The onus for adopting fair value has spread to the compensation of portfolio company executives. In the context of private equity, options, long considered the best way of aligning the interests of both the executives of portfolio companies and the private equity firm, are now subject to new accounting and tax regulations in the US.
The treatment of options falls under the FASB 123R regulations for accounting, and Section 409A of the IRS Code for taxes. It is the latter, which only applies to nonqualified deferred compensation plans, which is causing some consternation within the private equity industry.
Under the new 409A tax regime, the penalty of granting options “in the money” – options with an exercise price that is lower than its fair value – has been described as “draconian” and “onerous.” The penalty, applicable to the executive in question, is a 20 percent excise tax, paid upon vesting.
“From a tax perspective, if you’re granting options or stock appreciation rights, you want to make sure they’re not getting granted ‘in the money’,” says Michael Schoonmaker at Ernst & Young. “You want to make sure that the exercise price for those awards is no lower than the fair market value of the underlying stock on the date of the grant.”
Granting options at fair value is the goal, but for privately held portfolio companies, the path to fair value can be a bumpy one. Some private equity executives still complain that a value cannot be derived, or does not matter, until there is a liquidity event or an exit. One cannot look up the stock price of the private company on the internet. And how exactly does one come to the one exact value that everyone – from the portfolio company to auditors, taxmen and regulators – can agree upon for a private company?
To avoid penalty, section 409A regulations say that firms must get an independent valuation, either by a valuation firm or an in-house expert.
Obtaining this valuation will add cost and time, but at the end of the day, the industry will follow, for options are the best form of long term compensation.
What 409A says
The statute on 409A was first enacted in 2004, in the aftermath of the accounting scandals at companies like Enron and WorldCom. Final regulations were recently passed, which will become effective on January 1, 2008.
Section 409A came into effect for two reasons: to reduce the flexibility of executives to defer compensation, and to zero in on an exercise price for stock options. For the former, options can be viewed as a deferral of compensation because the compensation event is triggered when the executive exercises the option. For the latter, there was little pressure and no tax penalty to get the price exactly right in the past. Thus, discounted stock options have not historically presented problems for private equity sponsors.
But executives with discounted stock options will face tough penalties going forward. As law firm Nixon Peabody wrote in a client alert: “If these rules [409A] are not followed, a participant is immediately taxed on the value of his/her deferred compensation once it is no longer subject to a substantial risk of forfeiture. Additionally, the participant will have to pay a 20 percent excise tax on the amount that is included in his/her income, as well as an interest penalty. The interest penalty is calculated at the IRS underpayment rate plus one percent from the date the amount was deferred or, if later, the date it was no longer subject to a substantial risk of forfeiture.” Clearly, few find a tax rate as high as 55 percent to be palatable.
Pressure for compliance with 409A is also coming from auditors. With the demise of Arthur Andersen, auditors extra cautious about accepting valuations submitted by private equity firms – instead, they want to see documentation, evidence and independent valuations.
The pressure is higher when a portfolio company is within a year of going public. Lawrence Cagney, partner in the New York office of law firm Debevoise & Plimpton says, “If you’re going public, the accountants have to sign off on the financial statements and the SEC has to vet it. There’s a lot more pressure that the financial statements are right.”
When to appraise?
Section 409A’s tax penalty, which kicks in if an option is granted with a strike price that is less than the fair value, have struck fear in the hearts of many an executives and their private equity backers. That, plus it can be a major headache of getting to fair value in options.
The IRS has instituted a system of checks and balances in an effort to ensure that options are indeed fair. “In order to feel confident and comfortable you’ve gotten the right value and be able to withstand an IRS challenge, you have to have either get an independent appraisal – you hire a valuation firm to do the valuation – or you have to have a qualified expert in-house to do the valuation,” says Schoonmaker.
Understandably, there was some resistance initially from private equity firms. “But third party valuations have been reasonably priced,” says James Stevenson, chief financial officer at Baltimore, Maryland-based ABS Capital. “It’s a bit like an insurance policy – they’re assured of the fact that somebody won’t three or five years with the benefit of hindsight argue that your stock was worth a lot more and those tax penalties should apply. From a practical point of view, these portfolio companies have to go out and get third party valuations.”
Obtaining a valuation from a small, boutique firm can cost around $10,000 to $20,000, and upwards of $100,000 from a large investment bank. “By making the price reasonable, I think people have accepted that it’s just the cost of doing business now,” adds Stevenson.
But getting these valuations, even if they provide a safe harbor, is not a panacea. Valuations can differ from valuation firm to valuation firm. They may not include a premium for control or a discount for minority securities. Valuation is not a science, hence getting to an exact figure for what a private company is worth can be a headache.
“With 409A, you can go over – if a stock is $10 and you set the exercise price at $12, there’s no issue. If you set it at $9.95, there’s a problem,” says Cagney.
The timing and frequency of appraisals is another issue. Section 409A encourages firms to obtain regular appraisals, but it is unclear how long appraisals are valid for. Furthermore, what happens when a new employee joins the firm –should the firm make the new employee wait until the next appraisal before being granted options, in which case the value of the option may have increased, hence more expensive for the firm, or get an appraisal done?
“That’s still playing out in the marketplace,” says Cagney. “There are some firms who have capitulated and are getting quarterly appraisals, there are some doing annual appraisals, there are some who haven’t been doing appraisals at all and are now forcing themselves to get them.”
For venture capital firms, where valuation is already speculative, Cagney says that they have become much more cautious. Firms that tended not to get appraisals are now doing so, and “some firms are doing less options and more purchases,” he says.
Wait and see
Private equity firms who want to continue granting options under the new regime have little choice but to obtain appraisals, some as frequently as two to four times a year. But they aren’t exactly enthusiastic about the added work.
Stevenson says that his firm is trying to incorporate the added steps into the investment process. “The issue with fair value is that it can be a judgmental, subjective exercise and people struggle with that. I think probably the biggest issue for the industry is, how much time and effort do you want to put in attaching the value of a company now, when really the only thing that matters to our investors is what we ultimately realize for that?” he says.
Until the December 31, 2007 deadline, firms can still fix the options that may be subject to 409A tax penalties later. For firms that issued non-qualified options before the advent of 409A, there is one catch. “The grandfather rule requires that the compensation be earned and vested as of December 31, 2004,” says Cagney. If a firm granted an option that would not have vested by that cut off point, there could be an issue.
“This is one of the really hard questions for private equity,” Cagney explains. “Let’s assume we use the same methodologies that we used back then. We honestly believe that when we granted it, it was at fair market value. Do we fix that now, and how do we fix it? If we believe that is the correct price today, do we fix it or sit back?”
For the most part, the private equity community is taking the latter position – sitting back. Many GPs believe that the previous valuations assigned to options are acceptable, and not in need of a fix.
Whatever the headaches are with the advent of new accounting and tax rules, the fact remains that options remain a powerful tool to align interest – executives can get rich, and in the process private equity firms can get the returns they want. “The only way you can do options in this environment is to meet the fair value standard,” says Cagney. “I don’t think you’ll see private equity firms abandoning it. They’ll live with this complication [409A] because [options are] such a good tool.”
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