Stock Option Valuation
Many individuals and companies choose to invest in stocks, and stock options are one form of this type of investment. Stock option valuation is heavily regulated with severe legal and financial penalties for failure to perform or performing improper valuation. It is important for a company to retain a qualified appraiser with experience in valuing options.
Employer and Employees – Win, Win
Stock options are a way to give employees an incentive to work harder to ensure the company succeeds. Stock options give key employees the opportunity to benefit from the increase in the company’s value by granting them the right to buy stock at a future point in time at a price (i.e., the “exercise” or “strike” price) generally equal to the fair market value of such stock at the time of the grant. As milestones and objectives are met by the company (e.g., the creation of a prototype, revenue and profit goals, stock value, etc.), the value of the company will increase and thus so will the value of the underlying stock of the option. Because it provides employees with this opportunity to benefit directly from any gain in the company’s value, stock options are quite common in startup companies. From a founder’s perspective, they’re appealing since they avoid any cash outlays and align the interests of the owner and workers.
NSOs and ISOs
There are two types of stock options: non-qualified stock options (NSOs) and incentive stock options (ISOs). ISOs may only be issued to employees; NSOs may be issued to employees, directors, consultants and advisors, and other outside parties.
The valuation and reporting of stock options is highly regulated both for financial reporting and tax purposes. Companies must comply with Internal Revenue Code (IRC) §409A and Statement on Financial Accounting Standard (SFAS) No. 123R (revised 2004), Share Based Payment.
Internal Revenue Code and Penalties
IRC 409A requires that the valuation of the common stock be based on a “reasonable application of a reasonable valuation method.” IRC §409A sets forth a “presumption of reasonableness” in three instances: 1) valuation by independent, qualified appraiser, 2) fair market value applied in transactions, or 3) written report for illiquid stock of a start-up corporation. Under IRC §409A, the IRS will assess penalties on individuals granted options if the option strike price is not at least equal to the fair market value of the common stock at the date of the grant. The grant will be deemed deferred compensation and the recipient will face significant adverse tax consequences – in addition to paying regular income tax, a 20% penalty can be assessed. Companies do not want to issue options to their employees and inadvertently create a tax liability for those employees who may not have a means to pay the tax and possibly create a tax withholding liability for itself.
SFAS 123R and Company Auditors
Companies must also comply with the Financial Accounting Standards Board (FASB) pre-codification Statement on Financial Accounting Standard (SFAS) No. 123R (revised 2004), Share Based Payment, which focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions and provides guidance on the appropriate methods for valuing the options, including allocating a company’s total equity value to all forms of equity – common stock, stock options, preferred stock, etc. A company’s auditors will closely scrutinize the valuation of the company’s stock and options.
Given the various regulations covering the stock option valuation and the severity of penalties for failure to perform or performing improper valuation, it is important for a company to retain a qualified appraiser with experience in valuing options. With years of experience in stock option valuation and our knowledge of the latest regulations, Meridian Advantage is well qualified to provide these services.