Private Company Stock Options: Determining Fair Market Value in Light of Section 409A of the Internal Revenue Code

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1 Private Company Stock Options: Determining Fair Market Value in Light of Section 409A of the Internal Revenue Code Mark Bettencourt Ken Gordon Marian Tse Scott Webster March 2, Goodwin Procter LLP

2 Agenda Discussion of the Law Valuations Quasi Safe Harbors Case Studies Other Considerations Relating to Option Grants Best Practices 2

3 The Law American Jobs Creation Act of 2004 created Section 409A of the Internal Revenue Code IRS Guidance Notice on December 20, 2004 Proposed Regulations on September 29, 2005 Notice on December 28, 2005 Final Regulations expected this summer to be effective January 1,

4 The Law Broadly applies to all types of nonqualified deferred compensation arrangements (e.g., discounted options, supplemental retirement plans, restricted stock units, phantom stock, certain severance payments) Covers arrangements with employees, directors, consultants and other service providers 4

5 The Law 409A penalizes: Discounted options Options with a deferral feature Options to acquire preferred stock 5

6 The Law Covers options granted after December 31, 2004 or modified after October 3, 2004 Covers options granted before January 1, 2005 to the extent vesting occurs after December 31,

7 The Law Penalty for non-compliance includes taxation at vesting, plus a 20% additional tax For discounted options, spread is taxed (plus the additional 20% tax) at vesting and any incremental value is taxed annually thereafter until exercised 7

8 The Law For example, option granted at $2 when FMV is $3 At vesting, FMV is $7 Under Section 409A, the spread of $5 is taxed at ordinary income rates (a tax of $2 at 40% rate) on the vesting date Plus an additional 20% tax on the spread of $5 (or $1) 8

9 Valuation Methods To qualify for the exemption from 409A, the exercise price per share must not be lower than the FMV of the underlying stock at grant Options granted before January 1, 2005 are exempt from 409A if FMV was determined in good faith 9

10 Valuation Methods For options granted after December 31, 2004, FMV can be determined using any reasonable valuation method under Notice or using the reasonable application of a reasonable valuation method under the proposed regulations FMV means a value determined by the reasonable application of a reasonable method that takes into account all relevant circumstances 10

11 Valuation Methods Factors to consider: 1. The value of tangible and intangible assets; 2. The present value of future cash flows; 3. The fair market value of stock of companies engaged in substantially similar trades or businesses that can be determined by objective means; 4. Control premiums or discounts for lack of marketability; and 5. Whether the valuation method is used for other purposes that have a material economic effect on the company, its stockholders or creditors. 11

12 Valuation Methods A valuation method is not considered reasonable if it: is more than 12 months old; does not take into account all available information material to the determination of value as of the valuation date; or fails to take into account subsequent events such as the resolution of material litigation or the issuance of a patent. 12

13 Valuation Quasi Safe Harbor The proposed regulations provide a quasi safe harbor in the consistent use of one of the following methods: Independent appraiser Written report for illiquid stock of start-up corporation 13

14 Valuation Quasi Safe Harbor Valuation determined by an independent appraiser Cannot be more than 12 months old Must satisfy certain tax requirements 14

15 Valuation Quasi Safe Harbor Valuation of an illiquid start-up corporation Corporation must be in business for less than 10 years, cannot have publicly-traded equity, and stock must not be subject to any put or call right Must be made reasonably and in good faith by a person or persons with significant knowledge and experience or training in performing such valuations Must be evidenced by a written report 15

16 Valuation Quasi Safe Harbor Valuation of an illiquid start-up corporation (cont d.) Must take into account all relevant factors, including those described above Presumption not available if the corporation reasonably anticipates at the time of the valuation that the corporation will undergo a change-in-control event or an IPO in the next 12 months 16

17 Case Study Emerging technology company with two preferred rounds completed Company in existence for 5 years Board of directors includes CEO, two VC fund representatives, and two industry experts Historically options granted to new employees on the date of hire and to all employees twice each year 17

18 Option Grant Profile Historical options Options granted before January 1, 2005 good faith determination Options granted January 1, 2005 through December 31, 2006 reasonable application of a reasonable valuation method 18

19 Scenario 1 IPO likely in 2006 or 2007 Company should seriously consider obtaining independent appraisal to manage Section 409A and SEC cheap stock concerns 19

20 Scenario 2 Sale event likely in 2006 or 2007 Company should strongly consider obtaining independent appraisal to manage Section 409A concerns 20

21 Scenario 3 Neither IPO nor sale event likely in 2006 or 2007 Can use any reasonable method Consider use of written report quasi safe harbor 21

22 Modifications and Extensions Any modification of an in-the-money option, other than an extension of term, is treated as new grant If option term is extended, the option is treated as having a deferral from the date of grant 22

23 Modifications and Extensions Modification Any change in option that may provide optionee with direct or indirect reduction in stock price an additional deferral feature an extended exercise period 23

24 Modifications and Extensions Examples of changes that are not considered modifications: Shortening exercise period Accelerating vesting Adding right to tender shares towards exercise price Adjustment to reflect stock split or stock dividend Substitutions and assumptions in corporate transactions 24

25 Modifications and Extensions Extensions Exercise period is extended Notan extension if exercise period is extended to a date no later than the later of: the 15 th day of the third month at which, or December 31 of the calendar year in which, the option would have otherwise expired 25

26 Modifications and Extensions Rescission Modification can be rescinded if done before the earlier of the end of calendar year or date of option exercise Example: Option amended on March 1 to extend exercise period by two years Rescind extension before year-end and before option exercise Not a modification 26

27 Remedial Measures Alternative 1 Re-price discounted options to FMV on original grant date before December 31, 2006 Compensate optionee with cash bonuses Cash bonuses must be subject to vesting and may be tied to option vesting schedule Cash bonus may not be paid before 2007 Alternative 2 Fix option exercise date 27

28 Accounting Considerations AICPA Practice Aid Valuation of Privately-Held-Company Equity Securities Issued as Compensation Includes three valuation methodologies: market-based income-based asset-based 28

29 Accounting Considerations AICPA Practice Aid (cont d.) Ranks preferred methods: Contemporaneous independent appraisal Retrospective independent appraisal Contemporaneous or retrospective relatedparty valuation Pre-IPO companies should consider the AICPA Practice Aid 29

30 Best Practices Consider likelihood and timing of IPO or sale event Adopt valuation method, either appraisal or written report Apply valuation method consistently Reduce frequency of grants and vesting dates Be careful of modifications Consider increased use of restricted stock 30

31 GOODWIN PROCTER LLP Boston Exchange Place Boston, Massachusetts (617) New York 599 Lexington Avenue New York, New York (212) Washington, DC 901 New York Avenue, NW Washington, DC (202)

32 GOODWIN PROCTER LLP Mark Bettencourt Ken Gordon Marian Tse Scott Webster 32