Determining the correct FMV of private company stock when stock options are granted.

• Author: Adkins, G. Edgar, Jr.
• Position: Fair market value

When a stock option is granted to an employee, great care must be taken to ensure that the exercise price is equal to or greater than the stock's fair market value (FMV) on the option's grant date. If the exercise price is lower than the FMV, resulting in a "discounted" option, the option is subject to the Sec. 409A rules for nonqualified deferred compensation plans.

This produces an undesirable result for an option because in order to comply with these rules, the option may be exercised only upon a change in control, separation from service, disability, death, an unforeseeable emergency, or a specified fixed date in the future (Sec. 409A(a)(2)(A)). The decision as to which event will trigger the exercise must be made when the option is granted. Moreover, if any errors are made in fully complying with Sec. 409A, the employee will be subject to a 20% additional tax, over and above regular income tax, on the option's value. Thus, in order for the option to be exercised in the normal fashion of an option (i.e., the option can be exercised at any time in the future, at the discretion of the employee), great care should be taken to ensure that the option is not a discounted option.

The correct determination of a stock's FMV is a particular challenge for private companies because there generally is no market for the stock. Fortunately, the regulations under Sec. 409A provide guidance for determining the stock's FMV. The regulations set forth factors that must be taken into account in determining FMV, including the value of assets (both tangible and intangible), the present value of anticipated future cashflows, the market value of stock or equity interests in similar corporations, or equity interests in similar corporations or other entities engaged in substantially similar trades or businesses (Regs. Sec. 1.409A-l(b)(5)(iv)(B)(1)). In addition, the valuation may reflect control premiums or discounts for lack of marketability. The valuation may be used for up to 12 months, but it must be updated to reflect information that materially affects the corporation's value, such as the resolution of litigation or the issuance of a patent.

The regulations also provide safe-harbor valuation methods. When one of these safe harbors is used in lieu of the general valuation approach describe above, the valuation is presumed to be reasonable. The IRS may rebut the presumption only if the valuation is "grossly unreasonable."

There are three safe-harbor methods...