Stock Option Valuation: How Hard Have They Made It?

Gary Levine - In a recent issue of the popular newsletter Softletter, Edward Pratesi, CPA of Brentmore Advisors, LLC, does an outstanding job in the article entitled: “Valuing Options While Running the Compliance Gauntlet” explaining the complicated interplay between FAS 123R and Sec. 409A in the context of determining the fair market value for privately-held companies of the common stock underlying an employee stock option. This is a critical input for qualified stock options where the option must be issued with a strike price equal to fair market value on the date of grant to comply with IRS Sec. 422 and can’t be issued at a discount if you want to avoid the penalties under Sec. 409A.

Pratesi explains the background behind both 123R and 409A and then articulates the valuation standards under each section and how they differ. As he articulates it:

It is important to note again the difference between FASB 123R and IRC Section 409A as they appear to be similar but approach the valuation of options and securities from different perspectives. FASB 123R concerns stock option valuations for financial reporting purposes and is measured using the issuing company’s perspective … IRC 409A is concerned with the issuance of stock based compensation … The objective is to ensure that the securities being granted … are granted at fair market value … Under either regimen, the value of the underlying security – the common stock – is critical in determining the value of the stock option.

He later explains that the inherent difference is that FAS 123R uses a “fair value” standard and looks to the AICPA practice aid “Valuation of Privately-Held Company Equity Securities Issued as Compensation.” Sec. 409A uses a “fair market value” standard and offers three safe harbors for valuation: a) the binding formula presumption; b) the independent appraisal presumption; and c) the illiquid start-up presumption. If the valuation satisfies one of these safe-harbor presumptions, then it is assumed to be “reasonable” for 409A purposes and the burden shifts to the IRS to prove that the valuation was not “a reasonable application of a reasonable valuation method.”

In the latter part of the two part article, the author offers a set of questions and answers that many companies will come across as they deal with valuation for the first time. A few of the highlights are:

Question: Which one of the above standards will impact us the most?

Answer: Since most privately-held technology based companies will be issuing stock options (and in many cases more than once a year), anticipate that a valuation of the underlying stock will be needed to meet IRS standards first and the financial reporting requirements under 123R second.

Question: If both the FASB and IRS require that our privately-held company be valued, can we have one valuation report prepared to meet both standards?

Answer: Maybe.

I have read dozens of articles on this issue over the past one to two years and strongly feel that for the CFO or stock plan administrator who is not a valuation expert, but needs to know just enough to be able to talk intelligently when considering the various options for common stock valuation in the context of equity compensation reporting, this article is a diamond in the rough and for that reason appreciate the publisher of Softletter making this article available to the public.

Gary D. Levine, President and CEO
Two Step Software, Inc.

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