"Practical Guidance under Section 409A for Private Companies Granting"
Presentation December 13, 2005 9:00 a.m. – 10:30 a.m. PST Practical Guidance under Section 409A for Private Companies Granting Stock Options and Stock Appreciation Rights Joseph Yaffe, Partner, Latham & Watkins LLP Questions & Answers During the event, forward your questions to: 409A.Questions@lw.com Section 409A Background • Section 409A was added to the Internal Revenue Code in October 2004, as part of the American Jobs Creation Act • Intended to regulate nonqualified deferred compensation plans (NQDCPs) in the wake of Enron and increased concern over “excessive” executive compensation The Problem • Section 409A applies to many more arrangements beyond “traditional” nonqualified deferred compensation plans, including certain nonstatutory stock options and stock appreciation rights (SARS, collectively stock rights) 409A.Questions@lw.com 3 Section 409A History • Section 409A was added to the Internal Revenue Code in October 2004 • In December 2004, the IRS issued Notice 2005-1, providing initial guidance with respect to the application of Section 409A • October 4, 2005, proposed regulations are issued regarding the application of Section 409A 409A.Questions@lw.com 4 Section 409A • Section 409A applies to NQDCPs • What’s at stake? (I): If a NQDCP with any employee, consultant or director is subject to Section 409A and does not comply with Section 409A requirements, the service provider will: • Be immediately taxed on vested non-complying deferred compensation plus interest from the date of the original deferral of compensation; and • Be taxed an additional 20% 409A.Questions@lw.com 5 Stock Rights • Informally, the Treasury Department has expressed its concern that absent regulation, stock rights may be used to circumvent Section 409A • The Treasury Department opted not to exempt all stock rights from Section 409A • As a result, stock rights are only exempt from 409A under limited circumstances 409A.Questions@lw.com 6 Stock Rights • New Rule: A stock right to purchase service recipient common stock is exempt from Section 409A if: • the exercise price of the option or base price for the SAR equals or exceeds fair market value (FMV) of the underlying stock on the date of grant; • the stock right has no other feature for the deferral of compensation beyond the exercise date; and • with respect to SARs, the amount payable under the SAR is not greater than the difference between FMV of the underlying stock on the date of grant and FMV on the date of exercise 409A.Questions@lw.com 7 Stock Rights • Other Exempt Rights to Purchase Stock • Incentive Stock Options (ISOs) are not subject to Section 409A, however: • ISOs must be granted at FMV to qualify as ISOs, which standard is likely to converge with the 409A rules discussed below • The subsequent modification of an ISO (by, for example, amending it to extend the period within which it can be exercised after termination of employment) or failure to comply with the minimum ISO share holding requirements may cause it to become a nonstatutory option subject to 409A • Employee Stock Purchase Plans (423 Plans) are not subject to Section 409A 409A.Questions@lw.com 8 Stock Rights • What’s at stake? (II) • For stock rights not exempt from 409A • Immediate taxation for the stock right recipient upon vesting instead of at exercise (or later); and • 20% additional tax • Stock rights exempt from 409A remain subject to “regular” tax rules – taxation at exercise • The IRS has not yet provided guidance on how to calculate the tax that a stock right recipient will recognize upon vesting of a non-exempt stock right 409A.Questions@lw.com 9 Valuation of Stock The Most Significant Issue Facing Private Companies Granting Stock Rights: What is FMV? The proposed regulations provide guidance for purposes of valuing stock in connection with setting stock right exercise prices for: • Public companies; and • Private companies 409A.Questions@lw.com 10 Public Companies For public companies (those with stock that is readily tradable on an established securities market), the guidance is generally consistent with FMV determinations by most public companies and should not result in a material change in stock right grant practices 409A.Questions@lw.com 11 Public Companies FMV may be based on: • the last sale before or first sale after the grant; • the closing price on the trading day before or the trading day of the grant; or • any other reasonable basis using actual transactions in such stock as reported by such market and consistently applied FMV may also be based on average selling prices for a periods within the 30 day period pre- and post-grant; provided that the commitment to grant the stock right using such a method is used consistently and is irrevocably made before the beginning of the specified period 409A.Questions@lw.com 12 Private Companies With respect to private company stock (that is not readily tradable on an established securities market), FMV must be: “[A] value determined by the reasonable application of a reasonable valuation method.” The determination whether a valuation method is reasonable, or whether application of a valuation method is reasonable, is made based on a facts and circumstances analysis as of the valuation date. 409A.Questions@lw.com 