Since the mid-2000s, private companies have engaged outside valuation firms to determine the fair market value (FMV) for their common stock for the purpose of granting stock options. Private companies began using outside valuation firms in response to the IRS adoption of the Section 409A deferred compensation regulations which can impose significant tax penalties on options with exercise prices below FMV.
With the adoption of the Internal Revenue Code (IRC) Section 409A regulations, management teams, boards, and employees granting and receiving options grew concerned about the potential for the IRS to second guess the Board’s determination of fair market value of the Company’s common stock when granting options, and the potential tax penalties that could be imposed for such grants.
Fortunately, IRC 409A provides procedures that companies and boards can follow that minimize the risk of IRS second guessing boards’ FMV determinations and associated tax penalties under IRC 409A. The highest level of protection provided under the 409A regulations is to hire an independent, competent outside valuation firm to determine the FMV of the Company’s common stock. If a private company engages an outside, independent appraisal firm to determine the fair market value of its common stock, the fair market value determination is presumed to be reasonable unless the IRS can show that valuation method or its use was grossly unreasonable. Typically, an outside valuation prepared for 409A purposes can be relied upon by a private company for up to 12 months if no event occurs that would make reliance upon that fair market value assessment unreasonable (i.e., raising debt or equity capital, a material change in the company’s business or prospects, obtaining an offer to sell the company, etc.). What are the risks of not obtaining an outside 409A valuation?
If the IRS succeeds in second guessing your determination of FMV, a 20% excise tax is imposed on the person receiving the option;
Your incentive option program just turned into a large tax problem for your employees;
Employees may look to the company to pay their tax liability;
Employees may sue the company’s board of directors for its improper determination of the FMV and the resulting tax penalties;
Outside auditors could also second guess your FMV determination resulting in non-cash charges to earnings;
Potential acquirers of the company may second guess the FMV determination and either reduce purchase price or increase escrow for potential claims;
If the company file for an IPO, the SEC is more likely to second guess the FMV determinations resulting in non-cash charges to earnings and lengthy additional disclosure regarding prior option grants and exercise price determinations.
An independent, rigorous and thorough 409A FMV valuation will greatly reduce the likelihood that the IRS will second guess your FMV determination, thereby mitigating the likelihood of tax penalties and risks. Compared to the potential liabilities, risks and penalties associated with an improper FMV determination, the costs associated with a rigorous and thorough 409A FMV determination of your company’s common stock are trivial.