March 24, 2017
409A Valuations & Equity Management: The Need for Forward Thinking
Posted by Armanino Financial Advisory Team
The process of developing a business to ultimate enterprise success includes anticipating and avoiding potential future road blocks through the development of high quality, supportable and defensible procedures as early in the business life cycle as possible. One critical factor in developing such a process for ultimate business success―whether defined by efficient audits, or, even better, a highly successful sale or IPO scenario―is completing quality 409A valuations and managing equity accounting with proven partners in the field.
As with any other component of the financial management process, 409A valuations and equity management require a great deal of attention to detail and proven effective judgement. In order to avoid problems when you least want them―such as when going through an audit, securing equity financing, or nearing public or private liquidity events―a successful approach will include utilizing the expertise of specialists in their respective fields in order to avoid common pitfalls. Various pitfalls due to a lack of quality valuation and equity management processes include expensive and time-consuming restating of financial statements, inefficient use of resources, and the potential impact on timing and pricing of equity transactions.
Here are some ways improperly handled valuation and equity accounting can impact you and your firm:
- Tax cost for you/your firm’s employees. If improperly priced options are issued, it may result in a future tax liability for employees who receive equity compensation. A lack of sound valuation and accounting can result in potentially large unexpected tax bills for employees who were granted options at below market value. Depending on the size of the mispricing, these tax bills can be significant to recipients.
- Potential acquisition red flags. In the acquisition process, acquiring parties will be on the lookout for items that could create unexpected costs and/or tax liabilities. A lack of sound valuation and equity accounting can create both real expenses in the due diligence process and perceptions of potential red flags as the acquirer considers the terms of its offer. When a potential sale is on the table, equity valuation and accounting red flags can result in significant costs and delays, as well as affecting bids that acquirers may make.
- IPO delays and/or missed windows. When a company nears a potential IPO and begins issuing public financial statements, the level of review increases substantially, both in terms of oversight via audit partners and the U.S. Securities and Exchange Commission (SEC). Improper valuations and poor equity management practices in the years preceding an IPO can result in costly, and sometimes fatal, delays in the IPO process.
When the time comes to potentially secure a sale or IPO liquidity event for the company you have devoted your time, energy and effort into building, it should be an extremely exciting period for you both professionally and personally. However, not having your valuation and equity management “ducks in a row” can cause unnecessary challenges for potential investors and/or acquirers, as well as auditors. At such times, when your company most needs you to be a strategic visionary, the last thing you want is to be stuck cleaning up unnecessary accounting issues that may have been avoided with proper planning and forward-looking resource allocation in earlier stages.
While there may be certain shortcuts that can be taken along the way in these areas, failing to think strategically and with a long-term vision, and not accessing expert resources at early stages, can create eventual real costs, resource bottlenecks and unnecessary delays, and may result in arduous review and cleanup work when you would least like to be dealing with such challenges.
Instead of putting off “the process” until later stages, it is a sound strategic investment to look ahead and engage quality professional advisory and value-added services early on. Such expertise can assist you in developing a sound process that can help you and your business navigate effectively and efficiently to and through a successful, rewarding and exciting liquidity event.
Forward thinking early on often makes a big difference.
May 17, 2016
Importance of a 409A Valuation for Any Stage Business
Posted by Alex Florea
Ever since 409A valuations became a topic a decade ago, the IRS seems to have often be top of mind for law firms and their clients. We routinely have new clients referred to Armanino by their lawyers and they know they’re supposed to have a 409A valuation completed, but they’re often not particularly clear on why and how that valuation even matters. We often hear the common question “how many companies find themselves in trouble with the IRS due to 409A compliance issues?” The reality is that the IRS really just started their Compliance Initiative Project in 2014, stating that they “will try to limit the scope and burden on taxpayers by limiting [the IRS’s] inquiry on the top 10 highly compensated individuals.”
One of the results of this relatively limited enforcement in 409A compliance has been that many private companies – and to some extent even some of the lawyers who advise them – have embraced a somewhat cavalier attitude towards 409A compliance and specifically the defensibility and quality of the reports. Given the lack of IRS enforcement, it is not surprising that early stage companies are sometimes tempted to use a lower cost provider to just get the valuation done and out of the way rather than seeking a more reputable, established firm because of a misguided perception of low risk.
The fact of the matter is that the IRS is not going to be particularly interested in auditing 409A compliance for early stage companies that are not yet profitable and often haven’t even reached the revenue stage. Later stage companies typically have a different approach to 409A valuations than early stage companies because their financials are audited. Knowing 409A reports will be scrutinized by their audit firm, a more mature company definitely needs to ensure their 409A valuations are done right so they’ll sail through an audit quickly and smoothly. These later stage companies focus more on the quality of a service provider, rather than attempt to cut corners on getting the 409A valuation out of the way.