13 Private Companies The proposed regulations list factors that, as applicable, are to be used in determining FMV under a reasonable valuation method: • The value of tangible and intangible assets of the corporation; • The present value of future cash-flows of the corporation; • The market value of stock or equity interests in similar corporations and other entities engaged in businesses substantially similar to those engaged by the corporation; • Control premiums, lack of marketability and • “Other relevant factors” 409A.Questions@lw.com 14 Private Companies • Preferred stock liquidation preferences are not expressly included in the list of factors that are to be considered • A valuation method is not reasonable unless all available information material to the value of corporation is considered 409A.Questions@lw.com 15 Private Companies • Use of a previously determined value will not be reasonable if determined on a date more than 12 months earlier • Use of a previously determined value will not be reasonable in any event, if it does not take into account material information that became available after the prior valuation • The consistent use of a valuation method for other non-compensatory purposes is a factor supporting the reasonableness of such valuation method 409A.Questions@lw.com 16 Presumptions • The proposed regulations place the burden of demonstrating that FMV is reasonable on the company unless the company consistently uses a presumptively reasonable valuation method • The proposed regulations provide three presumptively reasonable valuation methods: • Independent Appraisal • “Start-Up Company” Exception • Formula Price • Presumptions are rebuttable only if grossly unreasonable 409A.Questions@lw.com 17 Independent Appraisal • The valuation must be performed by an independent appraisal • The appraisal cannot be as of a date more than 12 months before the date of grant of the relevant stock right • The valuation will be presumed reasonable until subsequent events occur that have a material effect on stock value 409A.Questions@lw.com 18 “Start-Up Company” Exception • Only applies to a private corporation that has conducted business for less than 10 years • The valuation needs to: • be made reasonably and in good faith; • be evidenced by a written report; • take into account the factors to be considered in determining FMV; • be performed by a person with “significant knowledge and experience or training in performing similar valuations;” and • be made with respect to stock not subject to any put or call rights (other than right of first refusal and certain repurchase rights that are “lapse” restrictions under the Internal Revenue Code) 409A.Questions@lw.com 19 “Start-Up Company” Exception The Start-Up Company Exception is not presumptively reasonable if as of the time the valuation is applied (i.e., the grant date of a stock right) the corporation or optionee may reasonably anticipate that the corporation will undergo a change in ownership or control or IPO within 12 months following the event to which the valuation is applied 409A.Questions@lw.com 20 Formula Price • Formula cannot lapse or expire over time (e.g., book value) • Reasonable only if used consistently for all valuations of the stock (including regulatory filings, loan covenants and transactions involving the issuance or repurchase of the stock) • Presumption does not apply for a stock right exercisable for stock that can be transferred without regard to the formula price 409A.Questions@lw.com 21 Service Recipient Stock In order to be exempt from 409A, stock rights must be exercisable for Service Recipient Stock Stock is defined as: • A class of common stock that, as of date of grant, is readily tradable on an established securities market, or if none, has the highest aggregate value of any outstanding class of common stock, or a class of common stock substantially similar to such class of stock • Stock cannot be preferred stock 409A.Questions@lw.com 22 “Service Recipient” “Service Recipient” is defined as: • The corporation or other entity for which the grantee is providing services • Any corporations or other entities that are related through at least 50% ownership interest (value and voting) • In limited circumstances (e.g., joint venture arrangements), ownership can be as low as at least 20% 409A.Questions@lw.com 23 Modifications A modification of a stock right, other than an extension or renewal of a stock right, is considered the granting of new stock right • The new grant must be “remeasured” for 409A purposes – it must have an exercise or base price that is at or above FMV on the date of such modification • If exercise price or base price is below FMV on the date of such modification, the stock right will not be exempt from Section 409A 409A.Questions@lw.com 24 Modifications “Modification” means: • A direct or indirect reduction of the exercise price or base price of the stock right (i.e., a repricing); • An addition of a deferral feature; or • An extension or renewal of the stock right 409A.Questions@lw.com 25 Extensions and Renewals If stock right is extended or renewed: The stock right is considered to have had an additional deferral feature from the date of original grant 409A.Questions@lw.com 26 Not Extension Stock right is not considered extended