Starting and growing a business requires leveraging the resources you have on hand. Often a new or rapidly growing company can’t afford to pay high salaries for great employees, so this is where Stock Option Incentive Programs can help. By using Incentive and Non-Qualified Plans, the corporation is able to provide a more attractive compensation package in situations where salaries may be below market rates. This enables key employees to share in the ownership, and, therefore, the upside value that gets created as sales and profits grow.

Taking a few minutes to get an independent, reasonable, and consistent view of your company’s value is essential for the implementation of such an equity incentive program. But many companies give little thought to the actual market value of their company when they promise or award employee equity-related incentives – and that can lead to significant problems down the road.

Why Is It Essential to Start with a Business Valuation?

Ascertaining a "reasonable" value for the company at the time incentives are created is fundamental because overvaluing or undervaluing the company – and therefore, the incentives – can create employee and management issues, as well as potential regulatory and legal problems down the road. Here are a few examples:

Overestimating Company Value

If the option incentives are overpriced (because the company value has been overestimated) at the time of the award, it makes it more difficult for the key employee to benefit.

Generally, a great deal of time and effort needs to be invested by employees in order for the true market value of their options to materialize. If the company is overvalued at the time of the option award, years could pass before the "true market" value of the company catches up with the value of the company as represented initially in the strike price of the incentive.

Employees who are relying on that initial estimated value for their long term incentive can gradually become demoralized as they realize the increase in company value they have been working hard to achieve is not likely to materialize for them. Similarly, if the options are overpriced, it makes it more difficult for the company to raise capital from investors.

The reason for this is that the same high corporate valuation that was attached to the incentive at the time of the award creates an established corporate valuation for every event that occurs thereafter. If options are awarded at an unrealistically high corporate value, then prospective investors will balk at using the same value for investment purposes.

This places the company in the uncomfortable position of either not being able to raise needed funds at the artificially high estimated value that was used for the incentive, or reducing the value of the company relative to the incentives that were previously awarded. If a new, lower value is forced upon the company in order to attract investment, then the employees who relied upon the more attractive valuation will see the value of their incentives reduced accordingly.

Underestimating Company Value

If the company is undervalued for the purposes of stock incentives, this creates a situation where key employees can unduly benefit at the expense of founders.

It also sets low valuation expectations for potential investors because it places owners in a situation where they must explain to investors why so much economic value (the new company value) has been created since the last valuation event in the incentive program. Professional investors can see this as a sign that the company is not realistic and perhaps is unprofessional in terms of their capital management or view of corporate valuation.

IRS Tax Implications for Corporate Valuation and Incentive Plans

Estimating company value in a haphazard way for the purposes of an employee incentive plan can also cause a potentially damaging situation with the Internal Revenue Service.

To comply with IRS Regulation IRC 409A, privately held companies need to estimate their valuations in order to arrive at the Fair Market Value (FMV) of their common stock and fix the exercise price of stock options. Failure to comply with the IRC 409A provisions can attract significant tax penalties.

Noncompliance with IRC 409a can lead to acceleration of taxable income, penalty taxes, company withholding tax issues, and potential legal exposure for board members. Company owners can help mitigate these issues by using reasonable valuation methodologies that are fair and consistent, or they can create a tax "Safe Harbor" by having an outside, qualified accountant or valuation specialist perform the business valuation for them.

The regulations state that for the IRS to accept a valuation of private company common stock, it must be done by "the reasonable application of any reasonable valuation method." Factors that the IRS states should be considered in the valuation in order for the valuation method to be considered reasonable include:

• The value of tangible and intangible assets of the corporation.
• The present value of future cash-flows.
• The market value of stock or equity interests in similar corporations and other companies engaged in trades or businesses substantially similar to those engaged in by the corporation being valued, the value of which can be determined by objective means (such as through trading prices on an established market or an amount paid in an arms-length private transaction).
• Other relevant factors, such as control premiums or discounts for lack of marketability and whether the valuation method is used for other purposes that have a material economic effect on the service recipient, its stockholders, or its creditors.

Because valuations conducted in compliance with IRS regulations should be updated every twelve months, it becomes obvious that, by taking the time to calculate a reasonable value for your business, and award incentives based on those calculations, management, owners, and employees will all benefit.

This article is not intended to be a complete tutorial on constructing Stock Equity Incentive Plans, nor does utilization of ValuSource’s business valuation service ensure compliance with IRS regulatory requirements. Many plans are complex and can require a variety of considerations, including classes of stock, options valuation methodologies, business objective integration, and capital structure review before equity incentives are actually awarded.

However, in all cases it is important to begin the evaluation process with a dispassionate view of the value of your business and related equity ownership. Recently introduced online business valuation services, such as those offered by ValuSource, can provide such a valuation baseline.

About the Author: Guy Cook is a Senior Partner at CreationWave, a consulting group focused on client growth and profitability results. He has held executive management positions at a number of high-tech, high-growth ventures, including CEO of SuperNet, which was sold to Qwest Communications for $24M. Mr. Cook thoroughly understands business valuation and currently consults with ValuSource.