The last few years have produced a resurgence of private equity companies
investing in start-ups at a more sustainable rate than the late 1990s and early 2000s.
A common way for these fledgling businesses to attract and retain top-flight employees is
to offer them a share of the company through
employee stock options.
But private companies using or considering
the use of stock options to supplement
employee compensation should be aware
that key revisions to the Financial
Accounting Standards Board (FASB) guidelines and IRS tax rules governing these
options might dramatically impact their current or future stock option programs.
“Compliance with both pronouncements
is based upon accurate determinations of
the fair market value or fair value for stock
options when they are issued,” says Jeff
Stegner, a partner at Armanino McKenna
LLP in San Ramon. “While this is not a difficult issue for publicly traded companies,
the overwhelming majority of privately
held companies that are issuing stock to
their employees must retain a qualified
professional to value these options.”
Smart Business spoke with Stegner
about the FASB and IRS rule changes and
what they mean to private companies
offering or considering employee stock
option programs.
What key elements of the FASB and IRS pronouncements impact employee stock
options?
For private companies, FAS 123(r) went
into effect on Jan. 1, 2006, stipulating that
costs related to equity-based compensation be recognized in a company’s income
statement. We have received a large number of calls on this issue from companies at
the behest of their auditors, who can’t issue
their audit opinion until this requirement is
completed.
The Internal Revenue Service jumped on
the bandwagon in October 2005 and issued
409(a), a measure that requires companies
to report compensation to their employees
if stock options were granted to them at
strike prices below fair market value.
How are these pronouncements prohibitive
to private companies?
A private company offering employee
stock options must prove that it has set the
exercise price of the stock option equal to
the value of the common stock. The days
when the board of directors could select a
price and say, ‘Yes, that’s the right number’
are over. Companies now must either follow a set of specific steps for valuation or
hire an independent valuation professional
to calculate their stock’s fair market value.
The reason companies are considering
employee stock options in the first place is
to attract and retain qualified employees
while preserving operating cash flow. In
my experience, the percentage of companies that have this in-house resource with
available time is very small.
Why is it crucial for employees that option
prices be properly calculated?
Your auditor will generally require a valuation to verify you have properly recorded
the noncash charge for granted options.
But — perhaps more important — a valuation can protect your employees from substantial income taxes and penalties if the
IRS determines options are priced at less
than fair market value. Obviously, management was handed the largest number of
options, so it’s going to impact their bottom
line the most.
For example, let’s say the option for the
fair value of the stock is determined to be
10 cents. If employees were granted the
option at a penny per share, the nine-cent
spread is now taxable to them, but what do
they really have?
They have an option to purchase shares in
a company that is not publicly traded and
may never reach a stage where they are able
to realize a gain from the options, yet they
can be charged current income tax on them
even if they never exercise the option.
What does a company gain from a professional valuation of its stock?
No one is interested in what start-ups are
doing today; they’re interested in the
upside potential next week, next year or in
five years. But you can bet that IRS auditors are going to look closely at big, splashy
news headlines like Google’s acquisition of
YouTube and others.
If your start-up eventually realizes a large
liquidity capital event worth many multiples of the original option price(s), the IRS
is going to ask how you determined the fair
market value of the stock at the time of the
option grant and decide if you complied
with the 409(a) valuation rules.
What actions should be considered before
implementing stock options?
Most important, companies should not
be afraid to offer stock option plans. With
proper implementation, stock options are
the lifeblood for successful companies generating and advancing new technology.
The key to a successful plan is following
the rules and utilizing an experienced,
independent appraiser to value the shares
of your company.
JEFF STEGNER is a partner and head of the ValueNomics
Department at Armanino McKenna LLP in San Ramon. Reach him
at (925) 790-2692 or [email protected].
