Equity compensation is attractive to employees and employers alike.  Because the opportunity to participate in the growth of a company provides potentially unlimited compensation to employees, its incentive value is quite powerful to employers.   In this last post in this series on Section 409A, we will sort through the types of equity compensation that are and are not subject to Section 409A and focus, in particular, on the importance of proper equity valuation as a key step in Section 409A compliance.

First, the good news!  Treasury Regulations provide that restricted stock is not subject to Section 409A.   However, while this fact may result in a lower Section 409A compliance burden for employers, a grant of restricted stock is a “full value” award; the recipient of an award of restricted stock will, upon vesting of the award, be entitled to the full value of a share of the employer’s stock.

Contrast this with other types of stock rights that are “appreciation” awards, such as stock options and stock appreciation rights.  These awards provide only the increase in value of a share of stock from the date of grant through the exercise or settlement date.    Here, the employee is not given the benefit of the preexisting value of the company at the time of the award.  From the perspective of a closely-held business owner, this may be a more sensible approach to incentivizing key employees while not excessively diluting their ownership.

These types of appreciation awards are subject to Section 409A, unless certain additional requirements are met.

Stock Rights – Nonqualified Stock Options and Stock Appreciation Rights

A nonqualified stock option (“NQSO”) provides the recipient with the right to purchase shares of company stock for a stated exercise price upon exercise of the vested NQSO.   In effect, the grant of an NQSO provides the recipient with an amount of compensation equal to the increase in value of the company’s stock from the date of grant through its exercise date (i.e., the “spread” of the NQSO).  A stock appreciation right (“SAR”), like an NQSO, provides the recipient with an amount of compensation equal to the increase in value of the company’s stock from the date of grant through the settlement date, when payment is made.  Unlike an NQSO, however, no exercise price is paid in connection with this award; it is simply settled by the company through delivery of an amount of cash, or a number of shares of stock with a fair market value, in each case, equal to the spread.

An NQSO or SAR will be subject to Section 409A (i.e., may only be exercised/settled upon a permissible Section 409A payment event) unless it satisfies each of the following requirements:

The shares covered by the NQSO/SAR qualify as shares of “service recipient stock” (defined, generally, as common stock of the entity for which the award recipient is performing services, or another corporation within the same controlled group);

  • The exercise price of the NQSO/SAR is equal to or greater than the fair market value of the underlying shares on the date of grant;
  • The NQSO/SAR covers a fixed number of shares as of the date of grant; and
  • The NQSO/SAR does not provide for the deferral of compensation past the exercise/settlement date.

If each of the above requirements is met, a NQSO and/or SAR will be exempt from Section 409A.

One issue to keep an eye on is the right to receive dividends or dividend equivalents with respect to an NQSO/SAR, as this may cause an otherwise excludible stock right to become subject to Section 409A.  The Treasury Regulations provide that the right to receive dividends or dividend equivalents upon exercise/settlement of an NQSO/SAR will be treated as an indirect reduction in the exercise price of the award, which would result in a stock right with an exercise price below the fair market value of the stock on the date of grant.  In order to steer clear of this inadvertent exercise price reduction, the right to receive dividends must not be contingent upon the exercise of the stock right but, rather, should be drafted to comply with Section 409A as a separate deferred compensation arrangement.

Fair Market Value – The Importance of Proper Valuation

A stock right need not be drafted to be exempt from Section 409A but, in reality, the grant of an NQSO or SAR that is only exercisable upon a Section 409A permissible event, and which must be exercised on the first such enumerated event to occur, is far less attractive to a key employee who would like the opportunity to monetize their award freely once vested.   In this respect, proper pricing of a stock right on the date of grant is crucial to delivering a freely exercisable stock right because, as stated above, only stock rights with exercise prices at or above the fair market value of the underlying stock will be eligible for exemption from the requirements of Section 409A.

The importance of this valuation is not to be taken lightly.  Awarding a key employee with a stock right that is not designed to comply with Section 409A, relying on the mistaken belief that it was exempt from Section 409A, will result in a twenty percent (20%) penalty on the amount of the spread, as well as inclusion of the spread in the employee’s income as of the date that the award vests, whether or not the award is ever actually exercised/settled.

Treasury Regulations require that a private company use a “reasonable application of a reasonable valuation method” in determining the fair market value of its stock for purposes of Section 409A.  Whether a valuation method is deemed reasonable by the IRS will depend on the facts and circumstances, but, in order to be considered reasonable, the method employed must take into consideration all material information available at the time of the determination.  Certain factors that may be appropriately factored into this analysis are mentioned in the Treasury Regulations, including recent arm’s length transactions, control premiums, discounts for lack of marketability and the value of tangible and intangible assets.

For those looking for certainty, the Treasury Regulations provide that an independent appraisal calculated no more than twelve months period to the date of the award can be used as a safe harbor, provided all available information material to the company’s valuation has been taken into consideration (i.e., a material change in the business would invalidate a prior independent appraisal conducted in that same year).

Another safe harbor, which does not require an independent appraiser, applies solely to illiquid start-up companies.  Such companies may safely rely on an internal valuation that is made reasonably and in good faith, provided it is (i) prepared by a person experienced and knowledgeable in the company’s line of business, (ii) evidenced by a written report, and (iii) takes into account relevant valuation factors.  For this purpose, Section 409A defines an illiquid start-up company as a company:

  • that has been conducting business for less than ten years;
  • that does not have a class of securities that are traded on an established securities market;
  • that does not reasonably anticipate that it will be acquired within 90 days or will be publicly traded within 180 days; and
  • the common stock of which is not subject to put or call rights or other obligations to purchase such stock (other than a right of first refusal or a “lapse restriction,” such as the right of the company to repurchase unvested stock held by the employee at its original cost).

Many closely-held businesses may fit within this definition of an illiquid start-up company and will be able to provide their employees with stock rights priced in reliance on a safe harbor valuation without incurring the expense of an independent appraisal.   On the other hand, valuation of a start-up is a complicated endeavor and should be undertaken with care, particularly if there is an expectation of providing stock rights that will not be subject to Section 409A.  It may well be worth the time and expense involved in securing an independent appraisal to provide a greater level of certainty with respect to Section 409A compliance.

Modification or Extension of Stock Rights

Modifications and/or extensions of a stock right may also subject an otherwise excludible award to Section 409A.   Generally speaking, a change in the terms of a stock right is treated as a new grant, which may or may not constitute a deferral of compensation based on the facts and circumstances as of the new deemed grant date.    Once a stock right is designed to be exempt from Section 409A, caution should be exercised with respect to making material modifications to that award.