if the extension is not beyond the later of: • December 31st of the calendar year in which grant would have expired in the absence of such extension; or • The 15th day of the third month following its normal termination or expiration date TRAP – Stock rights that are amended through adoption of an employment or change in control agreement providing for extended exercisability in certain circumstances 409A.Questions@lw.com 27 Not Modification Changes that will not be treated as a modification: • Shortening of the period during which stock right is exercisable • Addition of the ability to use previously acquired stock to pay the exercise price • Addition of the ability to withhold stock to pay employment taxes or income tax • Employer’s exercise of discretion with respect to transferability of the stock right • Acceleration of exercisability of stock right (note, however, that acceleration of exercisability of stock right that is considered deferred compensation under Section 409A may constitute an impermissible acceleration of a payment date under Section 409A) 409A.Questions@lw.com 28 Rescission Right If inadvertent modification results from a change or adoption of a new agreement, employer can rescind the change to avoid coverage under Section 409A if the change is rescinded by the earlier of: • The date the stock right is exercised; or • December 31st of the calendar year during which such change was made 409A.Questions@lw.com 29 Effective Dates For Section 409A Section 409A is effective with regard to stock rights granted in the following periods: • Stock rights granted before October 4, 2004 that vested by December 31, 2004 are not subject to Section 409A (regardless of exercise price) unless modified • Stock rights granted below FMV after October 3, 2004 that were vested as of December 31, 2004 are subject to Section 409A unless granted in accordance with the company’s past practices • Stock rights granted below FMV that were not vested as of December 31, 2004 are subject to Section 409A • Stock rights granted after December 31, 2004 with regard to common stock that is not service recipient stock are subject to Section 409A • Stock rights granted with regard to preferred stock that were not vested as of December 31, 2004 are subject to Section 409A 409A.Questions@lw.com 30 What Should You Do? • Assess current stock right grant practices: confirm that stock rights are not being granted at below FMV • Consider use of a presumptively reasonable valuation method going forward • Evaluate whether stock rights are granted with respect to stock of the “service recipient” • Assess whether outstanding stock rights that were unvested as of December 31, 2004 were granted below FMV • Discuss with legal counsel any potential modifications to outstanding stock rights, or modifications made to stock rights that were unvested as of December 31, 2004 409A.Questions@lw.com 31 What Should Employers Do? • Corrective Actions for stock rights subject to Section 409A • Exercise by December 31, 2005 • By December 31, 2005, cancel the stock right in exchange either for stock or cash equal to the intrinsic (“spread”) value of the stock right • By December 31, 2006, increase the exercise price of the stock right to the FMV as of the original date of grant • If the company intends to pay the stock right recipient for the difference between the original exercise price and FMV on the date of grant, any such payment must be made by December 31, 2005 • Amend the stock right to comply with 409A by December 31, 2006 • Will require that the stock right be exercised within 2-1/2 months after the year in which it vests or otherwise in compliance with 409A requirements for specified payment dates 409A.Questions@lw.com 32 Section 409A Latham & Watkins Attorney Contacts www.lw.com Boston Hamburg Milan Northern Virginia Shanghai David A. Gordon Götz Wiese Michael S. Immordino Eric L. Bernthal Rowland Cheng +1-617-633-5700 +49-40-41 40 30 +39 02-85454-11 +1-703-456-1000 +86 21 6101-6000 Brussels Hong Kong Moscow Orange County Silicon Valley Andreas Weitbrecht Mitchell D. Stocks Anya Goldin David W. Barby Joseph M. Yaffe +32 (0)2 788 60 00 +852-2522-7886 +7-501-785-1234 +1-714-540-1235 +1-650-328-4600 Chicago London New Jersey Paris Singapore Robin L. Struve Stephen Brown David J. McLean Christian Nouel Mark A. Nelson +1-312-876-7700 +44-20-7710-1000 +1-973-639-1234 +33 (0)1 40 62 20 00 +65-6536-1161 Frankfurt Los Angeles New York San Diego Tokyo Jörg Soehring James D.C. Barrall Jed W. Brickner David C. Boatwright David L. Shapiro +49-69-60 62 60 00 David Taub Bradd L. Williamson +1-619-236-1234 +81-3-6212-7800 +1-213-485-1234 +1-212-906-1200 San Francisco Washington, D.C. Gregory P. Lindstrom David Della Rocca +1-415-391-0600 +1-202-637-2200 409A.Questions@lw.com 33 Although this seminar presentation may provide information concerning potential legal issues, it is not a substitute for legal advice from qualified counsel. The presentation is not created or designed to address the unique facts or circumstances that may arise in any specific instance, and you should not and are not authorized to rely on this content as a source of legal advice and this seminar material does not create any attorney-client relationship between you and Latham & Watkins. 409A.Questions@lw.com 34