IRC 409A – COVID-19 Update
by Brad Smith, CPA, CFA | 09 Jun 2020
PRIVATE COMPANIES: IS NOW A GOOD TIME TO ISSUE STOCK OPTIONS?
COVID-19 (also known as coronavirus) officially became a pandemic on March 11, 2020. This outbreak has caused significant market volatility and substantial declines in market capitalization for public companies. The effects have taken a toll on many private businesses as well, potentially causing negative impacts on companies’ financial performance.
In uncertain times such as these, strategic planning regarding employee compensation and retention is a topic which has risen to the forefront. For business owners looking to incent management or compensate employees without draining cash reserves, issuing equity-based compensation could be an attractive strategy.
While equity-based compensation can take on many forms, we are focusing on the issuance of stock options to employees of privately held companies. When issuing stock options to employees, companies must be aware of IRC §409A.
WHAT IS 409A?
- 409A (“409A”) is a tax provision of the Internal Revenue Code. It was added in the code in 2005 due to perceived abuse of deferred compensation arrangements. If the series of rules detailed under 409A are not followed, employees who have been issued stock options could be subject to punitive tax consequences. However, an exclusion to the tax consequences is allowed if an option is issued with an exercise price that is at least equal to the fair market value of the underlying stock on the date of grant.
Further, the regulations under 409A provide a safe harbor that allows a company to rely on a valuation from an independent, third-party firm that specializes in valuations for 409A and follows consistent valuation methodologies. If the current fair market value is challenged, the burden of proof shifts to the IRS to prove that the fair market value at the time of option issuance was ‘unreasonable’.
Therefore, a 409A valuation is used to set the strike price of equity options issued to employees at the current fair market value of the stock.
HOW OFTEN DO YOU NEED TO HAVE A 409A VALUATION PERFORMED?
Generally, a company can rely on a 409A valuation for a 12-month period, as long as there are no events or circumstances during that period that would materially affect the valuation of the company.
Unfortunately, there is no definition of what constitutes a material change. Raising a financing round of new equity or debt, M&A activity by the company, or significant changes to a company’s financial outlook are all events that likely indicate a material effect on valuation.
Do the impacts of Covid-19 count as an event or circumstance that would cause a material effect on valuation? While dependent on the facts and circumstances, it is likely for most companies the current environment has caused a material effect on valuation.
If this is the case and you plan to issue stock options to employees in the near term, you will likely need to have a current 409A valuation performed, even if you had a 409A valuation performed within the past 12 months.
CAN WE RESTATE THE STRIKE PRICE OF PREVIOUSLY ISSUED OPTIONS?
As mentioned above, companies issue stock options to incentivize management or employees and align their interests with those of the shareholders. When values decline sharply and the current fair market value of the stock is below the strike price of previously issued options, the employees’ outstanding stock options become “underwater”. Underwater stock options have several negative consequences, namely a failure to provide their intended incentive, motivational, and retentive benefits. In addition, they likely have caused a company to take accounting charges for equity awards that are not providing value.
Common methods to handle this include repricing the option or an option exchange. Repricing involves lowering the exercise of the previous option to no lower than the new fair market value price. In an option exchange, the company offers to exchange the previous options for new options with a strike price equal to current fair market value or higher. In either scenario, a 409A valuation will need to be performed to determine current fair market value and set the price of the options.
Companies should consult their tax advisors or legal counsel whenever they are considering an option repricing or exchange, as there are many aspects to consider. However, these events do not generally create tax implications to the participant, especially if the options are Non-Qualified Options.
Intrinsic can help you navigate the valuation process and provide you with a comprehensive analysis to assist in issuing employee stock options or restricted stock. Providing equity compensation can help you retain employees and conserve cash in these uncertain times. Retaining a qualified and independent valuation firm helps ensure the 409A valuation work is defensible and the safe harbor applies.
For a discussion on the above and how COVID-19 may impact your 409A valuation, please reach out to me or any of our valuation team members.
// ABOUT THE AUTHOR
Brad serves as a Managing Director and head of Intrinsic’s Tax and Family Office practice. He leads the firm’s activities regarding tax valuation technical issues and resolution, as well as interactions with professional and industry associations. In addition, Brad fosters relationships with family offices, supporting their various needs from gift and estate, tax, and financial reporting matters to providing expertise in scenario analysis and financial modeling. His areas of expertise include the valuation of business enterprises, debt and equity securities, and options and warrants for purposes of financial and tax reporting, mergers and acquisitions planning, reorganizations and restructurings, employee stock ownership plans, minority-interest buyouts, stockholder litigation, and other matters. Brad has presented testimony as an expert witness on valuation matters for various district courts in Colorado, Wyoming, and Florida. He is experienced in valuing companies at all stages of their life cycle, from very early-stage startups to established global companies. Brad is an active member of the Association for Corporate Growth and a Chapter Leader for the Rocky Mountain Chapter of the Alliance of Merger & Acquisition Advisors
Prior to joining Intrinsic, Brad spent over seven years at Karsh Consulting, an accounting and consulting firm, where he concentrated on business valuations for litigation and gift and estate tax purposes. Prior to Karsh, Brad spent time at industry-leading firms Arthur Andersen and the Citigroup Private Bank. In these capacities, Brad advised clients on wide-ranging matters including valuation, investments, tax, and accounting.