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Two accounting and regulatory developments which are having significant effect on private companies who grant stock based awards to employees are the Financial Accounting Standards Board’s pronouncement SFAS 123R Share Based Payment and the Internal Revenue Code section 409A. Although the FASB statement is directed toward financial reporting considerations and section 409A relates to federal income tax, both require companies to estimate the fair market value of their common stock -- which can be especially challenging for private companies.

The FASB issued SFAS 123R in 2004, which requires companies to begin expensing, based on the grant date fair value, stock options granted to employees. Privately held companies are required to adopt this guidance on a prospective basis for fiscal years beginning after Dec.15, 2005, which means that calendar year private companies will need to adopt this pronouncement for their Dec.31, 2006 financial statements.

Included in the pronouncement is the requirement that companies use a valuation model to determine fair value of an award and guidance in the selection of assumptions for the valuation model. Among the assumptions that most valuation models require are the fair market value of the company’s underlying common stock on the date of grant and the estimated volatility of the company’s common stock. Privately held companies, in particular, will find it much more challenging to determine these assumptions given that there is no active market for their stock from which a fair market value or volatility may be derived. As such, the new guidance requires that private companies calculate a volatility based on publicly traded companies that are within the same industry (calculated value), and that the fair market value of a company’s stock be estimated by management on the date of grant. The guidance does not provide any specific method for estimating the fair market value of the company’s common stock but a few of the more common approaches used include the following:

1. Recent sales of common stock to an unrelated party;
2. Recent sales of preferred stock to an unrelated party (with consideration given to differences in rights and preferences between common and preferred stock);
3. Valuation by an independent third party appraiser;
4. Internally prepared valuation analysis, using projected discounted cash flows for example;

Companies should consider the strengths and weaknesses of each approach in valuing their common stock. Generally, sales to an unrelated party provide the best estimate of fair market value since it represents an arms length transaction. Sales of preferred stock to an unrelated party also provides a good indication of fair value, but assigning value to rights and preferences in order to reconcile the fair value of the preferred to the fair value of the common can be difficult. A valuation performed by a third party is viewed as objective and is typically based on sound economic theory. Whereas performing an internal analysis of fair value is typically deemed to be the least objective of the alternatives and depending on the financial expertise of the person performing the analysis, may or may not adhere to generally accepted valuation techniques.

Also in 2004, Congress passed the American Jobs Creation Act, implementing sweeping changes to the tax code, including significant provisions impacting executive compensation and employee benefits. Central to this tax legislation was the creation of code Section 409A, which is expected to be finalized in early 2007.

Parts of 409A apply to nonstatutory stock options and stock appreciation rights, granted at less than fair market value on the date of grant and unvested after Dec. 31, 2004. It also applies to vested stock options that are materially modified after Oct. 3, 2004. If such a stock option or stock appreciation right is granted at less than fair market value on the date of grant (or is materially modified at the time when the exercise price is less than the current fair market value), 409A imposes severe tax consequences upon the employee/ service provider which requires income recognition at ordinary income rates plus a 20 percent penalty tax on the amount of ordinary income recognized.

In response to concerns raised by privately held companies that further guidance was needed for providing methods to determine fair market value, the proposed regulations provided that fair market value could be determined by the "reasonable application of a reasonable valuation method." The proposed regulations set forth certain factors to consider when determining a reasonable valuation method. More usefully, the proposed regulations provided three "safe harbors," two of which are particularly relevant for privately held companies. Those proposed methods include:

1. Valuation by an independent third party appraiser and;
2. Valuation using a written report of an internal expert where the
company is an illiquid start-up corporation.

If one of the safe harbors is consistently used, it provides a presumption that the fair market value of the stock underlying the option is reasonable and places on the IRS the burden to demonstrate that the determination of fair market value or its application was "grossly unreasonable."

Section 409A clearly prescribes more narrow guidance of what would be presumed an acceptable approach to estimating fair market value of common stock than SFAS 123R. As a result, companies should consider using the approach outlined in section 409A in complying with both the tax regulations and SFAS 123R. Although 409A and SFAS 123R each have different objectives, companies will want to be consistent in their estimate of fair value for both, so as to not call into question the accuracy of the company's estimate.

Accordingly, if a company is not a start-up, it should seriously consider obtaining an independent valuation of its common stock. Although more costly than performing the evaluation internally, or pegging the value to recent sales of common or preferred stock, the chances of being acceptable to the IRS are much greater.

Companies should also consult with their accountants and attorneys to ensure that they are complying with all provisions of both SFAS No. 123R and Code Section 409A.