determine the intangible asset value. DEVELOP A STOCK OPTION PLAN An employee incentives plan should be a written plan that addresses all aspects of option issuance. It should be obvious that trying to circumvent an outside valuation to save money will likely cost the company more than it saves. The program should be coordinated with the valuation firm to determine what reports the company must provide prior to the periodic valuation so that the appraiser can properly reflect the diluted shares. The effect of this plan will insure: Compliance with IRC 409A requirements for exemptions Exercise of Fiduciary Responsibilities with respect to stock option issuance. American ValueMetrics Corp Page 5 of 9

6 Employee stock options are an effective employee incentive tool if administered properly by the Company. American ValueMetrics Corp Page 6 of 9

7 ABOUT THE AUTHORS Gerald W. Barney began his career as a financial professional in 1971 as a NYSE, ASE, and NASD licensed securities broker with the regional firm Mitchum, Jones & Templeton (later acquired by Paine Webber) dealing in mid-sized mergers and acquisitions and commercial real estate syndications. Since 1983 he has been active principally in providing financial services including, business appraisals, machinery and equipment appraisals, consulting, business brokerage and financing. During the years 1994 through 2003 he was the president of Barney & Associates, Inc., a firm engaged in business brokerage, machinery and equipment brokerage, and business appraisal. In 2004 the business appraisal division was spun off as American ValueMetrics Corp., where Mr. Barney continues to serve as president, and the brokerage operations were spun off as Triaz International. He is a member of the National Association of Certified Valuation Analysts (NACVA) and holds the designations Accredited Valuation Analyst (AVA) and Certified Forensic Financial Analyst (CFFA). He is a member of 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). In 2008 the National Commission for Certifying Agencies (NCCA) granted accreditation to NACVA for its CVA and AVA designations for demonstrating compliance with the ICE Institute for Credentialing Excellence, making these designations the only ones in the industry to receive this prestigious and internationally recognized accreditation. As an appraiser Mr. Barney has performed valuations of over 3,500 business entities and/or equipment assignments throughout the spectrum of industries, from start-ups to billion dollar sales companies. American ValueMetrics Corp Page 7 of 9

8 Melisa Silverman is a partner and senior appraiser in American ValueMetrics Corp, a boutique national valuation services firm providing defensible, certified business and business interest valuation reports that meet industry standards (USPAP and NACVA) as well as regulatory standards (IRS, ERISA and DOL) and substantiates the value of the assets. Ms. Silverman has a JD Degree. Ms. Silverman holds the following professional designations: Accredited Valuation Analyst (AVA) from the National Association of Certified Valuation Analysts; Senior Business Analyst (SBA) from the International Society of Business Analysts and Certified Machinery & Equipment Appraiser (CMEA) from the National Equipment and Business Brokers Institute. Ms. Silverman has prepared hundreds of complex business valuations for a variety of reasons including but not limited to: estate and gift tax purposes, mergers and acquisitions, partner buyouts, shareholder disputes, ESOP transactions, tax disputes, buysell agreements, conversions from C-Corps to S-Corps, divorces, non-cash charitable contributions, machinery & equipment, and discounted cash flow analyses. Ms. Silverman has researched court cases that may impact business valuations and developed a fluid legal foundation that is part of the valuation reports. Ms. Silverman combines extensive financial analysis of a business or business interest with a compelling legal foundation to make persuasive arguments in support and defense of the findings that result in the conclusions of value. Previously, Ms. Silverman worked for and consulted with large and medium companies such as Peregrine Systems, 3E Company and Sonare Technologies, a division of Herman Miller. She was responsible for negotiating with strategic partners and assisting them with sales, marketing, training and operations to sell the Company s products and services. She focused on vertical markets including retail, utilities, healthcare and manufacturing. Ms. Silverman was also involved with multiple acquisitions that were in American ValueMetrics Corp Page 8 of 9

9 process including due diligence, negotiations, acquisition announcements and integration plans and implementation. American ValueMetrics Corp Page 9 of 9