409A Valuation Update: Private Companies and Stock Options

by Jeff Faust, AVA

Companies shouldn’t wait until 2007 to establish valuation methods

Since the IRS issued Notice 2006-4 on December 23, 2005 many companies feel that they have continued flexibility in determining fair market value for stock option grant purposes and that they do not need to take action until the issuance of the final regulations, originally expected to be January 1, 2007, now extended to January 1, 2008.  Is this really the case?

Background

Under Section 409A, there are adverse tax consequences for option holders that have exercise prices below fair market value and that become exercisable after December 31, 2004.  To avoid this tax, 409A will require “a consistent application of a reasonable method that takes into consideration all relevant facts and circumstances.”

Timing

With respect to stock options granted before January 1, 2005, until further guidance is issued, where there was a good faith attempt to set the exercise price at fair market at the time of grant, such options will be treated as being excluded from the requirements of Section 409A.  Whether there was a good faith attempt to set the option price at fair market value depends on the relevant facts and circumstances.  In light of the transitional relief, companies that satisfy this good faith standard do not have to be concerned about the application of Section 409A to pre-2005 option grants unless those options were intentionally granted at a discount or provide a deferral feature.

With respect to stock options granted on or after January 1, 2005 and before the effective date of final regulations, Notice 2006-4 stated that companies could use any reasonable valuation method to determine fair market value.  The guidance provides transitional relief for private company stock options and the determination of fair market value.

Transition

Greenstein, Rogoff, Olsen & Co., LLP strongly suggests that private companies be conservative in their approach to determining the fair market value of their stock in connection with option grants and use this “transitional period” to establish their “consistent” methods of valuation. 

By obtaining a valuation report by an independent appraiser now, a company can ensure that their valuation methods will be in place when the final regulations under Section 409A become effective in early 2007.

For questions or comments, please feel free to contact Jeff Faust at (510) 797-8661 x249 or jfaust@groco.com.