Editor: Please tell our readers about your work at EisnerAmper.
D'Uva: I am a partner in the Litigation Services Group and have been with the firm for 14 years. I primarily prepare valuations for many different purposes: estate planning and gifting, dispute resolution, financial reporting, financial planning, and buying or selling a business or a particular asset.
Editor: What is Section 409A of the Internal Revenue Code?
D'Uva: Section 409A of the Internal Revenue Code relates to the taxation of deferred compensation. It was part of the American Jobs Creation Act passed by Congress in 2004. A common way for companies to defer compensation to employees is by issuing stock options and stock appreciation rights. In issuing stock in any form, it is important to know the fair market value of the underlying common stock.
Editor: What is considered deferred compensation under these rules?
D'Uva: Under the rules, if an option to buy stock has an exercise price that is lower than the fair market value of the common stock at the date of grant, then the difference is considered a deferred compensation arrangement. This becomes an important factor because there are federal tax consequences under Section 409A for nonqualified deferred compensation at the time of vesting. These rules also apply to a severance situation.
Editor: Why should companies be concerned about this?
D'Uva: Whether the company is public or a private, it should be concerned with the IRS rules as to how to set the fair market value of the company's common stock. In the case of a public company where the common stock is traded, there is not as much of an issue, but there are still some rules with respect to what value is used. For a private company the valuation of a common stock can be very complex. In many instances a company issuing stock options may be a startup, often in cases where it doesn't have the cash flow to pay its executives adequate compensation. In such cases the company issues stock options. Many times there may be several classes of stock where outside private equity groups invest, often in the form of preferred stock. Allocating the value between the common stock and the preferred stock becomes quite complex. Importantly, IRS rules need to be adhered to in order to avoid adverse tax consequences.
Editor: How is the strike price of options determined?
D'Uva: The strike price of options should be set equal to or greater than the fair market value of the underlying common stock. There were many different ways in the past that companies have arrived at the strike price. Today it is a common practice for a company to seek the advice of an outside appraisal firm because of new IRS rules.
Editor: I understand these rules were enacted back in January 2005 but didn't take effect until 2008. Why was that?
D'Uva: Section409 was added to the code in January 2008, although it was part of the American Jobs Creation Act passed by Congress in 2004.The cause of the delay in implementation may have been due to the amount of controversy among various companies lobbying for different provisions, especially with regard to the penalties.
My understanding is that the consequences of issuing options as deferred compensation at a below market price can result in the immediate inclusion in income of all deferrals made in the year of noncompliance as well as noncompliance deferrals made in prior years, to the extent the deferrals are not subject to forfeiture. There is a 20 percent excise tax on prior year noncompliant deferrals included in income. Furthermore, there is an interest charge on deferrals from prior years. I understand that some of the states impose taxes in these situations as well.
Editor: Can the board of directors set the fair market value of the company stock?
D'Uva: It is considered a best practice in meeting all IRS rules to engage an outside appraiser. In the past, the board of directors would set a price based on a a formula of multiples or a ratio and really didn't go through all the steps of preparing and performing a business appraisal.
Editor: How is fair market value of a company's stock determined?
D'Uva: In general there are three approaches: (1) the income approach; (2) the market approach; and (3) the asset approach. Within each approach there are several acceptable methodologies. For example, within the income approach one can look to historical income or projected income to determine value. A market approach would entail using market information such as looking at the price of a similar public company stock or looking at the acquisition price of an entire public company by another company. An asset approach would involve evaluating the specific assets, both tangible and intangible, of the company.
Typically this appraisal might be done by an appraisal firm or an accounting firm, who might use at least two of the three methods I described.
Editor: What other methodologies should be used to determine the fair market value of the company's stock?
D'Uva: In addition to the methodologies that I previously described, more complexity comes into the valuation process when you have different classes of stock to which value is allocated. There are other models that are used in allocating values to the different classes of stock. In addition to the three approaches I have referred to, the AICPA has a practice aid for stock issued as compensation that describes allocation of value to the various classes of stock. Some of the more acceptable methods are current-value method, the probability-weighted-expected-return method and the option-pricing method.
Editor: What are the IRS criteria for determining fair market value?
D'Uva: The valuation of the company stock must be reasonable, taking into account the company's specific facts and circumstances. Besides considering the value of tangible and intangible assets, the appraiser should examine cash flows and the present value of future cash flows, market value of similar publicly traded companies and other relevant factors such as discounts for lack of marketability, minority interests or control premiums.
Editor: How often does the company need to get an appraisal of its stock for the granting of options?
D'Uva: According to the regulations, it is considered reasonable to use an appraisal that was performed no more than 12 months prior to the grant date of an option as long as there has not been a significant event that could have changed the value of the business.
Editor: What should a company be looking for in an appraiser?
D'Uva: You want to see that the person has credentials in the business appraisal area. Business valuation isn't a licensed profession but a credentialed profession. One of the more highly regarded credentials is that issued by the American Society of Appraisers, which designates qualified appraisers as ASA or accredited senior appraiser. The AICPA also has an appraisal designation referred to as the ABV, accredited in business valuation, an accreditation only issued to CPAs who have passed an exam and demonstrated experience and knowledge in the area of business appraisal. Those would be the types of credentials that a company should be looking for in addition to asking about the person's experience and possibly asking for references.
Editor: What is the difference between the fair market value of common stock for 409A purposes and the fair value of common stock for financial reporting purposes (Accounting Standards Codification topic 718)?
D'Uva: Companies are required to account for and disclose stock options that fall under the definition of share-based payment arrangements, the terminology used under ASC topic 718, and the standard of value referred to as fair value. For Section 409A purposes the standard of value is fair market value. The methodologies for options and financial statement values are similar. One would consider the same three approaches - the income, market or asset approach - as well as discounted cash flow and capitalized earnings, but the difference would actually be in possibly some of the assumptions that are made because the Section 409A valuation is actually a valuation made from the perspective of the individual owner of the stock, while the ASC 718 valuation is made more from the perspective of the company. It is possible that some of the assumptions might be different. In an ASC 718 valuation some of the parties whom you might consider as market participants may not be the same participants as in a Section 409A valuation. But for the most part, the valuations are going to be the same, and often you can use the same appraisal for both purposes.
Editor: What is acceptable to the company's auditors?
D'Uva: The auditors are going to look for a well-documented report, something that follows appraisal standards. They are going to be looking for documentation of all the assumptions that are made, not just that the methodologies follow professional appraisal practice, but that the assumptions are logical and supported, that they are based on factors that make sense and that the person who is issuing the opinion is a person who has the credentials, the experience and the knowledge to issue such an opinion and reach such conclusions.
Editor: What measures are used in valuing the preferred stock as compared with the common?
D'Uva: Generally speaking, there isn't a rule of thumb. The rights and privileges of the preferred shareholder are factors in determining the value of the stock, such as whether preferred stock is convertible, whether the preferred shareholder is entitled to a dividend, whether dividends are cumulative, and what the liquidation preferences are. If there has been a recent round of preferred stock financing of the subject company, you can use that information in a model to try to back-solve for the value of the common stock. Using that approach the appraiser must still make certain assumptions based on his or her judgment.
Editor: What factors can ensure that the valuation process will be an efficient and timely one?
D'Uva: The most important thing is for the appraiser to gain access to the information that he or she needs in a timely fashion by conferring with the most knowledgeable persons in a fairly concentrated period of time. Getting material in one undertaking in order to analyze all the pieces together is most helpful.