ASC 718 (formerly FAS 123R) and IRC 409A Valuation Challenges Aren’t Just For Pre-IPO Companies

October 14, 2010 at 3:59 pm Leave a comment

The attorneys at Latham & Watkins and the SEC Institute have written an interesting and detailed monograph on cheap stock valuation issues for companies that are preparing for an IPO: Cheap Stock: An IPO Survival Guide. 

Here is a link to the document:  cheap stock whitepaper

While the focus of the document is on SEC compliance challenges for pre-IPO companies, a key risk it identifies concerns tax compliance with IRC 409A.  Additionally, in our view, the recommendations it puts forth also apply to companies contemplating an M&A exit.

The writers argue that cheap stock risks are substantial.  The key recommendation is that “The best way to avoid trouble with cheap stock issues is to avoid equity awards entirely during the 12-month period before filing your IPO.”  Although they add that this “…is not a realistic possibility for many pre-IPO companies…” the writers recommend a “second best” solution that centers on obtaining contemporaneous independent valuations, as well as including robust disclosure, in the IPO registration statement.

The writers summarize representative comments a company should expect from SEC staff.  Frankly, these comments come across as entirely reasonable, along the lines of: “Please reconcile and explain the differences between the mid-point of your estimated offering price range and the fair value included in your analysis.” 

IRS audit is the big risk

The big risks, according to the writers, center on tax compliance issues created by the SEC review process:  “If the SEC Staff requires an issuer to increase the compensation charge associated with a grant of stock options, this change indicates that, at least for accounting purposes the issuer has determined… that it has granted discount options.”  The writers then conjecture: “If by implication, these stock options are also treated as discount options for tax purposes, the options may be subject to additional taxes under Section 409A and may be ineligible for preferential…tax treatment.”  This is a big “if”.  The writers do point out that: “The IRS has issued no formal guidance on the interplay of cheap stock accounting charges and fair value for 409A…purposes” and “ Department of Treasury representatives have, on occasion, informally acknowledged that the SEC’s retrospective accounting valuation is not necessarily determinative of fair market value for purposes of Section 409A.”  The uncertainty of whether or not SEC conclusions could trigger a finding of non-compliance with 409A is the primary driver for the writers’ recommendations.  The writers also warn about the IRS’ audit initiative relating to potential 409A issues.  This IRS initiative is currently underway and is targeting 6,000 employers through 2012.  (I will write more about this initiative in a subsequent posting.)

In our view, companies contemplating an M&A exit are subject to similar (and potentially greater) risks as those faced by pre-IPO companies.  Just as a difference between an SEC valuation finding and the value at the time of a stock option grant may trigger an IRS audit risk, the difference between the selling price of the company and the price determined at the time of the stock option grants, may also trigger the interest of an IRS auditor.

Reconciling the value at exit for an M&A company to the values used for stock option grants may be complicated due to company fundamentals. In many cases, pre M&A companies are at an earlier stage of stage of development than pre-IPO companies.  Furthermore, the IPO process typically takes many months, and the potential value of the company at IPO can be included formally as part of the valuation process.  M&A transactions can progress from initial discussions to closure much more rapidly than the IPO process, and there may be less opportunity to formally consider realistic M&A exits at the time of many stock option grants.

 Even though we do not know the ultimate outcome of the IRS audit initiative, the 409A rules provide a “safe harbor” benefit.  For either type of exit, independent valuations conducted contemporaneously with stock option grants provide significant risk reduction benefits.

Bill Denebeim is a Vice President of The Brenner Group and has more than twenty years experience providing financial, regulatory and operational consulting services to executive management and investors of technology companies. Bill received his M.S. in Operations Research from Stanford University and his B.A. degree in Economics and English from the University of California at Berkeley. Bill is a holder of the Chartered Financial Analyst® designation and is a member of the CFA Institute and the CFA Society of San Francisco.

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Original post permalink:’t-just-for-pre-IPO-companies


Entry filed under: Valuations.

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