CUSTOMatrix™ Insights Newsletter

Valuing Restricted Stock and Stock Options

Cheryl Bostater, Principal, Financial Services, CUSTOMatrix, Inc.

Issuances of restricted stock and stock options just became even more hazardous with the new Internal Revenue Code 409A just finalized by the IRS……. It has long been the case that issuances of stock to management, employees, or board members would be taxed at fair market value if issued as compensation, and options issued at a strike price below fair market value are also subject to tax. In the past, rules of thumb were used to say that the preferred stock was worth 10 times the value of the common or some other estimate was used to determine the value of common stock. This is no longer acceptable to the IRS or the auditors, and a large unexpected tax liability may result. IRC 409A has strict requirements for valuation of stock in privately-held companies to determine the taxes due. In most cases, the common stock received as compensation or purchased is for privately-held companies where there is no market for the stock and no ability to sell the stock to pay for the taxes due on the receipt of the stock. Even for publicly-held companies, if the stock is restricted per Rule 144 or if the stock is thinly-traded, liquidation of the stock can be difficult or impossible.

A client of our recently ran into a large 409A valuation issue, resulting in a potential tax liability of millions of dollars to the management team. A business unit of a large company was purchased by preferred stock investors at the request of the management team for that unit. The preferred stock investors were successful in buying the company. A few months later, management purchased common shares in the company for a low stock price. At the time, the business unit had never shown a profit and it was unclear if management’s common stock purchase would ever be worth anything. The preferred shareholders had typical rights including a preferred stock dividend (that would be paid before common shareholders could receive any dividends) and liquidation preferences.

Approximately a year later, about the time IRC 409A was approved, the company was being audited. The auditors demanded to see the business valuation done at the time the restricted common stock was purchased by management in order to determine if the stock was issued below fair market value (and if compensation expense must be booked in addition to a tax liability). A valuation had not been done at the time, and thus management engaged a valuation firm to conduct the valuation after the fact. The valuation firm concluded a value per share of the common stock that was much higher than management paid for it. Thus, management was potentially going to have to pay a huge tax on the purchase of the common shares. Since it was a closely-held company and there was no market for minority shares, management had no ability to sell the shares to pay the taxes. Thus the only remedies that management would have is to ask the board of directors and shareholders for additional compensation, or work out a payment plan with the IRS to pay the tax.

CUSTOMatrix reviewed the facts with management and came to the following conclusions:

That there is typically a large differential in value between preferred stock and common stock, and that this valuation differential could be larger than the traditional rules of thumb would suggest.
Since the purchase price of the company by the preferred shareholders was at fair market value and no additional value was created by the company in the short time between the purchase of the company and the purchase of the common shares, the common shares may in fact have had very little value at the time of purchase.
The valuation methodology used for FAS123R purposes was not based on “fair market value” (similar to an ESOP valuation), yet instead was based on “fair value” as determined by FASB, and thus would not be acceptable to the IRS for IRC 409A purposes.

Management and board members are strongly advised to hire a reputable valuation firm anytime shares or options are issued to, or anytime shares are purchased by, management, employees, or board members. Since these transactions are not arm’s length, they will be heavily scrutinized by the IRS.

For additional newsletter articles go to:

CUSTOMatrix™ Insights Newsletter