Mitchell Law Firm has discussed Fair Market Value in different aspects such as The Need for Fair Market Value Determination and The Fair Market Value Safe Harbor. This week, the discussion continues focusing on equity incentive awards.
Equity incentive awards such as stock options and restricted stock awards provide opportunities for Founders and early-stage companies to attract and retain key employees and other service providers, align the interests of these parties with the Company, and promote the long-term success of the Company.
Because the tax code states that when a company gives an employee or contractor something of value, the value of the item is likely to the recipient, the actual grant of equity by the Company may create a taxable event to the individual receiving the equity grant. To comply with IRS regulations and achieve maximum tax benefits for recipients, equity incentive awards must be issued by the Company at fair market value (FMV). Early-stage companies often find determining the FMV of their stock a complex and challenging question, however due to their limited operating history and lack of resources to pay for a more formal valuation. The IRS regulations (§ 26 CFR 1.409A-1(iv)) outline a process for determining the FMV of stock issued in connection with option awards. In general, the regulations require that FMV be “determined by the reasonable application of a reasonable valuation method.” The IRS regulations provide three safe harbor methods that carry a presumption of reasonableness. For practical considerations however, the safe harbor methods may be cost-prohibitive or otherwise impractical for start-up companies.
Companies that cannot rely on the safe harbor methods must instead determine the FMV of their stock based upon a reasonable application of the facts and circumstances on the valuation date and considering all available information.
The regulations include several factors the company may consider in determining the FMV, including, but not limited to:
- The value of tangible and intangible assets of the company;
- The present value of anticipated future cash-flows of the company;
- The market value of stock or equity interest in similar companies engaged in similar trades or businesses;
- Recent arm’s length transactions involving the sale or transfer or the company’s stock or equity interests;
- Control premiums or discounts for lack of marketability;
- The start-up nature of the company and its limited operating history;
- The uncertainty of potential business prospects; and,
- The current state of the Company’s operations.
Determining the FMV is a critical step in the equity process. By reasonably applying the factors outlined above, a Company that otherwise cannot afford to satisfy the 3 safe harbor tests (conducting an outside appraisal, use of a valuation formula, or preparation of an outside written report), can nevertheless have confidence that their determination of the FMV for equity incentive awards will be considered reasonable and withstand any potential IRS scrutiny.
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