Start Up Companies – Why You Need a Valuation for Stock Options

Demystifying Valuation, Economic Damages + Forensic Accounting

It seems everyone remembers the Enron accounting scandal. Prior to the company going bankrupt, Enron executives were accelerating payments under their deferred compensation plans in order to cash in before the bankruptcy. Other publicly-traded companies were seemingly abusing the timing of stock option awards by back-dating the option grants. Section 409A was added to the Internal Revenue Code to combat these perceived abuses. The impact of Section 409A is far-reaching due to the broad definition of “non-qualified deferred compensation.”

Section 409A deals with all types of non-qualified deferred compensation arrangements, including certain stock option plans. These arrangements require that the deferred compensation may only be paid upon a service provider’s separation from service, disability, death, a fixed payment date or schedule, a change in control of the business or the occurrence of an unforeseeable emergency. In the event that operational or documentary failures occur, the income is subject to immediate taxation to the service provider (employees and contractors). In addition, significant penalties and interest may be imposed on the service provider (not on the employer).

Non-qualified stock options having an exercise price at least equal to fair market value of the underlying security are generally not subject to Section 409A. However, if the fair market value is more than the exercise price, the compensation would be subject to immediate taxation to the service provider on the date of the grant. The penalties are onerous and include a 20% federal penalty, increased underpayment penalties and possible state penalties (e.g., California imposes a 20% penalty). These penalties are in addition to the regular tax on the income. Interest may also be imposed.

Ensuring that the exercise price is at least equal to “fair market value” of the underlying stock is important. Since valuation is a complex endeavor, we recommend retaining a qualified appraiser to value the company and its equity securities.

By Steve Koons, CPA, ABV, ASA, CFF