As COVID-19 continues to curtail economic activity, private companies granting equity-based incentive awards should consider whether the pandemic’s impact on their business warrants a new independent valuation of their equity securities.
As a reminder, with limited exceptions Section 409A of the Internal Revenue Code and its associated regulations (“Section 409A” and/or the “regulations”) require companies to issue equity-based incentive awards at fair market value (“FMV”) to avoid potentially significant tax penalties resulting from a determination that such awards constitute deferred compensation issued under non-qualified deferred compensation plans.
Section 409A clarifies that a company may determine FMV for stock that is readily tradable on an established securities market (such as the NYSE or Nasdaq) by any reasonable method using actual transactions in such stock as reported by such market. However, determining FMV is more difficult for privately held companies, including early-stage companies, whose stocks are not freely transferrable and/or cannot be readily liquidated.
The regulations provide that such companies may determine FMV for their stock by the reasonable application of a reasonable valuation method, based on facts and circumstances existing as of the valuation date. Fortunately, the regulations also provide that the use of certain methods, including a valuation determined by an independent appraisal that meets the requirements of the regulations (a “409A valuation”), are presumed to be reasonable.
Impact of Material Events
Companies can generally rely on a 409A valuation for a period of 12 months after the valuation date. However, the use of such a valuation may not be reasonable if it fails to reflect information available after the date of the valuation that may materially affect the value of the company. The issue of a 409A valuation not accounting for a material event is more likely to arise when the material event increases the company’s value, since granting equity-based incentive awards at a price above FMV will not trigger the negative tax consequences associated with the issuance of deferred compensation under a nonqualified deferred compensation plan. Nevertheless, obtaining a new 409A valuation where a material event negatively impacts a company’s value merits review, at least from the perspective of the additional incremental value that may accrue to service providers who receive equity-based incentive awards. A lower valuation allows a company to issue options and other equity based compensation at a lower exercise price, meaning a greater potential upside for recipients.
Factors to Consider
While the recent decrease in the value of indices of publicly traded stocks appears to indicate that the COVID-19 pandemic has materially adversely impacted businesses overall, some businesses and sectors have increased in value. Each company must therefore determine how, and to what extent, the pandemic has impacted its value. Companies should consider the following in assessing the need for a new 409A valuation:
- Has the pandemic materially impacted and/or is the pandemic material impacting its business?
- Does the company intend to issue equity-based incentive awards in the near future?
- Should the company wait for more clarity regarding its business prospects?
- How do strategic business initiatives and/or plans factor in?
- What are the financial and operational costs associated with a new valuation?
In addition, companies should consult with their 409A valuation provider, along with their tax, financial and legal advisors, to assist in their analysis. The cost of a 409A valuation is generally significantly less than the cost of a full appraisal but the potential benefits for incentive award recipients could be meaningful.
Common Questions about Tax Rules for Pricing Options:
Taxation Of Deferred Compensation – An Overview of Section 409A.
COVID-19 Client Resource Center
Authors: Louis Wharton