Jump to content

Valuation of Options


Randy Watson

Recommended Posts

I posted this on the nonqualifed deferred compensation board.

As everyone knows statutory stock options under Section 422 are excluded from the reaches of Section 409A. What I'm not so sure about is whether you have to use a 409A valuation method to keep those statutory options out of 409A or whether you can still use the Section 422 regs to value the stock. The following paragraph from the preamble seems to contradict itself:

"Several commentators expressed concerns regarding the determination of the fair market value of the underlying stock. Some commentators requested that the valuation rules applicable to incentive stock options be applied for purposes of the exclusion from section 409A. Under those rules, if the stock option would otherwise fail to be an incentive stock option solely because the exercise price was less than the fair market value of the underlying stock as of the date of grant, generally the option is treated as an incentive stock option if the issuer attempted in good faith to set the exercise price at fair market value. See section 422©(1). The Treasury Department and the IRS believe that this is not the appropriate standard for determining whether stock rights are subject to section 409A. Incentive stock options are subject to strict limitations on the amount of such options that may be granted to a particular employee. See section 422(d). In contrast, there are no such limits applicable to nonstatutory stock options, and grants of nonstatutory stock options often far exceed the limitation applicable to incentive stock options. In addition, section 422©(1) explicitly provides for the good faith standard with respect to incentive stock options, while no such provisions exist within section 409A or its legislative history."

Link to comment
Share on other sites

Both rules apply. Like 457(f)s are subject to two "substantial risk of forfeiture" definitions. All options have to meet 409A FMV or they are dead meat. Also, ISOs have to meet the ISO rules.

So an ISO that is issued below FMV, but continues to satisfy Section 422 because it was valued in good faith will fail to satisfy the 409A exclusion?

Link to comment
Share on other sites

Guest Guest_jpod_*

I listened to presentations by Dan Hogans of Treasury on Wednesday (during the ALI-ABA teleconference) and on Thursday (at the ASPPA mid-atlantic meeting in Philadelphia), and he did not say anything to suggest that "both rules" apply (i.e., options qualifying as 422 or 423 are exempt).

I'm not sure I see how the statements in the preamble are contradictory. The preamble goes to great lengths to cite reasons why a distinction in valuation requirements should be drawn between statutory and non-statutory options (e.g., the statutory $100k limitation and the statutory "good faith" standard).

Link to comment
Share on other sites

Guest Harry O

I think the regulations are fairly clear that if the ISO meets the 422 requirements on the grant date (including the good faith FMV standard) it is exempt from 409A. Of course, subsequent changes to such an option may cause 409A to apply at such later date . . .

Link to comment
Share on other sites

I listened to presentations by Dan Hogans of Treasury on Wednesday (during the ALI-ABA teleconference) and on Thursday (at the ASPPA mid-atlantic meeting in Philadelphia), and he did not say anything to suggest that "both rules" apply (i.e., options qualifying as 422 or 423 are exempt).

I'm not sure I see how the statements in the preamble are contradictory. The preamble goes to great lengths to cite reasons why a distinction in valuation requirements should be drawn between statutory and non-statutory options (e.g., the statutory $100k limitation and the statutory "good faith" standard).

My confusion stems from the commentators' question about whether the "valuation rules applicable to incentive stock options be applied for purposes of the exclusion from section 409A." As you know, the IRS/Treasury said no, those rules are inappropriate. Is the commentator asking whether you can apply the good faith valuation rules under 422 for purposes of the 422 exclusion or the general exclusion for other stock rights?

Link to comment
Share on other sites

Randy,

I read the commentator to be asking whether the "good faith" ISO standard could be extended / applied to general (non-ISO) valuations as well and assumed that only the ISO "good faith" rule would apply to ISOs even after 409A.

I too have not heard anybody actually suggest that both standards apply to ISOs; however, I wouldn't want to be the one to really try and convince the Service that there was a "good faith" effort to value an ISO if that effort would clearly fail the 409A requirements.

Link to comment
Share on other sites

Both rules apply. Like 457(f)s are subject to two "substantial risk of forfeiture" definitions. All options have to meet 409A FMV or they are dead meat. Also, ISOs have to meet the ISO rules.

I changed my mind. ISOs should be exempt from 409A. Only the ISO valuation rules should apply, BUT . . .

aren't there several situations where ISOs can become NQSOs, such as exceeding the 100K first exercise rule or exercising more that 3 months after termination of employment. If you are going to issue ISOs without following the 409A valuation rules, you better make sure there is NO POSSIBILITY of any ISOs turning into NQSOs.

Agree??

Link to comment
Share on other sites

Both rules apply. Like 457(f)s are subject to two "substantial risk of forfeiture" definitions. All options have to meet 409A FMV or they are dead meat. Also, ISOs have to meet the ISO rules.

I changed my mind. ISOs should be exempt from 409A. Only the ISO valuation rules should apply, BUT . . .

aren't there several situations where ISOs can become NQSOs, such as exceeding the 100K first exercise rule or exercising more that 3 months after termination of employment. If you are going to issue ISOs without following the 409A valuation rules, you better make sure there is NO POSSIBILITY of any ISOs turning into NQSOs.

Agree??

You're not allowed to change your mind.

Link to comment
Share on other sites

ISOs are specifically exempt from 409A, so for ISOs you're looking entirely to 422 and the regs there which allow a reasonable good faith effort.

What has been brought into issue by the 409A regs is whether your ISO method of valuation will be considered a reasonable good faith effort. In the past Boards may have just used a rule of thumb, like 10% of the preferred price, for the exercise price of ISOs, or 1 cent a share. Now, the Board may want to be more deliberate and take into account the 409A guidance from the IRS. Also if a valuation is done for the underlying stock of the nonqualified stock options, it would be difficult to argue with that as being a reasonable valuation.

Link to comment
Share on other sites

Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account in our community. It's easy!

Register a new account

Sign in

Already have an account? Sign in here.

Sign In Now
×
×
  • Create New...