January 23, 2008 A 2008 reflection on 409a
With the implementation of 409a over the past several years, we have seen and heard it all. Frustrated, mad and confused executives, auditor/client disagreements, auditor/valuation firm disagreements; however, there are a large portion of companies that handle 409a compliance with ease- minimal time and minimal stress. Knowing that the regulations will be enforced by the end of the year, we reflected back over the 200+ 409a valuations we have done over the past several years to comment on what works (and doesn't work). Here's some thoughts on how to make 409a compliance less time consuming, stressful and costly:
· Assemble a team and get them on the same page- early. As you pick your valuation firm, have a pow-wow with your auditor (and even legal counsel) to set the standards and expectations. Most reputable valuation firms prefer to talk to your auditor before the project begins (and sometimes even before the contract is signed). Buyoff on the front end helps control back end fees and headaches.
January 31, 2007 The SEC Agrees with the Market
Brought to light in yesterdays WSJ, The Securities and Exchange Commission for the first time has blessed a method for valuing employee stock options derived from market prices rather than academic models.
Since the institution of FAS 123R, a big problem has traditionally centered around the fact that employee stock options do not resemble those that are publicly traded on common option exchanges. Most significantly, the term of the employee options may be as long as 10 years. A common flaw in the Black Scholes model is that it is best for "short-term" options, usually 1 month to less than 1 year,
like those that are publicly traded. The flaw resulted in overstated option values, which to any company's chagrin, resulted in lower reported earnings.
Last year, Zions Bancorp (ZION) addressed the problem by creating securities that mirror the stock options granted to its employees. The company then sold the securities to sophisticated investors in a public auction, deriving a market value for the options from the bidding. The buyers paid about one half the amount indicated by the Black Scholes model.
This is good news for all companies facing FAS 123R issues. How auditors interpret this news will be interesting. Many companies already create markets for their options, although they tend to be related party transactions. Now employee option grants just have to include a public auction to institutional investors. This may be a big task for the smaller cap companies, who by the way, tend to be the largest issuers of employee stock options.
January 19, 2007 Thoughts on the PWERM
This week I was in Seattle and met with the valuation group of a large accounting firm. The subject of 409A arose as it often does because of its huge impact in the valuation community. Our discussion moved to valuation approaches and we actually agreed that the Probability Expected Return Method ("PWERM") was the best approach to 409A for emerging technology companies with complex capital structures. I know you wish that you could have been in the room for such a riveting discussion. We actually talked about other crazy stuff as well, the weather, commuting, sports...
Actually a sense of relief crossed my accounting firm counterpart's face as I went into my reasoning for PWERM and he mentioned that most of the reports he reviews use the Option Pricing Model ("OPM"). We agreed that OPM can be a great solution for late stage companies, but is very difficult to scale. The option pricing model treats the value of the common stock like an option and employs the Black Scholes model, which is dependent on a volatility measure. In the end, the outcome is very sensitive to the volatility input and we both agreed that if we worked for the IRS, challenging one input (e.g. the volatility measure) would be a better fact pattern to attack than a more thorough PWERM model. In the long run, OPM is a much easier target...
November 15, 2006 When an IPO is not a homerun...
Quist has done a large number of 409A valuations this year, many of them for early stage, pre-revenue biotech firms. Our analysis, as within all 409A engagements, is heavily based on the projected value of the company at certain exit points. When we sit with management to discuss probable exits, often management estimates the probability of an IPO at 20-50%. Even more surprising is that the majority of management teams characterize an IPO as a "homerun."
November 02, 2006 Future of 409A Becomes a Little Bit Clearer
It appears that we are getting close to final regulations on 409A. For those
interested in the state of 409A regulations and the progress being made by
the Treasury, see the article released yesterday by CCH® PENSION AND BENEFITS -
11/1/06. "409A guidance "well along," says Treasury benefits tax counsel",
http://hr.cch.com/news/pension/110106a.asp. The message appears clear that
1) "the definition of nonqualified deferred compensation is broad, with most
exceptions and carve outs limited in scope" and 2) "the basic structure and
fundamental principles underlying the proposed rules have remained intact
during the comment process". In terms of underwater stock options "the
spread, not just the discount, would be considered as the stock value
increases" and "underwater stock options would not require any reporting
since a violation would take place only if and when an option was
exercised." In other words, "something for the file" will only be exposed if
and when you are successful and the IRS can identify that there are
significant dollars at stake.
October 13, 2006 The Downside of Pushing Back IRC 409A Compliance
Just what the market needs is a little time to sort out unclear rules and to
speculate on which ones might stick. Pushing back compliance of 409A helps
from a tax standpoint on an issue that is quite frankly not much of a tax
issue. While the "potential" tax exposure is "clear as mud" according to the
proposed regulations, the larger issues appear on the audit and transaction
side for companies with significant option plans. On the audit side, key
inputs to calculating the option expense on the income statement under SFAS
123R are the price at which the option is granted and the current strike
price of the stock, both obviously are outputs of the original and current
409A valuations. On the transaction side, the issue remains foggy from a tax
exposure side for both the SEC and a potential acquirer. Pushing back
compliance, I believe actually works against private companies considering a
near term exit. Uncertain rules lead to higher exposure and attention during
the S-1 process from both an accounting and potential tax liability
standpoint, as has been evidenced by the SEC's attention to option pricing
this past year. From an M&A perspective, a poorly priced option plan with
uncertain rules tilts the scale of power to the buyer and may cause sellers
to indemnify an uncertain outcome, which could result in uncertain exposure.
In the end, par for the course as practicality and IRS regulations appear to
be oil and water.
September 18, 2006 The Deep Impact of IRC 409A
Many emerging companies rely on equity compensation as a primary component of their incentive pool for key executives and employees. Near the end of 2005, the proposed section 409A was released. Initial reactions
varied widely as to its impact on private companies and the extent of exposure it actually created. However, IRC 409A extends well beyond a tax issue. In fact, tax exposure is quite possibly third or fourth on the enforcement/exposure list. For What its Worth targets this small segment of IRC 409A and explores how it is effecting board members, companies and most importantly the employees who receive them. While the primary focus will be on the valuation issues that arise for companies with complex capital structures we will explore issues such as the cascading effect on financial reporting as private companies begin to expense stock options. We will also examine issues important to board members such as the potential effect on future rounds of funding for companies raising capital and the reporting requirements of limited and general partners.
