How Do I Value My Company To Grant Stock Options?

Company ValuationGuest Post By Marek Omilian, CFA

Startup companies frequently have to confront this issue.  After the founder stock issuances, the company will want to be able to grant stock options to new hires.  Internal Revenue Code Section 409A requires that stock options be granted at fair market value (FMV) to avoid adverse tax consequences.

How to Determine Fair Market Value

The law does not require that companies hire an independent third party appraiser to value their stock, but it may be very helpful to you if you do.  What the law does require is that the valuation be determined by the “reasonable application of a reasonable valuation method.” The regulations state:

Factors to be considered under a reasonable valuation method include, as applicable,

  • the value of tangible and intangible assets of the corporation,
  • the present value of anticipated future cash-flows of the corporation, (i.e. DCF method)
  • the market value of stock or equity interests in similar corporations and other entities engaged in trades or businesses substantially similar to those engaged in by the corporation the stock of which is to be valued, (i.e. Comparable publicly traded companies method)
  • the value of which can be readily determined through nondiscretionary, objective means (such as through trading prices on an established securities market or an amount paid in an arm’s length private transaction),
  • recent arm’s length transactions involving the sale or transfer of such stock or equity interests, and
  • other relevant factors such as control premiums or discounts for lack of marketability and whether the valuation method is used for other purposes that have a material economic effect on the service recipient, its stockholders, or its creditors.

One should attempt use all of the above recommendations before making final conclusion. One should also reconcile different indications of value. FMV of common stock does not equal value of preferred stock in the latest round of financing or post-money valuation from the latest round. In fact, FMV of the common stock will always be lower than preferred stock because of liquidation preference given to preferred.

AICPA Practice Aid

“Valuation of Privately-Held Company Equity Securities Issued as Compensation – Accounting and Valuation Guide” commonly referred to as the “Practice Aid,” provides guidance on determining the fair market value of common stock for financial reporting requirements outlined in ASC 718 (old SFAS 123R). The same valuation satisfies the IRC 409a requirement. The Practice Aid is used by all qualified valuation professionals (hint: ask potential service provider if they follow the AICPA Practice Aid to avoid problems down the road when IRS or the auditor reviews the valuation).

In order to come up with fair market value of common equity to establish option strike price the valuation expert has to follow a two-step process:

  1. Determine Business Enterprise Value (BEV) – this is done by using discounted cash flow methodology and/or comparable transaction and/or comparable publicly traded companies approaches. Most of us are somewhat familiar with these approaches as they are the same used for any other business valuation.
  2. Allocate BEV to all of its invested capital: debt, preferred and common equity. This has to be done very carefully, as it needs to reflect all of the preference and priorities given to various classes of preferred stock. This part could be highly technical as, the leading value allocation method between preferred and common is the Option Pricing Method and involves series of option valuations.

One of the new techniques introduced in the revised Practice Aid is the concept of using the latest round of funding to “back-solve” for values of the company and its preferred and common securities. See this post for more info on using the “back-solve” approach.

marek-omilian-150x150Marek Omilian, CFA, Managing Director, Value Prism Consulting – Marek manages the delivery of valuation and decision support analysis.  He has 20+ years of consulting and line management experience working with companies in such areas as: valuations; business case and ROI analysis; decision support analysis; shareholder value enhancement analysis; mergers, acquisitions and divestitures; synergy identification and capture in a post-merger business integration. Office: 206.262.5695 or cell: 404.307.8194. momilian@valueprism.com, www.valueprism.com

European Data Protection Issues No Business Can Ignore

European Data ProtectionGuest Post By Felicity Fisher – Associate – Osborne Clarke

Doing business in Europe invariably means collecting data relating to EU citizens. This means your business will need to comply with the European data protection regime, even if you don’t have any kind of formal EU establishment.

Here are some of the key European data protection issues you should be thinking about:

  1. Transfers of data outside of the EU (including to the US) are prohibited unless you have a European compliant international transfer solution in place. For most US companies, this means getting Safe Harbor certified but there are other options to consider.
  1. The rules across the 28 member states of the EU vary, so a “one-size-fits” all approach to European data compliance will not generally work. A strategic approach to formal establishment within the EU can help to reduce the compliance burden.
  1. US privacy policies and practices do not normally go far enough and will not generally work in Europe. You should localise your US centric policies and procedures for compliance with European data protection laws.
  1. You may need to register with the local data protection authorities. Failure to notify is a criminal offence. Luckily in most EU member states, the notification process is relatively straightforward so this should be one of the easier issues to tackle.

Why should you care?

The European data protection regime is technically one of the strictest and most comprehensive in the world. Failure to comply means you risk not only regulatory scrutiny and fines (which are set to increase to up to 2 % of a company’s worldwide turnover for severe breaches), but also a potential PR disaster as European consumers are particularly privacy conscious.

Of course, we recognise that technical and resource constraints mean that a putting in place a fully compliant approach may not (at least initially) be possible, particularly if this is your first voyage into the European market!