Many early stage companies – “We’re early stage, just completed our Series A, and we’re not audited.” – tend to want to invest more in product development, marketing, sales, etc. rather than compliance. An understandable desire for an early stage company. However, poor 409A compliance can have unintended negative consequences a few years down the line, if not sooner.
It should be no surprise to anyone that the vast majority of start-ups never make it to Initial Public Offering (IPO) and the most common exit is an acquisition. Those acquisitions are not always targeted at mature companies, but often targeted at relatively young companies, sometimes pre-revenue and in some cases within 18-36 months of inception. Often, the acquiring company is a Fortune 500 company employing some of the top accounting professionals in the industry for their own audits causing sudden and tremendous scrutiny of the young company’s compliance and accounting practices during the due diligence process. This scenario spurs the early stage company into a mad rush to clean up their accounting and compliance issues in an effort to get everything in order for the potential acquisition.
Arguably, the greatest financial penalty of poor compliance is the weakened negotiating position of the company being considered for acquisition. The impetus for the acquisition may be a product or technology that the acquirer finds very attractive, but no company is too keen on acquiring an accounting and compliance mess with potential future liabilities. The temptation to take initial shortcuts or bypass proper compliance practices can have far-reaching and sometimes unexpected consequences for an early stage company. Ensuring your 409A valuation is solid and done properly helps mitigate risks for businesses.
Learn more about Armanino’s Valuation team and find more details on how to ensure your company’s compliance needs are handled properly from the start.
July 23, 2019
Decoding Modifications for Stock-Based Compensation
Posted by Asfar Siddiqui
In today’s fast-moving world where the only constant is change, stock-based compensation is increasingly becoming an intricate part of an employee’s overall compensation package. As more and more companies offer equity to attract top talent, it is inevitable that sooner or later, they will run into the complex world of modification accounting for stock-based compensation.
So what is a modification when it comes to stock-based compensation? As defined under ASC topic 718 a modification is a “change in any of the terms or conditions of a share-based payment award.”
Some of the most common types of modifications private companies run into are:
- Acceleration of vesting: Type III Improbable to Probable.
Under a Type III modification, the vesting of a grant is originally considered to be improbable. However, under the modified conditions the vesting is now considered probable. There are a few items to keep in mind when accounting for this type of scenario:
- Since under the original conditions the probability of vesting was improbable, only the fair value of the modified award is recognized.
- Any compensation cost originally recognized is reversed.
- If the shares immediately vest under the modified terms, then compensation cost must also be immediately recognized; otherwise, it will be recognized over the requisite service period.
- Extension of Post Termination Exercise Period at Termination: Type I Probable to Probable.
Under a type I modification, the probability of vesting is not affected and for a post-termination exercise extension, only the vested portion of the shares are subject to the modification. The following are the key items when accounting for a post-termination exercise extension modification:
- Recognize the original grant date fair value plus the incremental fair value. To calculate the incremental fair value, there needs to be an “immediately before” and “immediately after” calculation of the fair value as of the modification date. The difference of the two is the incremental fair value which is used to record the incremental expense.
- Since only the vested portion of the shares are subject to the modification, the incremental compensation cost is recognized immediately.
Note that modifying the post-termination exercise period for on-going grants is potentially a much larger endeavor.
- Repricing or Option Exchange Program: Type I Probable to Probable.
Companies usually go through an option repricing or exchange program when the current stock price drops below the exercise price of options. For public companies, this price will usually sustain before making an adjustment. For private companies, it might occur when the latest valuation of their common stock (409A valuation) comes out to be lower than the value at which they had previously issued stock options. As a result, grants that were granted with a higher grant price are now considered to be underwater or out of money. Due to this, companies may decide to do a repricing of the underwater stock options which will result in canceling those grants and issuing new ones with a lower grant price.
As explained in bullet II, the probability of vesting is not affected under a Type I modification. The grants are considered to continue vesting both before and after the modification takes place. As a result, the expense recognized prior to the modification is not reversed and there may be an incremental expense resulting from the modification. The experts of Armanino’s CFO Advisory Team have a long history of assisting and providing solutions to a wide array of clients with modification accounting for stock-based compensation.
If you are need assistance or are considering a modification, please reach out to Scott Schwartz at Scott.Schwartz@armaninollp.com.
November 26, 2018
3921 and 3922 Statements
Posted by Hung Tran
It’s that time of year again to start thinking about tax reporting for CY 2018. If you have issued Incentive Stock Options (ISOs) to employees and/or have an Employee Stock Purchase Plan (ESPP), your company will need to prepare 3921 and 3922 statements and related filings under Section 6039.
