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3/2008

Client Alert: Private Company Stock Valuations Under Section 409A

One of several requirements that must be satisfied for a stock option or stock appreciation right ("SAR") to be exempt from the non-qualified deferred compensation rules of Internal Revenue Code ("Code") Section 409A ("Section 409A") is that the exercise price of such award must be no less than the fair market value ("FMV") of the underlying stock at the time of grant. An option or SAR with an exercise price that is less than the FMV as of the grant date is a deferred compensation arrangement which must comply with Section 409A to avoid adverse tax consequences to the recipient. The only way to make an option or SAR that is subject to Section 409A comply with Section 409A is to specify, at the time of grant, an exercise date that cannot be changed. Because of this inflexible rule, the vast majority of employers will want to avoid the application of Section 409A to any options or SARs and, therefore, will need to comply with the FMV requirement.

To exempt options and SARs from the constraints of Section 409A, they must be granted with an exercise price which is no less than the FMV of the underlying stock on the grant date.

This Alert is intended to provide a brief explanation of rules applicable to the valuation of private company stock under Section 409A. This Alert is not applicable to publicly-traded companies. To the extent the information in this Alert applies to any of your company's plans or arrangements, we strongly urge you to contact one of the individuals listed at the end of this Alert to discuss the specific terms of these plans and arrangements.

Options and SARs can be split into two categories for purposes of the FMV analysis: (1) awards granted before January 1, 2005; and (2) awards granted on or after January 1, 2005.

Awards Granted Before January 1, 2005 - Companies must have complied with the "good faith" fair market value rules of Section 422 applicable to incentive stock options.

For options and SARs granted prior to January 1, 2005, the good faith standard under Code Section 422 applicable to incentive stock options ("ISOs") will apply for purposes of valuing company stock under Section 409A, whether or not the stock award is an ISO. If the company attempted in good faith (as determined based on relevant facts and circumstances) to determine the FMV of the underlying stock and set the exercise price of the award at or above that value, the FMV requirement of Section 409A will be deemed satisfied.

Awards Granted On or After January 1, 2005 - Companies must "reasonably apply" a "reasonable valuation method" or make use of a "safe harbor."

For options and SARs granted on or after January 1, 2005, and prior to January 1, 2009, companies may "reasonably apply" "any reasonable valuation method" to determine the FMV of stock, as provided in IRS Notice 2005-1 (http://www.irs.gov/irb/2005-02 IRB/ar13.html) and Notice 2006-4 (http://www.irs.gov/irb/2006-03 IRB/ar12.html). In the alternative, for that period, and for grants on or after January 1, 2009, companies may make use of the valuation methods described in the final Treasury regulations (explained below).

Reasonableness - Facts and Circumstances

The final regulations generally provide that the reasonableness of a valuation method will be made based on "facts and circumstances" on the valuation date.

To "reasonably apply" a valuation method, a company must consider all available material information at the time the method is applied ("Valuation Factors").

The factors to be considered for purposes of the valuation include the following factors:

The use of a valuation method is unreasonable if:(i) the method does not take into consideration all available information material to the value of the company; (ii) the valuation is more than 12 months old at the time it is used to establish FMV; or (iii) the valuation is used at a later date if the calculation fails to reflect material information available after the calculation date.

The company's consistent use of the valuation method, including for purposes unrelated to compensation of service providers, is also a factor supporting the reasonableness of the valuation method.

Reasonableness - Safe Harbor Valuation Methods

There are three "safe harbors" available under the final regulations: (1) qualified independent appraisal; (2) early stage company written valuations; and (3) nonlapse restriction valuation (formula based).

An alternative to the facts and circumstances approach is the use of a "safe harbor" method described in the final regulations. If a company uses one of the safe harbor methods, the IRS will presume that the valuation is reasonable. The safe harbors are summarized below and more fully described in the final regulations. The use of a safe harbor method is presumed to result in a reasonable valuation; provided, however, that the IRS may rebut that presumption if it can show the valuation was grossly unreasonable.

  1. Qualified Independent Appraisal. A qualified independent appraisal will be presumed to be reasonable if it is performed by a "qualified independent appraiser" and the valuation is not more than 12 months old at the time it is used for establishing FMV.
  2. Early Stage Company Written Valuations. If a company has conducted business
    for fewer than 10 years and is not reasonably expected to undergo (i) a change in control within 90 days or (ii) a public offering within 180 days of the date a valuation is used, a valuation will be presumed reasonable if:
    1. the valuation was performed within the past 12 months by a person the company reasonably determines is qualified to perform such valuation based on such person's significant knowledge, experience, education or training;
    2. the valuation is evidenced by a written report that takes into account the Valuation Factors; and
    3. the company's stock is not subject to put or call rights or other obligations to purchase such stock (other than a right of first refusal or certain other similar restrictions).
  1. Nonlapse Restriction Valuation – (use of formula).
    1. The valuation must be based on a consistent application of a formula, such as a multiple of book value, assets or earnings that, if used as part of a nonlapse restriction with regard to the stock, would be considered to be the FMV of the stock under Code Section 83.
    2. The final regulations clarify that to meet this presumption, the valuation formula is required to be applicable to compensatory and non-compensatory stock transfers to the issuer or any person owning more than 10% of the voting power of the company, other than an arm's length transaction involving the sale of all or substantially all of the stock of the issuer to an unrelated purchaser.

In certain situations, different valuations may be used for separate actions for which a valuation is relevant, provided that a single valuation method is used for each separate action and, once used, may not be retroactively altered. For instance, it is permissible to use one method to establish the exercise price of an option and another method to determine the value of the stock on the date of its repurchase by the issuer pursuant to a put or call right. If a private company later becomes public, the valuation method for public companies must be used for all periods after becoming public, but it cannot retroactively change the exercise price established using the above rules prior to becoming public.

Action Steps for Private Companies

  1. Companies should review their grant practices, specifically their exercise price determinations, and should confirm that all previously granted awards have an exercise price that was no less than the FMV of the underlying stock on the grant date. Companies may want to consider hiring an independent appraiser to make this determination, if necessary.
  2. If the pricing process used did not satisfy the applicable good faith or reasonable standard at the time of grant, the exercise price should be adjusted (through cancellation and reissuance) by December 31, 2008, so that the exercise price is not less than the FMV on the original grant date.
  3. Companies should consider adopting a method, such as the use of an independent appraiser or other applicable safe harbor method, to ensure that the exercise price of any future grant is not less than the FMV of the underlying stock on the grant date.
  4. Companies should consider limiting option and SAR grants to a few times per year to more closely tie these grants to the process of valuing company stock. For example, limiting grants to an annual or a quarterly basis following an independent valuation, or the close of a financial statement period, would make the process of compliance with Section 409A more manageable.
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