In a recent issue of the popular newsletter Softletter, Edward
Pratesi, CPA of Brentmore Advisors, LLC, does an outstanding job in the
article entitled: “Valuing Options While Running the Compliance
Gauntlet "explaining the complicated interplay between FAS 123R and Sec. 409A
in the context of determining the fair market value for privately-held
companies of the common stock underlying an employee stock option. This is a critical input for qualified stock options where the option
must be issued with a strike price equal to fair market value on the date of
grant to comply with IRS Sec. 422 and can’t be issued at a discount if you want to avoid the penalties under Sec. 409A.
Pratesi explains the background behind both 123R and 409A and
then articulates the valuation standards under each section and how they
differ. As he articulates it:
It is important to note again the difference between FASB 123R
And IRC Section 409A as they appear to be similar but approach the
valuation of options and securities from different perspectives. FASB123R concerns stock option valuations for financial reporting
purposes and is measured using the issuing company’s perspective … IRC 409A
is concerned with the issuance of stock based compensation … The
objectives to ensure that the securities being granted … are granted at
fair market value … Under either regimen, the value of the
underlying security – the common stock – is critical in determining the value
of the stock option.
He later explains that the inherent difference is that FAS 123R
uses a “fair value” standard and looks to the AICPA practice aid “Valuation
of Privately-Held Company Equity Securities Issued as Compensation.”Sec. 409A uses a “fair market value” standard and offers three
safe harbors for valuation: a) the binding formula presumption; b) the
independent appraisal presumption; and c) the illiquid start-up
presumption. If the valuation satisfies one of these safe-harbor
presumptions, then it is assumed to be “reasonable” for 409A purposes
and the burden shifts to the IRS to prove that the valuation was not “a
reasonable application of a reasonable valuation method.”
In the latter part of the two part
article, the author offers a set of questions and answers that many
companies will come across as they deal with valuation for the first time. A
few of the highlights are:
Question: Which one of the above standards will impact us the most?
Answer: Since most privately-held technology based companies will be
issuing stock options (and in many cases more than once a year),
anticipate that a valuation of the underlying stock will be needed to meet
IRS standards first and the financial reporting requirements under 123Rsecond.
Question: If both the FASB and IRS require that
our privately-held company be valued, can we have one valuation
report prepared to meet both standards?
Answer: Maybe.
I have read dozens of articles on this issue over the past one
to two years and strongly feel that for the CFO or stock plan
administrator who is not a valuation expert, but needs to know just
enough to be able to talk intelligently when considering the various
options for common stock valuation in the context of equity compensation reporting, this article is a diamond in the rough and
for that reason appreciate the publisher of Softletter making this article available to the public.