For ISOs, you need to file a 3921 for options exercised in the calendar year. For ESPPs, a 3922 form should be prepared for purchases made during the calendar year for any employees taxed in the United States. (Since these transactions are only subject to AMT, the tax implications do not get captured elsewhere, except for employees subject to Pennsylvania taxes, but that’s another story…)
There are a few items to keep in mind before processing the statements and filing with the IRS.
- It is very important to determine the correct fair market value on day of exercise.Many private companies go with the most recent 409A valuation as of the exercise date.
- For public companies, it’s usually the closing value on the date of exercise but may depend on your specific plan.
- Make sure to confirm that each ISO option holder or ESPP purchaser is subject to income taxes in the United States.
- We often see companies inadvertently grant ISOs to foreign participants and many clients have ESPPs for international participants who are not subject to Section 6039.
- With ISOs, confirm that ISO status is still valid as of the exercise date. (For example, ISO exercises that occur more than three months after termination are treated as a non-qualified stock option. For these, taxes should be withheld and ordinary income reported on the employees W-2.)
- If your ESPP crosses multiple years, make sure you are only capturing purchases that occurred in the calendar year you are filing for.
- Once you have your list ready, make sure all data points in the statements are updated. This includes making sure you have the correct mailing addresses for each employee.
- With terminated employees, give yourself and the HR team some extra time to confirm demographic information.
Ideally, all your statements should go out before the January 31, 2019 deadline. Statements to employees must be postmarked by January 31, 2019. Filing with the IRS must be completed by February 28, 2019 (paper) or April 1, 2019 (electronic).
Armanino currently offers 6039 services which include both the mailing of statements and e-filing with the IRS. We are very cost-efficient as we handle these as well as 1099s for hundreds of clients. Armanino also offers employee education surrounding stock-based compensation and the related income taxes implications. If you are interested, please reach out to Niki Rahimi at (925) 790-2848 or Niki.Rahimi@amllp.com or me at (925) 790-2689 or Hung.Tran@amllp.com
April 19, 2018
Tax Reform and Valuation Impacts to Consider
Posted by Kemp Moyer
Federal tax reform is here and there are several elements of business and asset valuation that are impacted by the recent change in legislation.
The Tax Cuts and Jobs Act of 2017 (tax reform) was signed into law on December 22, 2017, and impacts all private company business valuations performed after this date in several potentially material ways.
The change in tax rates will affect many U.S.-based businesses, and these changes, which ultimately flow through to the bottom line, will have a meaningful impact on business and intangible asset valuation, as well as the value of underlying equity securities.
Is the valuation of your company and its equity securities affected by these changes?
Simply put, any company that projects to pay U.S. taxes in the future is impacted in several ways, and this includes the enterprise value of the company, as well as its securities and certain assets. As the fair value of a company is based on the cash flow generation potential of the company on a forward-looking basis, changes in the percentage of tax cash outflows required by federal tax legislation impact the current outlook for forward retained cash flows.
These changes in tax rates will impact valuations of businesses, assets, and equity securities in several ways, including:
- Prior to tax reform, blended federal/state tax rates for entities that conducted business across the United States were estimated at approximately 39% of pre-tax income when averaging state corporate rates by population. With tax reform, this same population-weighted blended rate has been reduced to under 26%. When valuation and finance experts complete dfiscounted cash Flow (DCF) or capitalized net earnings analyses to estimate the present value of businesses or other income-generating assets, the reduction in the tax rate will generally – all else being equal – increase the present value of the estimated future cash flows. This result will be most pronounced with businesses or income-generating assets that are projected to have positive pretax income immediately or soon after the valuation date.
- In converse to the above, the value of net operating loss carryforwards (NOLs) is generally reduced in a reduced tax environment, as accumulated NOLs that will shield future pretax income will shield a lower percentage of the projected positive future earnings. Additionally, tax reform has changed the allowed usage of pre- and post-2018 NOLs. The updated laws will certainly impact values of entities that have accumulated NOLs or project operating losses prior to generating positive future operating income.
- In addition to effects on the value of NOLs, other deferred tax assets and liabilities are also impacted by the change in federal tax rates. To put it simply, companies with deferred tax assets on their balance sheets will see the value of those assets fall, whereas those with deferred tax liabilities will generally see a reduction (net positive) in the value of those liabilities.
- Also affecting DCF analyses will be the impact on the weighted average cost of capital (WACC) determined by analyzing the estimated cost of capital associated with guideline public companies (GPCs). As estimated tax rates change, this will impact the after-tax expected return on debt, as well as unlevered beta estimates. These adjustments could lead to tweaks in the expected WACC applied to subject company cash flows, affecting the estimated value.
