New ventures go through stages as they progress toward an IPO or acquisition: the start up phase, the angel stage, the venture capital stage, the mezzanine or bridge stage, and finally, the exit event. The exit can take several forms, including an IPO or an acquisition by a publicly held company. During these stages of development, companies
typically issue common stock and stock options to employees.
When stock is issued, taxation is determined under Section 83 of the Internal Revenue Code. The general rule is that the value of the stock is ordinary income when all restrictions on the employee’s ability to receive or resell the stock have lapsed. This could be years after the grant of the stock award if, for example, the employee must work for the company for a few years before he is entitled to keep the stock or resell it. The stock could be nearly worthless now, but worth a significant amount later if the company succeeds.
Legal counsel usually recommends that the employee recipient file what’s known as an “83(b) election.” The election causes the employee to be taxed on the value of the stock when received, instead of later when the restrictions lapse. The value of the stock must be determined in accordance with the rules of that section. These rules generally require that any restrictions on the receipt or resale of the stock be ignored, except a restriction which by its terms will never lapse. Companies are wise to document the value of the stock for
Section 83 purposes with a written valuation report.
Stock options (excluding statutory plan options and ESPP shares) are taxed in accordance with a different set of rules. These rules are known as the “deferred compensation” rules of Section 409A. The rules can cause the inclusion in taxable, ordinary income of the value of the stock, even before exercise, as soon as all risks of forfeiture lapse. Typically, a ten-year option becomes exercisable after two years of continued employment, but the employee waits as long as possible after that before actually exercising. Nevertheless, Section 409A would tax the employee on the value of the stock at the two-year mark when his right to exercise and retain the stock vests. And furthermore, the continuing increase in value of the stock will also be taxed annually. And in addition to that, there is
a 20% tax penalty imposed.
There is an exception to the inclusion rule. If the exercise price of the option is at or above the fair market value of the stock at the date of grant, the stock option is excepted from the Section 409A rules. Thus, for start up companies as well as closely held companies issuing stock options to its employees, it is essential to document the value of
the stock subject to the option.
The company can perform its own value calculation, but if the IRS decides to challenge it, doing so leaves the burden of proof that the result is reasonable on the company. So it becomes an uphill battle from the start. The alternative is to hire a qualified appraiser to perform the valuation. A written appraisal by a qualified appraiser shifts the burden of proof to the IRS. This is an important advantage in the event of an audit.
The value is determined without regard to any restrictions that will lapse. The valuation must take into account the tangible and intangible assets of the company, projected cash flows, similar publicly traded companies, lack of control and lack of marketability, and all other factors affecting the value of the stock. The valuation methodologies used for compliance with generally accepted accounting principals are also applicable to Section
409A compliance.
The valuation is as of a day certain, but is applicable to all stock or option awards granted during the following twelve months, unless there an important event occurs that would affect the value of the company, i.e., another round of financing, achieving first revenue, an IPO, an offer to purchase.
Please contact us to discuss the valuation of your company’s common stock before implementing a stock or stock option award plan. The consequences of not addressing value are too ominous to ignore.
Getting Your Business Ready to Sell
Any good real estate agent will tell you that to get your home ready to sell you need to make improvements to the home’s “curb appeal” as well as fix any obvious flaws on the interior of the home. A selling agent can also provide pointers on how to do a lot of fixes for the least amount of money. For example, a coat of paint is relatively inexpensive but can provide immense returns when the time comes for a potential buyer to make an offer.
Selling a business is a much more complex process. At the risk of over-simplifying the issue, the following are some things to think about if you believe you will be selling your business:
Improve cash flow: A critical review of spending in the months leading up to marketing your business is a necessity. Buyers will want to know how much of the historical cash flow will carry over to them if they were to purchase the company. Normally, they will ask for, or prepare projected cash flows. A clean history assists the seller and buyer in easily determining the true cash flows of the company and, ultimately, cash flow is in many cases what the buyer will be willing to pay for. In other words, you will want to get family members off the payroll, don’t pay for personal expenses through the business, get family cars (and the related loan and insurance payments) and other non-business assets
off the balance sheet, etc.
Due diligence: The process of selling a company will involve “opening up the books” to the prospective buyer-or several potential buyers. Being prepared mentally for this exercise is important. But it is also important to have the relevant documents located and ready. These may include tax returns, historical financial statements, cash flow analysis and projections, business plans, lease agreements, long-term contracts, employment agreements, sales and marketing materials, compensation documentation, etc. And that is just the beginning. Depending on the circumstances of the company being sold there may be extensive site visits and source documentation review by a prospective buyer.
Having everything ready to go improves the “curb appeal” of a business.