However, if you’re ultimately looking to win the hearts and minds of European customers, data protection compliance should be right up there on your to-do list. The earlier you can start factoring in privacy to the design of your business processes and terms, the better.

Getting advice from a European data protection professional is a good starting point. If they’re worth their salt – they will be able to help you pragmatically navigate the compliance challenges and reduce some of the compliance burden.

Felicity FisherFelicity Fisher specializes in technology transactions and regulatory matters. She works predominantly with digital business sector, advising on commercial agreements, technology licensing and procurement, cloud services, outsourcing, e-commerce issues as well as privacy and consumer regulatory matters.

Stock Bonuses Ought Not Be Taxable

You would think that stock bonuses to employees would be encouraged as good for societal and worker welfare.

However, this is sadly not the case.

The Tax Problem with Stock Bonuses to Employees

Here is the problem with employers paying stock bonuses to employees:

  • Stock bonuses are taxable just like cash compensation, despite the fact that the stock may be stock in a private company and not salable.
  • Both income and employment taxes apply to employee stock bonuses.
  • To receive a stock bonus, unless the employer is going to pay the employee’s taxes (an unusual event) employees actually have to write checks to their employers so that their employers can satisfy the employee’s share of and employment tax withholding.
  • The amount of income and employment taxes applicable to stock bonuses can be so significant that most employees would rather forego the award rather than pay the tax.
  • This adverse tax treatment of employee stock bonuses results in employers resorting to stock options rather than stock bonuses.
  • Stock options are less favorable than stock bonuses for a number of reasons, including, among other things: (i) stock options have to exercised in order for the stock to be issued to the employee; (ii) taxes may be due on exercise; (iii) the taxes due on exercise may be so significant as to dissuade the employee from exercising in full; and (iv) stock options ultimately expire.

Public Policy Recommendations

Here is what Congress should do:

  • Repeal the taxation of transfers of private company stock to company workers.
  • This will allow companies to more readily share equity with workers, which will increase worker and ultimately societal welfare.

When Should I Sell My Vested Equity Compensation?

Vested Equity Compensation

Guest Post by Jordan Taylor, CPA/PFP – Co-Founder of VestBoard 

As the overall economy has continued to build positive momentum over the last few years, the IPO market has exploded, culminating in over $85 billion raised in 2014. With the recent surge, employees of these growing companies stand to capture the upside. The many varieties of equity compensation structures available to both C-level executives and key employees offer immense opportunities for planning and strategy around minimizing tax liabilities on an annual basis.

One common form of equity compensation is Restricted Stock Units (RSU’s), which are typically subject to a vesting schedule. A key component is the fact that they become compensation to the holder at the full market value (FMV) of the units that vested on that date. The employer will also sell certain shares to make withholding tax payments on behalf of the employee, which is reported on the W-2.

As mentioned above, employees of companies who have recently gone public–or are close to an IPO–stand to have significant wealth added to their bottom line. However, when tied to a wildly fluctuating stock price, it can be a bit unnerving.

Twitter is a good example. The company debuted on the New York Stock Exchange on November 7th, 2013 at $26 per share. After a monumental first trading day, it closed at $44.90. Fast-forward to 2014 and in less than seven months, the stock price went from a high of $74 to trading as low as $29 a share.

Imagine you worked for Twitter and had 100,000 shares as part of their compensation. Now picture the value of your portfolio falling from $7.4 million to $2.9 million in less than 7 months. If faced with a similar scenario it would certainly have me thinking about running for the exits (selling off all my shares). But before you consider doing that, keep in mind that it is also important to understand that blackout periods are common among companies. Blackout periods force employees to only have access to sell shares at various time periods (typically quarterly). Picture this: You may find yourself watching the stock price plunge to historic lows and not be able to do anything about it.

After reading the scenario above, it’s important to consider a few things related to RSUs:

  1. What is my cash situation?  – Depending on where your income has been historically and how much you are receiving in stock you would find yourself pay taxes at the top rates (39.6% Federal and 0-13% in your state). It is important to understand where your projected tax will fall so you can consider it for planning purposes.
  1. Do I hold for future long-term capital gains (LTCG)? – Your holding period starts when the stock vests, which means you would need to hold the stock for one-year to achieve LTCG treatment on any additional appreciation and if you have a crystal ball on where the stock will be in twelve months (or you have unbridled devotion to your employer) you may want to hold everything. If you received Apple stock or Amazon stock when they went to IPO years ago and never touched or sold everything, you would be doing just fine.
  1. Do I sell? – The benefit to selling immediately at vest is that you avoid any capital gains or losses, as your basis is the FMV on vest date and in most cases, the stock price hasn’t fluctuated significantly. You then have the cash available to either diversify or spend all of the money on toys, cars and fine art. All joking aside, it gives you flexibility and to leverage against having all of your eggs in one basket and to begin planning around a long-term strategy.

When faced with decisions regarding your equity compensation, make sure you consider the tax implications of holding/selling shares. It may be a one-time opportunity that you have to create lasting wealth for your retirement. Choose wisely!