- In market approach analyses, where observed multiples from the public markets drive applied multiples for the subject company, the impact of tax reform is not as direct, but may be similarly impactful as the fundamental value of cash flows for public companies may rise given a reduced federal tax rate. Again, all else being equal, the value of the earnings of public companies is higher with a lower tax burden. This increase in fundamental value versus a comparable higher tax environment may result in higher baseline multiples observed in the market, especially related to lines higher in the profit and loss statement, such as revenue and EBITDA.
- It should be noted that any income-generating asset, including intangible assets that are often a measurable element of transactions, may see valuations change, as these assets are commonly valued based on a DCF methodology, which will be impacted by the change in tax rates. Common identifiable intangible asset values that may be affected include: customer relationships, developed or in-process technology, tradenames/trademarks, etc. This change in fundamental value due to reduced tax rates may have a follow-on impact of changing negotiated multiples associated with transactions.
- Given the reduction in C-Corp tax rates, there may be a reduced estimated cash flow benefit to profitable business owners who elect to file under S-Corp tax status.
- Finally, as total equity values are impacted by the change in tax rates, the valuation of individual securities will also see an effect. Most notably, more junior securities such as common stock or options may see larger impact, as they are more levered to total equity value changes as compared to more senior preferred equity securities. With this leverage in play for junior securities, it is that much more important that valuation professionals properly assess the effect of tax reform at the total equity level.
The recently passed tax reform legislation is complex and the impacts may be material for the value of many businesses and their underlying securities. In this changing environment, partnering with qualified experts for business, security, and income-generating asset valuations is increasingly important to properly estimate the value of the respective assets for many needs, including IRC Section 409A analyses, ASC 805 Business Combinations, and the estimation of business or asset value for transaction analysis purposes.
As always, don’t hesitate to reach out to the Armanino team if you need assistance with business, security or asset valuation. We are happy to help our clients navigate the changes in valuation impacted by tax reform, as well as any business or asset valuation needs.
January 23, 2015
Stock Based Compensation – Year End Inventory
Posted by Niki Rahimi
It’s that time of this new year to start thinking about updating your stock based compensation for fiscal year 2014. If you’ve been keeping up with quarterly activity and updates, you are already ahead of the game. Regardless, there are several things to keep in mind to ensure your stock-based compensation expense is accurate and up to date. We highlight a few of the bigger items you can incorporate into your yearly checklist for stock-based compensation.
1. Forfeiture Rates: Is this updated? Are you using a rate and if so, are you allocating by employee type? Normally, allocating expected rates amongst executives vs. non-executives is a good basic approach to bifurcation. The assumption is that executives would normally stay on longer with the company and thus have a lower forfeiture rate.
Running actual forfeiture calculations on historical grants/awards will give you a better idea of expected rates, but this assumes a long enough history with a relatively sufficient amount of terminations over the years. If you have an unusually loyal workforce with relatively zero termination activity, using a low flat rate should be fine. With fairly new plans, determining a good rate is difficult, and so, the consideration of even using a forfeiture rate should be kept in mind.
2. Volatility: Is this updated? If calculating for a private company, are you using the most recent 409A valuation to update public peers? If you’ve recently gone public, you probably won’t have sufficient price history for the look-back/expected term in question. If not, continuing to run with public peers that have a sufficient history is a good option.
October 29, 2013
The 5 Best Practices of Cheap Stock
Posted by Armanino Financial Advisory Team
From a tax perspective, cheap stock has major individual tax consequences—back-dating and granting equity instruments below fair market value (FMV) can create cheap stock scenarios. In some cases, this type of compensation can trigger a 20% tax penalties on top of ordinary income rates (to learn more about this issue, watch our recorded webinar on 409A Valuations – Hot Button Issues with Auditors), in other cases the company may cover this penalty for the goodwill of its employees.
The other side of the coin for cheap stock is a much different story. When referring to cheap stock from an accounting perspective to the corporation, we typically move into ASC 718 Accounting for stock-based compensation. Here, cheap stock carries different weight, as it causes greater non-cash expense than would otherwise be recognized. (more…)
November 5, 2012
Microsoft Shares Study on Cloud Usage for SMBs
Posted by Lindy Antonelli
In a recent study of 3,000 SMBs in 13 countries, Microsoft found that cloud usage is surging, thereby leveling the playing field for small and midsize businesses. Marco Limena, vice president, Operator Channels, Microsoft, stated, “Gone are the days of large enterprises holding the keys to enterprise-class IT and services. The cloud levels the playing field for SMBs, helping them compete in today’s quickly changing business environment, by spending less time and money on IT and more time focused on their most important priority — growing their businesses.”
Below you will find some key findings from the study including understanding of the cloud, motivators for moving to the cloud, concerns about moving to the cloud, and usage projections. For more information, read the entire Microsoft SMB Business in the Cloud 2012 Research Report.