Clean accounting: Just as a home should appear neat, clean, and orderly when it is up for sale, so should the accounting records of a business that is being sold. Prospective buyers, or their accountants, should be able to easily review the detail reporting in support of financial statement disclosures. Difficulties in reconciling the financial statements to supporting documentation increase the cost of the transaction and almost always results in a reduced offer price since buyers want to recoup their costs. More importantly, incomplete or haphazard accounting and financial reporting raises the possibility in buyers’ minds that there may be more risk associated with the proposed transaction than they originally thought. Buyers are not willing to pay as much for a riskier investment.
Protection: You should invest in the time of an attorney to guide you through the process. This is particularly true if your business involves trade secrets and/or a highly competitive industry. No prospective buyers should be allowed to roam through your corporate information without signing a non-disclosure agreement.
Know your value: Most home sellers have a very good idea what their home will sell for when they put it on the market. You might be surprised how many business owners attempt to sell their business with no real idea of what their business is worth. If you are contemplating a sale, understand in advance what the business is worth and what the tax ramifications of the sale will be. Retaining a business valuation expert to work with you, your attorney, and your CPA is a wise decision. Not only can the expert assist you in determining a fair price, he or she can alsoassist you in evaluating the taxramifications and the fairness of any offers that come in. You have likelyworked hard to build a business-great care should be taken to assure that the value you have built isunderstood prior to entering the emotion and stress of reviewing an actual offer.
Buy-Sell Agreements Between Business Partners
Businesses are often started by two or more people-with capital and personal effort from each owner. The partners trust each other implicitly and happily share the fruits of their joint undertaking. The business grows and becomes something of value. They envision that they will some day sell the business, retire and remain close friends forever. Unfortunately, things can happen to alter the course of this happy plan. Injury, sickness, disability or death may visit one of the partners. Some may come to believe that one of the partners is no longer pulling his weight. Any number of life’s changing circumstances may lead to one of the partners exiting the business early, either by choice or by force.
By the time these circumstances begin to develop, the aura of camaraderie evident at the formation of the union may have dissipated. Or even worse, the continuing partners suddenly find themselves with a new partner: the estate or widow of their former co-owner. A disagreement arises over the value of the business, the exiting partner’s share of that value, the terms of a buyout, and the right to compete. If only these issues had been dealt with while all the partners were healthy and contributing, there would be a road map to a successful resolution of the matter. They should have had a buy-sell agreement in place.
A well drafted buy-sell agreement will bind the co-owners to its terms. However, great care is needed to insure that it also binds the Internal Revenue Service in the event of a death. Arms length terms and pricing are essential to insure that the IRS accepts the transfer price as the value for the estate.
Imagine yourself on one side of this equation, and then on the other. What is fair and reasonable under each circumstance, and from each point of view? Then begin a dialogue with your partners about what should be done. We can help you design the plan. Here are the basic questions that need to be addressed:
- What circumstances will activate the buy-sell agreement?
- What is the current value of the business?
- How will the value of the business be determined in the future?
- As of what date will the company be valued?
- Should the exiting partner receive a pro rata share of the full fair value of the business, or should he receive the fair market value of his minority interest?
- Will the purchaser be the company or the co-owners?
- Will the agreement be funded with life insurance, and who will pay the premiums?
- How much can the company afford to pay up front (with life insurance and without)?
- What should be the term and interest rate for the balance of the buyout price?
- How will the deferred portion of the price be secured?
- What procedures should be set forth for dispute resolution?
Value for a buy-sell agreement is often determined by fixing it annually at the stockholders’ meeting. In this case it is critical that the value be updated every year, as a stale value will result in a windfall to one side, and a hardship to the other. An alternative is to require that a current valuation be performed whenever the buy-sell agreement is activated. If fixing the value annually is the best choice for your ownership group, it is nevertheless advisable to require a current valuation if the stockholders failed to update the fixed value at the last annual meeting.
Some businesses are conducive to valuation by formula. A properly designed formula will keep the value calculation up to date. The formula should be tested periodically to make sure it is still appropriate for the business, and includes the value of any non operating assets. All financial expressions used in the formula should be clearly defined. Many buy-sell agreements contain a “Russian Roulette” clause, which provides that any offer to purchase shares from a fellow owner is also an offer to sell shares at the same price. This clause is especially appropriate among two or three equal co-owners.
Call Ronald J. Adams, CPA, CVA, ABV, CBA, CFF, FVS, CGMA, at Foxboro Consulting Group, Inc. at (774) 719-2236; or e-mail us at: adams.r@foxboro-consulting.com for an appointment to help you design your buy-sell agreement in conjunction with your attorney.
