Sometimes practical reality and legal niceties collide like trains guided by Chas Adams. Here is a typical situation that must happen on a daily basis somewhere: I recently had a start up client call up and say that he wants to issue options to a new employee. The company was founded a couple of months ago, founder shares were issued, IP was contributed, options were offered, new guy was hired, client wants to know how to price the options. Enter Section 409A of the Internal Revenue Code which provides that the options must have an exercise price not less than the fair market value of the stock and fair market value be determined “by the reasonable application of a reasonable valuation method.”

Client: “OK, you’re my lawyer, how do I do that?”

Dave: “Well, according to my tax partner:

The regulations provide that whether a valuation method is reasonable, or whether an application of a method is reasonable, is a facts and circumstances test. The factors to be considered include: (i) the value of tangible and intangible assets, (ii) the present value of anticipated future cash flows, (iii) market value of stock in similar corporations engaged in a similar business, the value of which can be readily determined by objective means such as trading prices on a securities market or prices paid in an arm’s length private transaction; (iv) recent arms’ length transactions involving the stock, and (v) other relevant factors, such as control premiums and discounts for lack of marketability. The use of a value which was previously calculated under a valuation method is not reasonable as of the later date if it is more than 12 months old or if it fails to reflect information made available after the date of the calculation that may materially affect the value. 

With respect to non-publicly traded stock, the proposed regulations provide for three safe harbor valuation methods which, if used consistently for all equity based compensation arrangements, will be presumed to be reasonable unless the IRS establishes that the valuation was “grossly unreasonable”. Therefore, the burden of proof shifts to the IRS if one of these safe harbor valuation methods is used.

Method one is independent appraisal. This safe harbor requires a valuation determined by a qualified independent appraiser, made not more than 12 months prior to the relevant transaction to which the appraisal is applied.

Method two is start-up company “Appraisal Lite”.   This safe harbor is available only to start-up companies (generally, those that have been in business for less than 10 years and that do not have any class of traded securities), which at the time the valuation is applied do not have a reasonable anticipation of a change in control within 90 days or a public offering within 180 days. In order for the safe harbor to apply, the valuation must be based upon a written valuation report (made in good faith) which takes into account the factors described above with respect to a reasonable valuation method, and which is prepared by a person with significant knowledge and experience or training in performing similar valuations. Unlike the independent appraisal safe harbor, the person preparing the report need not be independent, and thus could include a Board member who meets the “significant knowledge and experience” requirement (which generally means at least 5 years of relevant experience).

Method three is using a Formula Price. This safe harbor is a non-lapse formula valuation under Code §83, provided that the formula is used for all compensatory and non-compensatory valuations of the stock, including loan covenants and issuance to and repurchases of stock from persons other than service providers.”

Client: “Gee, thanks Dave”